Bogleheads® Wiki 2016 annual report

REITs were created from a law that Congress enacted in 1960 to enable small investors to invest in real estate without either the large capital required to purchase single properties, or the responsibilities of property maintenance on a direct realty purchase. When holding shares of an equity REIT, an investor is an actual owner of the underlying real estate.

REITs receive special tax treatment--the deduction of dividend payments on their corporate income taxes-- as long as the primary purpose of the company is to own real estate and it pays out 90% of its dividend income (rental income or mortgage interest) each year to shareholders. The special tax treatment REIT dividends receive means that they are deemed non-qualified dividends for the investor (ie. not subject to the lower "qualified" dividend tax rate granted to firms subject to double taxation). This makes REITs very tax-inefficient, and best held in tax-deferred accounts. If an investor has filled up available tax-advantaged space with bonds and wants to invest in REITs, placing them in a low-cost variable annuity or a non-deductible Traditional IRA is usually more tax efficient than holding them in a taxable account. Alternately, an investor can also switch taxable bonds held in tax-advantaged accounts for REIT held in tax-advantaged and adding municipal bonds held in taxable accounts.

Types of REITs
REITs are typically characterized by the nature of the assets the company holds: real estate, mortgages, or a combination of the two.
 * Equity REITs: own physical real estate and are traded on a public stock exchange. This makes REITs very liquid unlike owning real estate on your own. Equity REITS make up over 80% of the U.S. REIT market, and include the following sectors:
 * Diversified REITs: own a diverse group of properties not tied to any specific sector or industry.
 * Industrial REITs: own industrial real estate, ie. used for industry manufacturing.
 * Office REITs: REITs that own office buildings or other similar property.
 * Residential REITs: REITs that invest in residential real estate, such as apartment complexes.
 * Retail REITs: REITs that invest primarily in retail properties such as shopping malls.
 * Specialized REITs: own property that is specialized in a single use (such as lodging or storage).


 * Mortgage REITs: Invest primarily in mortgages backed by commercial real estate, and the earnings are from the mortgage loans.
 * Hybrid REITs: REITs that invest in both property ownership and mortgages.
 * Private REITs: Private (non-traded) REITs are not traded on a public stock exchange, and are very illiquid. These are often sold by financial advisors who receive large commissions, an indication that they are not looking out for your best interest, and are designed to be sold and not bought.

Valuation of REITs
REITs are typically valued using two factors: yield, and premium (discount) to NAV.

Dividend yield
A REIT's yield is calculated exactly as stocks and is expressed as an amount of dividends (in percent) a REIT will pay investors.


 * $$\mbox{Dividend yield}=\frac{\mbox{dividend per share}}{\mbox{price per share}}$$

Unlike a bond's Yield-to-Maturity (YTM), there is no presumption that capital, i.e. NAV, will be returned to investors in that equation (the redemption of a bond).

With common stocks, company boards decide how much of Earnings Per Share are to be paid out as Dividends Per Share. This can cover a large range, as many pay no dividends at all, but Dividends Per Share may typically range from 1.5 to 3 times Earnings Per Share.

With REITs, Earnings Per Share are not an accurate measure of a REIT's performance. Investment analysts usually use an adjustment to earnings known as Funds From Operations (FFO) as a more accurate measure of an equity REIT's profitability and capacity to pay dividends.

US tax laws require essentially a payout of 90% of GAAP (Generally Accepted Accounting Principle) taxable income, so "adjusted" Earnings Per Share and Dividends Per Share are closely aligned. Therefore, it is appropriate to value the REIT on a dividend yield basis.

For example: A REIT has a share price of $100. The total dividend for the REIT is expected to be $3.00 over the next 12 months. The REIT is therefore said to be trading at a prospective dividend yield of 3/100 or 3%.

Average premium (discount) to NAV
A REIT's Net Asset Value is calculated as:


 * $$\mbox{NAV per share}=\frac{\mbox{gross value of buildings}-\mbox{debt}}{\mbox{number of shares}}$$

Debt is taken deducting any cash that is on the REIT balance sheet.

The quoted price of a REIT, which trades like any stock, can differ from NAV. Historically, when the market is bullish about future Commercial Real Estate values, stocks move to a premium to NAV. This is also true if there is a lot of takeover activity in the REIT sector. In essence, investors are expecting NAVs to rise. The discounts are quite analogous to closed end funds, which normally trade at a discount to the value of their underlying investments.

Green Street Advisers publishes graphs showing estimated average premium (discount) to NAV. The premium (discount) to NAV has ranged from over 30% premium to 40% discount over time.

Dividend composition
REIT dividends are composed of three different types of yield income, which are taxed at different rates:
 * Return of Capital: This is a return of your own investment and is not taxed upon distribution, it reduces your cost basis by the amount of the dividend.
 * Capital Gain: Results from sale of properties or other assets, taxed at either short or long term capital gains rates.
 * Dividend: Income which usually results from rental income of properties, which is non-qualified and taxed at your full marginal tax rate.

The exact breakdown of the REIT fund dividends are not known until after the calendar year, sometimes as late as late February or early March. Beware of this if you hold REIT in a taxable account.

Composition of MSCI REIT index
Below is a table of a percentage breakdown of the different types of REITs in the MSCI REIT Index.

Interest rate risk
REIT prices may decline as the interest rate rises.

Sector risk
REITs are one specific sector, there are only 97 stocks in the MSCI REIT index. This makes REITs more volatile than broad market index funds. Some suggest that public REITs are only a small slice of the commercial real estate market, and best referred to as a separate asset class than a sector.

Role in a portfolio
Most Bogleheads allocate REITs up to 10% of their total portfolio according to a forum poll. David Swensen, CIO of Yale University and author of Unconventional Success suggests a 20% allocation to equity REITs in his model portfolio for individual investors. REITs should be treated as equity, even though they have income-producing characteristics similar to bonds, due to the risks involved. REITs can act as a portfolio diversifier since they have varying correlation to stocks and bonds (either higher or lower). REITs are weakly correlated to inflation, due to the hard asset/rental income nature of the investment, however if you are looking specifically for inflation protection, use TIPS instead. For investors using a portfolio of Vanguard market based or style based index funds, one should consider what Percentages of REITs Present in Vanguard Index Funds these funds already own before adding a separate REIT fund.

Funds
Indexed portfolios of equity REITs are available as both mutual funds and exchange traded funds. Fidelity and Vanguard offer low cost REIT index mutual funds. Ishares, Schwab, Guggenheim, State Street Global Advisors, and Vanguard offer equity REIT exchange traded funds.

Forum discussions

 * The Core Four is a good forum discussion thread regarding the inclusion of REITs in a portfolio.
 * How Would Mr.Bogle Calculate Expected REIT Returns?