Are REITs riskier than stocks?
I don’t think so.
Real Estate Investment Trusts (REITs) and stocks are popular investment options, but there are often debates on whether REITs are riskier than stocks. REITs represent an ownership stake in a company that owns and manages real estate properties or mortgages, while stocks are shares of individual companies.
Both investments involve varying levels of risk.
REITs are exposed to real estate market fluctuations, while stocks are subject to broader market trends and individual company performance.
- REITs and stocks come with distinct risk factors influenced by factors like market fluctuations and individual performance.
- Diversified portfolios include both REITs and stocks to balance risk and return expectations.
- Taxes and income potential also play a role in determining these investment options’ risk and reward profiles.
What are REITs?
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate.
REITs allow investors to invest in a diversified portfolio of commercial real estate assets, including office buildings, shopping centers, hotels, and apartment complexes. By pooling the capital of multiple investors, REITs allow individuals to invest in large-scale properties that would otherwise be difficult to access.
REITs are structured as trusts and must meet specific regulatory requirements to maintain this status. For example, they must invest at least 75% of their total assets in real estate and distribute at least 90% of their taxable income to investors as dividends. This income distribution requirement results in consistent and attractive income streams for shareholders.
Investing in publicly traded REITs is similar to investing in stocks of publicly traded companies. Shares of REITs are listed on major stock exchanges, making it simple for investors to buy and sell shares. (You do need a brokerage account).
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This provides liquidity and the potential for capital appreciation, as share prices can increase over time.
There are different types of REITs, including:
- Equity REITs: These REITs own and manage income-producing real estate properties. They primarily generate income by collecting rent from tenants and then distributing it to investors as dividends.
- Mortgage REITs: These REITs lend money to real estate owners and operators or invest in existing mortgage-backed securities. They generate income mainly through interest payments on the loans they provide or by investing in mortgage securities.
- Hybrid REITs: A combination of both equity and mortgage REITs, hybrid REITs invest in income-producing properties and mortgages or mortgage-backed securities.
In summary, REITs are an investment vehicle that allows people to invest in a diversified portfolio of income-producing real estate assets, providing an attractive income stream and potential capital appreciation. They are traded on stock exchanges like traditional stocks, offering investors liquidity and access to the real estate market.
What are Stocks?
Stocks represent a share of ownership in a company.
When investors purchase a company’s stocks, they essentially buy a part of that company, therefore acquiring equity.
In doing so, they can profit from the company’s success and potentially earn dividends in the form of cash payments, often paid quarterly.
Several types of stocks are available in the market, including common and preferred stocks.
Common stockholders are at the forefront of corporate ownership, having voting rights at shareholder meetings and the potential to receive dividends. Although preferred stockholders typically do not have voting rights, they have a higher claim on the company’s assets and earnings regarding dividend payments and in liquidation cases.
One popular benchmark for gauging the performance of stocks is the S&P 500, which includes 500 of the largest publicly traded companies in the United States. As a result, this index is frequently used as a guide to assess the overall health of the stock market and the US economy.
Investing in stocks offers the potential for significant returns but can also be volatile.
The stock market is subject to fluctuations as it reacts to external events, economic conditions, and market sentiments. Investors must consider their risk tolerance and investment horizons when participating in the stock market.
By diversifying their investment portfolios, investors can mitigate some risks associated with stock investments.
A well-balanced portfolio includes a mix of assets, such as stocks, bonds, REITs (real estate investment trusts), and other investment vehicles. By diversifying, investors aim to balance riskier, potentially high-reward investments like stocks and safer, more stable assets.
Risk Factors in REITs vs. Stocks
REITs and stocks tend to have different levels of volatility.
In general, most REITs are less volatile than the S&P 500. This is because REITs are backed by real estate assets, which are more stable than stocks in the volatile equity market. However, this can vary depending on the type of REIT and its sector exposure. For example, mortgage REITs, which invest in mortgage-backed securities, can exhibit higher volatility due to their sensitivity to changes in interest rates.
Stocks are typically subject to greater fluctuations in price due to various factors, including market sentiment, company performance, and macroeconomic events.
Interest Rate Risk
Both REITs and stocks can be affected by changes in interest rates.
However, the impact of interest rate risk on REITs can be more pronounced, particularly for mortgage REITs. As interest rates rise, the cost of borrowing increases, which can negatively affect the profitability and dividend payments of these REITs. In the case of equity REITs, the risk may be somewhat mitigated by the ability to adjust lease rates and maintain occupancy.
For stocks, higher interest rates can have an indirect effect by increasing borrowing costs for companies. This may lead to lower investment, reduced profitability, and the potential for slower economic growth, which can negatively impact stock prices.
During market downturns, both REITs and stocks can be negatively affected.
Similarly, stock market downturns can lead to decreased company valuations, reduced investor confidence, and decreased stock prices. However, the extent of the decline may vary depending on the sector the stock belongs to and the company’s specific characteristics.
Liquidity can vary significantly between REITs and stocks.
Publicly traded REITs and stocks traded on major exchanges tend to have higher liquidity, allowing investors to enter and exit positions more easily.
However, non-traded REITs (which I avoid) can have lower liquidity due to their lack of listing on an exchange. This can make them more difficult to sell at a desirable price, particularly in times of market stress.
Exchange-traded funds (ETFs) can provide a more liquid alternative for investors who want to gain exposure to the real estate market or a diversified portfolio of stocks.
Diversification and Portfolio Allocation
A well-diversified portfolio typically includes a mix of different investment categories, such as stocks, bonds, and real estate.
Real estate investments can take various forms, including Real Estate Investment Trusts (REITs) which hold income-producing properties or mortgage-backed securities. Equity investments, on the other hand, represent ownership in individual companies through stocks.
Diversification aims to reduce risk and enhance returns by spreading investments across various asset classes.
Portfolio Allocation Strategies
Portfolio allocation strategies involve determining the appropriate mix of investment categories based on an investor’s financial goals, risk tolerance, and investment horizon.
For example, younger investors with a high-risk appetite and a long investment horizon may allocate more to stocks and REITs, while conservative investors nearing retirement may prioritize bonds and other fixed-income securities.
A well-diversified portfolio can help achieve the desired balance between risk and reward.
Role of REITs and Stocks in Personalization and Control
Both REITs and stocks offer a certain degree of personalization and control for investors.
REITs allow investors to gain exposure to a diversified pool of properties without managing them directly (which is a full-time job). They also provide a regular income stream through dividends.
Stocks, in contrast, offer the opportunity to participate in the growth of individual companies and potentially accumulate capital gains over time (in addition to dividends).
The choice between REITs and stocks depends on the investor’s goals, risk tolerance, and preferences.
Comparison of REITs vs. Stocks in Diversification
Regarding diversification, REITs and stocks both have their merits.
REITs are considered less volatile than individual stocks because their underlying assets are diversified across multiple tangible properties. Realty Income (O) has over 5000 individual properties in its portfolio.
Studies have shown that REITs are still closely correlated with the broader stock market, suggesting that they may offer limited diversification benefits. It is essential to consider the specific types of REITs or stocks being analyzed, as certain sectors may have unique risk characteristics.
Allocating a portion of the portfolio to REITs is recommended by some studies, with suggested allocations ranging from 5% to 15%. I typically have about a 25% allocation to REITs.
Combining REITs with stocks in a portfolio can offer a decent risk-return profile over time, but investors need to be prepared for potential fluctuations during market downturns.
Income and Taxation Factors
REITs can provide investors with a stable source of income, mainly derived from their dividend payments.
Remember that REITs are required by law to distribute at least 90% of their taxable income as dividends to shareholders, resulting in higher dividend yields than most stocks. This characteristic makes REITs particularly attractive for income-seeking investors, such as retirees, who search for consistent cash flows.
The nature of the dividend income from REITs differs from that of regular stocks.
REIT dividends are often considered ordinary income for tax purposes rather than qualified dividend income, typically taxed at a lower rate.
Capital gains occur when an investor sells their shares in a REIT or stock for a higher price than the original purchase price.
In the case of REITs, share price appreciation can result from improvements in the real estate market or through the effective management of the underlying properties.
Stocks generally see capital gains through increased revenue and growth in the overall company valuation.
While both REITs and stocks can provide investors with capital gains, their historical performance has shown that they have outperformed stocks on 20-to-50-year horizons and in the latest full year of data (2021).
Investors should also consider the reduced volatility, as most REITs are less volatile than the S&P 500.
The taxation of dividend income and capital gains from REITs and stocks differs, affecting the overall return on investment.
As mentioned above, REIT dividends are generally taxed as ordinary income, subject to the individual’s federal income tax rates. Some portion of the dividends may also be classified as capital gains or return of capital, resulting in different tax implications.
Qualified dividend income from stocks is typically taxed at a lower rate.
Capital gains from stocks are subject to capital gains tax rates, with long-term capital gains being taxed at lower rates than short-term capital gains.
Types of Properties and Industries
Commercial and Industrial Properties
REITs allow investors to diversify their portfolios with various types of properties and industries.
One key area is commercial and industrial properties, including office buildings and business parks. These properties generate rental income from tenants who operate businesses and require space for operations.
Industrial properties, such as warehouses and distribution centers, are also important components in a diversified portfolio.
Another category within REITs is residential properties.
These investments focus on apartment complexes and multi-family housing units, providing rental income from the properties’ residents.
Investors can diversify within this category by focusing on various segments, such as luxury, affordable, or student housing.
Healthcare and Self-Storage Facilities
Healthcare-focused REITs invest in various healthcare facilities, including hospitals, medical office buildings, and senior housing communities.
These properties cater to the growing demand for healthcare services and can offer stable returns due to the essential nature of the industry.
Self-storage facility REITs invest in storage properties where individuals and businesses store their belongings.
The self-storage industry caters to various needs, including downsizing, moving, and excess inventory storage. This sub-sector has shown resilience during economic downturns, making it an attractive option for investors.
Hospitality and Public Storage
Hospitality REITs invest in hotels and other lodging properties such as resorts, motels, and serviced apartments.
These investments benefit from tourism growth and business travel but may also be affected by economic cycles and changing consumer preferences. When investing in this sub-sector, investors must consider location, brand strength, and management quality.
Public storage REITs focus on large-scale, high-quality storage facilities catering to commercial and industrial clients. These properties benefit from the increasing demand for storage space due to business growth and inventory management needs.
Frequently Asked Questions
How do REITs compare to stocks in terms of returns?
REITs and stocks offer the potential for growth and income, but their performance can vary based on market conditions and the specific investment.
Generally, REITs tend to provide higher dividend yields than stocks, which can be attractive for income-seeking investors. They have also outperformed stocks over the years.
Stocks MAY provide greater capital appreciation potential over the long term.
What factors make REITs more or less risky than stocks?
Factors that can influence the risk of REITs compared to stocks include the state of the real estate market, interest rate fluctuations, and the management quality of the underlying properties. (Focus on internally managed REITs).
While some investors may perceive REITs as riskier due to their vulnerability in certain financial crises, it’s crucial to evaluate each REIT or stock based on its own unique characteristics and risks to determine a suitable investment strategy.
What are the downsides of investing in REITs?
Some potential downsides of investing in REITs include exposure to fluctuations in the real estate market, vulnerability to interest rate changes, and increased regulations and taxes compared to traditional stocks.
Also, since REITs are traded on the stock market, they may experience price volatility similar to equity investments.
How does REIT performance compare to the S&P 500?
REIT performance can vary widely, with some outperforming and others underperforming the S&P 500, which is an index of the 500 largest publicly traded companies in the U.S.
The comparison between REITs and the S&P 500 will depend on the specific time frame and market conditions being analyzed. No one has a crystal ball and can tell the future.
What is the historical return on REITs?
Historically, REITs have delivered competitive return profiles when compared to other equity investments, especially in the long term.
While past performance doesn’t guarantee future results, it’s helpful to consider the historical track record of an investment class when making allocation decisions.
Are REITs Riskier than Stocks? Final Thoughts
So, are REITs riskier than stocks?
I don’t think so.
REITs have outperformed stocks on 20-to-50-year horizons and tend to be less volatile than the S&P 500.
REITs are focused on the real estate industry and provide a reliable TANGIBLE investment, with real estate being a necessity. Their long-term growth and dividend yields deliver a better hedge against inflation than many stocks.
I define an investment as something that pays me money while owning it.
That said, stating that one asset class is riskier than the other is an oversimplification. You can buy a high-risk mortgage REIT, lose principal, and buy a high-growth stock that triples in value.
It is not a stock market. It is a market of stocks.
You need to pick good ones.