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As investors continue to search for yield in the current environment of ultra low rates, REITs are becoming increasingly popular due to their solid dividend payouts. In addition to attractive income, REITs have rewarded  investors with excellent capital appreciation over longer term. Further, they add diversification benefits to the portfolio and also act as an inflation hedge.

What are REITs?

REITs own and operate income-producing real estate. They are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends and in turn, they can deduct those dividends paid from their corporate taxable income.

The Outlook Remains Strong

With gradually improving economy and low interest rates (at least through 2014), the outlook for REITs remains strong. (Read: 4 Excellent Dividend ETFs for Income and Stability)

Residential real estate market has most likely bottomed out and commercials real estate prices are also now significantly up from their year ago levels.

Further, with increasing rents and improving occupancy, the industry fundamentals are expected to remain strong.

REITs in general are now much less leveraged compared to historical levels and many have refinanced their debt at much lower interest rates. Also, many REITs were able to acquire premium properties at attractive prices during the downturn.

REITs in a Portfolio

Many investors wonder whether REITs are closer to equities or to real estate in characteristics

Research shows REITs are highly correlated with equities in the short term but over longer term they exhibit positive correlation with real estate and low or even negative correlation with equities. Thus, they add diversification benefits to the portfolio.

Another debate regarding REITs relates to their ability to hedge against inflation. Assets can be considered effective inflation hedges if they are able to grow their returns with rising inflation. 

Since REITs derive majority of their income from rents, their incomes generally increase with inflation. The following chart from iShares website shows that US REIT dividend yields have consistently exceeded inflation from 1990 through 2010.

On valuation basis, REITs do look expensive compared with the broader markets, after their nice run-up since 2009, but given solid outlook, they are expected to continue to outperform in the near-to-mid term. (Read: 3 High Yield ETFs for Your IRA)

Beware of Mortgage REITs’ Risks

Unlike equity REITs, mortgage REITs do not hold properties, but they invest mainly in mortgage backed securities (MBS) issued by Fannie Mae and Freddie Mac. They use short-term debt for financing their purchases and are usually highly leveraged.

Mortgage REITs have done very well of late as investors have been pouring in money, due to their double digit yield yields. 

They have benefitted from low short term rates but increasing purchases of MBSs by the Fed under QE3 is now driving the yields lower, putting pressure on Mortgage REITs’ profitability. Further, due to their high leverage, they are exposed to greater risk once interest rates start going up. (Read: Best ETF Strategies for 2013)

Looking at the Performance

After their plunge in 2008, REITs recovered nicely and have been outperforming the broader market for the last four years. While volatility has been high if we look at five years’ history (mainly due to massive plunge in 2008), it has been in-line with the broader market if we look at one year’s performance.

 

Based on one year price performance

   

 

SPY

VNQ

IYR

RWR

 Annualized St. Dev*

12.82%

12.52%

11.95%

12.63%

 Annualized Return*

13.02%

13.99%

14.79%

12.33%

Based on five years price performance

   

 

SPY

VNQ

IYR

RWR

 Annualized St. Dev**

18.96%

32.62%

31.24%

33.05%

 Annualized Return**

6.56%

11.42%

9.89%

10.02%

*Using daily price returns

**Using monthly price returns

Vanguard REIT ETF (VNQ - ETF report)

VNQ tracks the MSCI US REIT Index that covers about two-thirds of the value of the entire U.S. REIT market. Launched in September 2004, this fund has attracted about $19.1 billion in assets so far, making it the largest product in this space.

The fund has highest allocation to Specialized REITs (30.8%) followed by Retail REITs (26.7%) and Residential REITs (16.2%). 

Simon Property (SPG), HCP Inc (HCP) and Public Storage (PSA) occupy the top three spots in terms of exposure.

The fund is one of the low cost choices in the space, charging only 10 bps in annual fees from investors  Further, it is quite is liquid as it trades in high volumes of 2.6 million shares per day on  an average. It currently yields a solid 3.3% in annual dividends.

iShares Dow Jones U.S. Real Estate Index Fund (IYR - ETF report))

IYR seeks to replicate the Dow Jones U.S. Real Estate Index, before fees and expenses, and holds 89 securities in the basket.

Launched in June 2000, the fund has so far garnered $5.9 billion in assets.  It chares 47 bps in annual fees and pays out an attractive 12-month dividend yield of 3.41%. The fund is extremely liquid with an average daily trading volume of about 5.4 million shares.

Like VNQ, SPG occupies the top position in the basket with 8.3% allocation, while American Tower and HCP rounded out the top three.

Among sector holdings, Specialty REITs (29.8%), Retail REITs (20.3%) and Industrial REITs (18.1%) occupy the top three spots.

SPDR Dow Jones REIT ETF (RWR - ETF report)

RWR tracks the Dow Jones U.S. Select REIT Index which follows companies that operate commercial real estate properties across the country.

The fund which made its debut in April 2001 has amassed over $2.3 billion in assets so far. It charges investors 25 basis points annually for operating expenses.

Like VNQ, SPG, PSA and HCP occupy the top three positions in the fund’s basket of assets. Looking at the sector exposure, Regional Malls take the top spot in the basket with 18.4% share while Apartments (17.6%) and Healthcare (15.2%) round out the top three.

The fund pays out about 2.7% in annual dividend yield while trading volume is about 18 thousand shares on a daily basis.

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