Investing in REITs for income and capital appreciation

By Markets Covestor

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Investing in commercial real estate can help allow individuals to participate in the recovery of the U.S. economy and property market while also granting the opportunity to earn decent income.

You don’t have to be a landlord or office owner to get exposure to this asset class. Real estate investment trusts (REITs) give investors liquid access to companies focused on retail, industrial, residential properties and other subsectors such as hotels and self-storage.

REITs can also help diversify a portfolio of U.S. stocks because of their lower correlation to the S&P 500.

“We use REITs for diversification, and the yield is a complementary benefit,” said Albert Gutierrez, a partner at Atlas Capital Advisors, which manages the Broad ETF portfolio on Covestor.

One of the portfolio holdings is Vanguard REIT ETF (VNQ), a fund that lets investors buy a basket of stocks rather than picking individual companies.

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To qualify for federal tax breaks, REITs are required to distribute 90% of their taxable income to investors via dividends. The ETF is now paying a 12-month yield of 3.9%, according to Morningstar, more than a full percentage point higher than the roughly 2.5% yield of 10-year Treasury notes.

Indeed, REITs have attracted income investors frustrated by low interest rates in bonds in recent years. Meanwhile, rock-bottom rates have allowed leveraged REITs to keep their financing costs low as the economy slowly recovers after the credit crisis.

However, investors looking to boost yield with REITs should remember the asset class behaves much differently than bonds.

Over the past three years, REITs were about 20% more volatile than the S&P 500, and six times more volatile than the aggregate U.S. bond market.* Looking ahead, the sector’s key risks include rising interest rates or a setback in the economic recovery. For example, REITs were hit hard during the credit crunch and have yet to recapture their 2007 peak.

Still, Vanguard REIT ETF (VNQ) has been a strong performer in the aftermath of the financial crisis with total returns that beat the S&P 500 in each of the last four calendar years, according to Morningstar performance data. The REIT fund is however trailing the S&P 500 in 2013 as interest rates move up. There are also concerns that real estate stocks could cool after outperforming the market in recent years.

However, Gutierrez at Atlas Capital Advisors said REITs still look attractive based on cap rates,which are closely equivalent to the income a property generates divided by the value of the property.

“We have a commonsense perspective on REITs, which can’t distribute to investors what they don’t have. When REIT cap rates and dividend yields are much greater than rates on 10-year Treasury notes, that’s an attractive metric to see,” he said.

The bottom line is that investors willing to take on more risk can earn extra income with REITs as long as they remember they’re investing in a basket of real estate stocks that can be much more volatile than bonds.

VNQ data by YCharts

*Morningstar analyst report on Vanguard REIT ETF (VNQ) dated June 11, 2013.

Photo Credit: swisscan

DISCLAIMER: The investments discussed are held in client accounts as of September 30, 2013. These investments may or may not be currently held in client accounts. Real Estate Investment Trusts (REITs) are subject to various risks such as illiquidity, real estate market conditions and the product’s fees will impact total performance. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.