Advancements in healthcare are allowing retirees to be more active and live well into their late 80s or longer. That means retirement income is becoming increasingly important for aging retirees. While traditional income vehicles like CDs (a Certificate of Deposit or conservative savings account with a high interest rate and penalty for withdrawal) and bonds can help, financial advisors are increasingly looking for other sources of income to help bridge retirement income gaps.
One alternative that has been gaining the attention of advisors and investors alike is the real estate investment trust, or REIT. The average daily dollar trading volume for REITs continues to increase over time, from $2.9 billion in July 2009, to $4.6 billion in July 2014 and $6.6 billion in July 2019. REIT income offers six distinctive advantages to those looking for a retirement income strategy that is likely to weather the ups and downs of both the stock market and changing life circumstances.
[Editor’s Note: It’s important to note that despite being a well-regarded option for investing in a down market, there are still risks associated with REITs, such as adverse effects from low real estate prices, a lack of liquidity (they cannot always be sold on the public market, though some public REITs are available), and (if not publicly traded) difficulty determining value of a single share and/or the value of the overall investment. Other factors to consider are that dividends may be paid from offering proceeds and borrowings which can reduce share value and limit the company’s future asset purchases, and that use of external managers poses a risk of conflict of interest.]
Created by Congress in 1960, REITs give investors the opportunity to invest in income-producing real estate through pooled portfolios of securities modeled after mutual funds. In other words, you are investing in a professionally managed group of properties.
REITs can include actual land, as well as apartments, offices or hotels that generate income through the collection of rent. They may also include mortgages or mortgage securities tied to the properties. REITs provide investors with access to diverse portfolios of income-producing assets they would not be able to afford on their own.
Listed REITs are prominent in today’s investment landscape. They are included in 225,000 401(k) plans, and more than 80 million individuals are invested in REITs through these and other investment plans. There are more than 200 mutual funds and ETFs dedicated to stock exchange-listed REITs sponsored by major investment management firms. Additionally, REITs are in a majority of target-date funds, most pension fund and endowment portfolios, and one of the fastest-growing retail investment default options.
For investors looking for a retirement income-producing asset that’s as familiar as an investment “next door,” there are six good reasons to diversify your portfolio with REITs.
Even at relatively low levels, the cumulative effects of inflation over long periods can erode the purchasing power of portfolio assets. The dilemma for retirees is that it can be tough to stay ahead of inflation with fixed income securities while equities are trimmed back to reduce investment risk.
“Across all generations, individuals tend to create their retirement nest egg during their prime earning years based on long-term growth and accumulation strategies,” says financial planner Patrick W. McKeon JD, CFP®. “Then, they gradually switch toward more conservative, income-oriented approaches as retirement day draws closer.”
According to NAREIT, the national REIT trade group, REITs offer a form of inflation resistance, because commercial real estate rents and values tend to increase when prices do.
This, in turn, supports equity REIT dividend growth, which can then provide retirement investors with reliable income even during inflationary periods.
A look at the long-term track record for REITs, as measured by the FTSE NAREIT All Equity REITs Index, shows how well this class of investments performed as a hedge against inflation. REITs have proven to be more inflation-resistant than the S&P 500 Index and Barclays Capital U.S. Aggregate Index for the six-month rolling periods from December 31, 1975 through December 31, 2018.
Beyond yields, however, a major benefit of REITs is their requirement to distribute most of their taxable income — at least 90% — annually to their shareholders as dividends. On average, 70% of the annual dividends paid by REITs qualify as ordinary taxable income, 15% qualify as return of capital and 16% qualify as long-term capital gains.
Most income distributed from REITs is taxed as ordinary income, rather than as dividend income. Like mutual funds, REITs are able to deduct from their corporate tax liability the amount they pay out as dividends. Shareholders pay tax on the dividend income they receive, generally at ordinary income tax rates.
For a 65-year-old married couple, the probability that at least one will reach 92 is 60%. That means that in addition to income, an investment will need to deliver an attractive level of risk-adjusted return. According to recent performance numbers from JP Morgan, REITs outperformed gold, oil, the S&P 500, bonds, the EAFE index and inflation for the 20 years ending December 31, 2018 on an annualized basis.
Portfolio diversification is arguably one of the most important ways investors can temper risk. In fact, REIT investors share an advantage with other real estate investors: the ability to hedge against national and even international market risks.
The long-term correlations of equity REITs with other asset classes range from a low of -0.28 to a high of 0.76. Negatively correlated to currency prices, REITs have only a 30% correlation to bond prices and a 71% correlation to domestic large cap equities.
REITs can provide tax-deferred income as a result of the depreciation of a property or a portfolio of properties. The greater the amount of depreciation expense, the more likely it is that the taxable portion of distributions made by the REIT will decrease. In order to capitalize on this potential tax benefit, it is important to understand the two classifications of distributions:
With so many pre-retirees searching for new ways to diversify their income beyond traditional investments, a REIT may be the right complement to a portfolio..
According to Paul D. McConville, President of Quincy Capital Partners, LLC, “Self-directed IRAs in invested alternatives like REITs may also provide a way for investors to diversify a portfolio beyond traditional equity, bond and mutual fund choices.”
In effect, with a self-directed IRA, investors and advisors may gain a wider scope of action for how, when and where to invest retirement assets. When combined with a self-directed IRA, the tax advantages of a REIT can be dramatic. Through a self-directed IRA, a REIT can grow dividends and capital gains on a tax-deferred basis. Taxes are paid on proceeds once they are distributed to an investor.
While listed equity REITs are an investment in real estate, they also are stocks, which means their prices may rise or fall. Additionally, commercial real estate is a cyclical business with cycles that differ from those of other equities. Changes in the values of the property portfolios owned by listed equity REITs affect the valuation of their shares. Like every other investment strategy, there is no substitute for a close examination of a REIT’s underlying prospectus.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Real Estate Through Equity Crowdfunding, Investing in Residential & Multi-Family Real Estate and Investing in Commercial Property.]
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