How to Add a Real Asset to your Portfolio

Real estate investments should have a presence of some size in nearly everyone’s portfolio. As an asset class, real estate offers an alternative to U.S. and foreign developed stock markets. It’s considered to be a cyclical asset class, like stocks, in that its values rise and fall with the growth of the economy.

Like bonds, though, real estate values don’t always rise and fall in lockstep with those of equities. This lack of correlation can enhance long-term growth and reduce risk in a portfolio.

There are lots of ways to invest in real estate. Most of us own homes, and although a personal residence is considered to be a personal asset rather than an investment asset, a home does offer the possibility of appreciation – and, as we found out during the financial crisis, the possibility of loss.

Beyond a home, investors who are comfortable with being a landlord and who have sufficient funds (and credit) can buy residential, commercial or industrial rental properties. Such assets offer the possibility of gains as well as current income with some tax benefits.

Most of us, though, are best served buying real estate through investment pools that offer broad diversification as well as professional management. These are real estate investment trusts or funds that buy such stocks.

By law, and to avoid double taxation of income, a REIT must pay out 95% of its net profits. This, plus the fact that the payouts for most REITs and REIT funds are fairly stable, makes REITs a nice choice for retirees seeking current income.

The average 12-month yield on 29 global and domestic exchange-traded funds tracked by Morningstar was 4.26%; on 521 open-end mutual funds it was 2.03%; and on 408 REIT stocks it was 5.42%. Variance in yields can be ascribed to fund management fees, which can drag down income, and the fact that some REITs are liquidating properties or borrowing to make distributions.

Fund and stock REITs are very easy to buy and sell; their prices are set every day, and in the cases of ETFs and REIT stocks, throughout the day. Shares are priced by the markets based on supply and demand.

There is another type of REIT that doesn’t trade on any exchange, called a non-listed REIT. This is a pool of real estate assets that is offered to qualified investors directly through a prospectus from the underwriter. Two advantages of a non-listed REIT: It tends to be less volatile, because it isn’t subject to the whims of stock-market investors; and it can be less expensive to hold, since the underwriter doesn’t have to comply with the requirements for listing on an exchange.

Two other issues can be negatives for non-listed REITs: liquidity and valuation. Most non-listed REITs cannot be sold, because there is no active market for them. They are designed to experience some type of liquidity event in the future – either a sale, a merger or listing on an exchange. Until one of those events takes place, the investor is locked in for the most part. In addition, because there is no active market for most non-listed REITs, their worth cannot be accurately assessed at any given time. The investor has to be content collecting his or her income (not a bad thing at all) and “someday,” getting back principal.

At least one non-listed REIT has overcome the valuation and liquidity issues by engaging with a third party to have its shares priced every day. The Cole Income Strategy Real Estate Investment Trust is available to qualified investors ($70,000 of net worth and $70,000 of income, or $250,000 of net worth). State Street, an independent fund accountant, sets share price each day based on portfolio makeup and what’s going on in the real estate market and the economy. The REIT’s redemption plan allows investors to sell back their shares on a daily basis, but limits total sales to 5% of total net assets at the end of the previous quarter.

Call us if you’d like to discuss employing real estate in your investment portfolio.