A Primer on Real Estate Investment Trusts (REITs)

Real estate investing offers an important source of diversification while serving as an inflation hedge. Historically, real estate growth has shown to have very little correlation with the broader US stock market. Also, as inflation rises, the real estate rises too, thus providing a hedge against inflation. So, real estate is a double-edged sword.

There are primarily two ways to invest in a real estate — (1) invest directly in a piece of land or a rental property (2) invest indirectly using REITs. Both these options have plusses and minuses.

Investing Directly in Real Estate

If the economy is performing well, your real estate will appreciate. Most likely, you will be able to find renters to provide you with steady income stream. If you buy the property using borrowed money, then it can also serve as a great leverage (assuming you can borrow).

But, owning a physical piece of property comes with headaches. First, real estate is highly illiquid and takes time to sell. Then, you will need to worry about tenants and their ability to pay. You will also need to worry about maintaining the property regularly or pay someone else to do it. If something breaks down, you will need to fix it immediately for tenants. If the economy performs poorly, your property value may decline. Lastly, property taxes, homeowner's insurance, and other costly repairs will constantly eat into your returns.

Investing Indirectly in Real Estate using REITs

Instead of owning real estate directly, you can also purchase shares of real estate investment trusts or simply REITs. REITs pool money to own and manage real estate such as offices, apartments, shopping malls, hospitals, and industrial facilities. REITs are governed by regulations. For example, at least 75% of REITs gross income must come from rents, interest from mortgages, or other real estate investments, and, REITs must distribute at least 90% of their income to shareholders each year as dividends. Because of these regulations in place, REITs provide steady income streams, similar to getting a rent every month.

The other most important advantage of owning REITs is that you can liquidate shares of REITs just like you can liquidate shares of mutual funds or stocks. This means that you can free up your money at will, unlike a physical property. Also, if you invest in an index fund that is comprised of multiple REITs such as Vanguard REIT Index Fund, you are essentially diversifying your money across ~111 REITs.

Historically, REITs have provided higher yields than S&P 500. Also, REITs provide stable income because they are secured by rents from long-term leases by large companies. Additionally, REITs have historically appreciated in value, providing decent capital gains. Filing taxes is as easy as filing taxes on your mutual funds.

REITs also have some drawbacks. REITs must pay property taxes to state and local governments and any increases in property taxes can reduce dividends. REIT dividend income is considered ordinary income and depending on your income bracket can be taxed at a higher rate. As a matter of full disclosure, I own Vanguard REIT Index Fund exclusively in my Roth IRA account because income generated in Roth is tax-free. For more info on my portfolio details, see My Investment Portfolio Details, and My Investment Porfolio Details Part 2.

Primary Home as an Investment

Many people treat their primary home as their real estate investment. Even though I own a home, I personally do not consider it as an investment. Because I am living in it, it is not really providing me with any rental income and there is no true way to know its value until I sell it. To keep things simple, I do not put any price tag on my home. For me, it is still a liability until the mortgage is paid off.

One more point I want to touch on the primary home. I bought my home in late 2006 at a peak time. It was technically a foreclosed property, but real estate bubble hadn't busted, so the bank sold it at a regular price. Even though recession has erased its value by 30%, we still think it is a great purchase for us because in the last 6 years alone, we have saved over $60000 in rent. For us, the savings vs. interest payments/decline in value is so far a wash. But, as years go by, we will come out on top. Money aside, a tangible home where our baby is growing and playing is priceless. It provides a sense of security and homeliness, which we value dearly.