A Real Estate Investment Trust (REIT) is a trust that makes money from income-generating real estate. You can think of it as the real estate version of a mutual fund. There are also index funds of REITs that allow you to own a low-fee, broadly-diversified portfolio of REITs (and therefore of real estate) similar to the way you can own stocks or bonds via index funds. Vanguard’s VNQ is an example of a REIT index fund.
How do REITs work?
You can read more here, but in short, REITs finance, lease, or own real estate, and distribute any profits as dividends to investors. Many REITs trade like stocks or (when bundled together) like mutual funds. They essentially have to pay out the bulk (90%) of their income each year to shareholders, hence why their income generation is high relative to investments like stocks that are not required to distribute income.
How are REITs taxed?
REIT dividends are taxed at regular income rates
One negative aspect of REITs is that instead of their dividends being ‘qualified’ for long-term capital gains rates on shares held for a while (like stock funds), the income is taxed at regular income tax rates (same as for bond funds, or bank interest.)
Per the Tax Cuts and Jobs Act of 2017, you might get some of that back in the form of the 20% QBI deduction. Say your tax bracket is 24%. 20% off that equals an effective rate on REIT dividends of 21.6%, which is still higher than the 15% long-term capital gains/qualified dividend bracket that you’d be in for stocks you’ve held for over 60 days.
Because of the higher income generation of REITs vs stocks combined with the dividends being taxed at regular rates, you probably want to have REITs in your retirement/tax-advantaged accounts, and have more stocks in your taxable funds to balance out whatever asset allocation you’re going for.
Other forms of (non-dividend) REIT income
You can also have capital gains (long-term or short-term) from REITs that are taxed the same way as capital gains generally (e.g.: for stocks), as well as ‘return of capital’ distributions which would lower your cost basis at the time of sale. These forms of income seem to be rare for most publicly-traded REITs.
How have REITs performed vs stocks or bonds?
Trying to use past returns to predict the future is often a fool’s errand for financial markets, but the longer back you look at broad asset classes the more helpful it probably is.
For Vanguard’s REIT fund (our proxy for the REIT sector), the results are not very favorable compared to the total US stock market (light blue line below) or even an overall US bond fund (Vanguard’s BND, the yellow line) given that the bond fund was MUCH less volatile compared to the REIT fund, despite price appreciation that was only slightly less over the ~16 year period that I could get data for (when all 3 funds were in existence together.)
I should note that this chart from Yahoo! Finance understates the total returns for both the bond fund and the REIT relative to the stock fund (VTI) since the dividends in those funds were likely higher than those from the stock fund, and reinvested dividends aren’t shown in this chart, just the total (capital gain) return.
Even so, I doubt it would make enough difference to change the conclusions: Y-charts shows 5-year total returns of 35% for VNQ vs 13% shown over the same 5-year period in Yahoo! Finance due just to price movement, so any extra ~4-5% per year isn’t shown. VTI probably had dividends of about 1.5-2% per year during the past 10 years, so REITs’ should have an extra ~30-40% of absolute return tacked on relative to VTI.
Yahoo has 3-year trailing total returns (as of 1/12/2023), and these showed 0.60% per year for VNQ (REITs), 7.40% for VTI, and -2.33% for BND (the negative returns were due to interest rates rising somewhat dramatically– compared to recent history of very low interest rates– in the past year or two.)
Should I have REITs in my portfolio?
I don’t see any reason to. No past data of returns & risk/volatility will ever be ‘conclusive’, but the long-run returns of real estate vs stocks helps cement my belief that individual investors can prudently ignore REITs and just use a mix of stock and bond index funds (with cash for needs in the next year) for their portfolios.
You have real estate exposure already
Most investors already have significant exposure to real estate in the form of a personal residence, which is another reason to skip REITs. (Yes, I know, your single residential property isn’t the same thing as a basket of many commercial properties, but you’ll still be impacted by national real estate trends on top of local market conditions.)
Businesses like those owned via the total US stock market also have commercial real estate in the form of office, retail, and manufacturing space, so you have some exposure to commercial real estate already through stocks.
Keep it simple and skip REITs. Stick to my recommendation of just bonds & stocks in the form of low-fee, diversified index funds. But, if you really want to own real estate as part of your financial portfolio, use a low-fee REIT index fund like those from Vanguard.