Do the REIT Thing

If you’re looking to diversify your portfolio, a real estate investment trust, or REIT, is one way to invest in the housing and commercial real estate market without purchasing property outright.

REITs are essentially corporations that own and manage a collection of real estate properties and mortgages. They trade on public exchanges the same way most stocks do. In short, when you own a REIT, you gain the benefit of owning real estate even if you don’t have money to purchase property or time to manage and maintain it. Why invest in a REIT instead of real estate? First, a REIT has the advantage of being more liquid than property, which means you can sell it quicker and easier than a house or parcel of land. Also, REITs are generally made up of diverse real estate holdings; there’s often more risk involved in banking on the prospects of a single piece of property.

Here’s how REITs work: A real estate group borrows money to invest in and maintain properties. In order to be considered a “real estate investment trust” by regulators, the trust must pay out 95% of its earnings in the form of dividends to shareholders. The average REIT yields about 4% today while REIT mutual funds average slightly less. Still, that return is better than the yield on most CDs, money market mutual funds, and five-year Treasury bonds. In general, REITs are popular among investors who like stocks that generate dividends.

REITs offer portfolio diversification because, historically speaking, they do not move in tandem with volatile stocks. That so-called “low correlation” with stocks can help counter the effects of up-and-down periods of equities markets. REITs behave differently from stocks for a few reasons, according to Jeffrey Feldman and Andrew Hyman, authors of Three Paths to Profitable Investing (FT Press; $34.99). First, landlords, unlike corporate executives, aren’t in the business of creating new technologies, lines of business, or services. So their business is thought of as less risky than others. Also, the long-term nature of leases means that rents are more stable than corporate earnings.

As you might expect, REITs dropped in value drastically during the 2008 market crash. That year, Vanguard’s REIT index fund (VGSIX) plummeted 42%. They’ve rebounded, however, with considerable strength. If buying into a REIT in the midst of a real estate crisis gives you pause, consider this: The Vanguard REIT index fund rose 16.5% during the first nine months of 2010. At the same time, the First Trust S&P REIT Index exchange-traded fund (FRI) grew nearly 18%. Meanwhile, the S&P 500 lost almost 1% over the same period. REITs may continue to outperform financial markets as a whole for years to come, as real estate agents fill vacancies in shopping malls, apartment buildings, and office parks, and as rents and real estate prices begin to stabilize.

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