For decades, when investment advisors talked about “diversifying your portfolio to include real estate,” they typically meant adding REITs to your stock portfolio.
Don’t get me wrong, real estate investment trusts (REITs) have their advantages. They’re extremely liquid and easy to buy or sell with the click of a button in your existing brokerage account. And you can invest for the cost of a single share, which could mean investing $15 instead of $50,000.
But do publicly-traded REITs offer true diversification from the stock market at large? Perhaps not as much as you’d like to think.
What are REITs?
Real estate investment trusts are companies that either own real estate investments or loans secured by real estate. In fact, to qualify as a REIT under IRS code, the company must earn at least 75% of its gross income from real estate in some way, and at least 75% of its assets must be real estate-related, among other more technical requirements.
As the names suggest, equity REITs own properties directly, and mortgage REITs own debts secured by real property. Hybrid REITs own both.
REITs typically specialize in one real estate niche. For example, a REIT might focus exclusively on self-storage facilities, or on multifamily properties in gateway cities, or a hundred other niches.
Some real estate crowdfunding companies offer private REITs sold directly to investors. But most REITs trade on public stock exchanges.
That subjects them to the same volatility and violent mood swings as the stock market at large. Prices can crash in a single day, even if the underlying real estate assets haven’t budged in value. But we’re getting ahead of ourselves.
REIT Rules
As outlined above, companies must earn the overwhelming majority of their income from real estate to qualify as a REIT.
REITs must also pay out at least 90% of their taxable income in the form of dividends. In practical terms, that means they usually pay high…