Your Life Simplified

Real Estate Investing Part 2: REITs & ETFs

June 23, 2022

In part 2 of Your Life Simplified’s real estate series, Mike Mackelvie, wealth advisor, and Valerie Escobar, senior wealth advisor, discuss how REITs, or real estate investment trusts, and ETFs, or exchange-traded funds, have performed in high-interest rate environments and the advantages of investing in real estate assets.


Mike MacKelvie: There is one asset class that seems to stand above the rest, at least with its stature as well as its perceived reputation. And today we’re going to dive deeply into this perception for arguably the greatest asset class from a performance standpoint of all time, and that is real estate. But we’re going to specifically look at REITs, that is real estate investment trusts, as well as REIT ETFs.

We’re going to talk a little bit more about how they’ve performed in rising interest rate environments. Maybe what you should be thinking is, obviously the expectation is now, interest rates will continue to rise. My name is Michael MacKelvie. I’m a Certified Financial Planner with Mariner. And today, I’m joined by Valerie Escobar, who’s also a Certified Financial Planner with Mariner. This is Your Life Simplified. Valerie, how are we doing?

Valerie Escobar: Hey, Mike. I’m good. How are you doing?

Mike: I’m doing good.

Valerie: Good.

Mike: I think, as always, real estate is a big topic, and today, obviously this is something a lot of people have asked some questions about just as far as, “Hey, how does this affect real estate within my portfolio, maybe with REITs, real estate ETFs? What should I be thinking about?”

Valerie: Perfect. No, it’s a huge topic. If you joined us for part one, we talked a little bit about the private or owning it personally, but now we’re going to shift over to that REIT, real estate investment trust, like you said, where really, you are offloading the operation piece, the direct ownership and the financing to another company, which is that REIT company. When we’re talking about REITs, we can be talking about all sorts of different types of real estate. So apartment complexes, real estate, I mean, shopping centers, retail centers, warehouses, medical facilities, the list goes on and on.

With all of those different types, there’s also different structures for those trusts, the REITs. But we’re going to talk about two different types, and what I’m going to look at on my piece is private placements. These are going to be things that are a little bit more difficult to access, perhaps, with private placements. They are exempt from SEC regulations, which is really important to know, because that does mean that there is going to be less visibility into the investment itself. And it does not trade on regular stock exchanges or national stock exchanges.

With these private placement REITs, you kind of got to know a guy, basically. Those cannot be advertised in general. You won’t be able to see a commercial for it, and that’s because you have to meet certain criteria in order to be there. If you’re an accredited investor, which means that you are either making $200,000 individually or $300,000 with your spouse for at least the last two years or reasonably expected to do so going forward, or you have at least a $1 million net worth excluding your primary residence; those are the accredited investor qualifications.

You first need to pass that hurdle in order to even know about these private placement real estate investment trusts. There’s good reason for that, which we’ll talk about a little bit later. But just as an overview, that’s the general structure and how to get into a private placement REIT.

Mike: Yeah. I think private placement REITs typically present a few different facets in comparison to maybe just a publicly traded REIT. Right?

Valerie: Absolutely.

Mike: I think some important differentiators there would just be, obviously, the publicly traded ones you can just buy on an index online somewhere. But typically, when someone’s going to a private placement REIT, there’s additional reasons why they’re doing so. A lot of times, maybe there is some excess in expected return, which could come with some more risk, but again, different than publicly traded REITs.

Now, the other type of just real estate, I would say investment, a lot of people have within their portfolio is just REIT ETFs. These are obviously different than private placement REITs in that they’re passive. They tend to invest their underlying holdings just in equity REIT securities and other derivatives. Typically, what comes with a passive investment like this is, obviously, lower expenses. You typically have a little bit lower expense ratio with an exchange traded fund because it’s more passive.

They tend to include a number of different REIT types. It’s not just one REIT, for example. It’s a number of different REITs. Really again, the idea here for any investor is you can gain broad exposure with a REIT ETF, with not a lot of capital. One of the big challenges with investing in real estate is the high unit cost. If you’re going to go buy a home, you can’t just buy the shed. You have to purchase the home. You have to put a down payment down.

That’s part of the reason why people look at REIT ETFs, and I think a lot of times, people are unaware of just how much they already have in their portfolio. It’s likely that you have some REIT ETF in your total market allocation, or at least some REIT exposure in the form of maybe a REIT ETF in your 401(k) or some other account, if you just have the automated target date fund, right?

Valerie: Absolutely.

Mike: I think one of the big questions that people just have because they like real estate, there’s an entire channel dedicated to it, what are some of the advantages of real estate, Valerie?

Valerie: Yeah. As you mentioned early on, one of the biggest is the performance. Looking at a study from S&P, Dow Jones, and just so our listeners are aware, those are really the biggest indices that they really track and monitor all of the major investment companies and all the performance of returns of different types of asset types. Just looking at a study between 1992 and 2017, so that’s 25 years, they tracked the performance of REITs versus stock, bonds, and commodities. Over that time period, REITs had outperformed at 10.8% versus stocks at 9.5%, bonds at 5.7%, and commodities actually had a negative 0.05%.

Mike: Yeah. Those haven’t been great.

Valerie: Yeah. Which is just wild.

Mike: Recently, they’re the buzz though, right? Yeah.

Valerie: Yeah. Absolutely. The performance is fantastic. We love the fact that it’s tangible property. When we’re talking about private placement or even direct ownership of private placements, you know that I own that shopping center. I own that condominium. When people get into investments, sometimes they’re thinking this is so complicated.

I don’t understand anything that’s happening. But with physical piece of real estate, they can say, “Oh, I know that the roof needed to get replaced. I spent this much money on it, and it got replaced.” Just having that familiarity, I think, is a big piece.

Mike: Right.

Valerie: Another advantage is that generally, it has a pretty steady income flow. With the private placements, you are sacrificing, and we’ll talk about the disadvantages of it, but you are making certain sacrifices in order to get a pretty good rate of return. Right now, when you can’t get hardly anything on bonds, you can say, “Okay, I’m going to get a 6% return every … 6% annual, but it’s going to come every month, every quarter,” whatever it is. That’s a pretty dependable cash flow for you. And feasibly, also get a gain when they sell out of that property that’s in there.

The last advantage that I will add in there is that historically, it has been a pretty good buffer of inflation. We’ll talk about that with rising interest rates and how all that correlates, but just being that diversifier, a hedge against inflation, that’s another attractive piece to have in the portfolio.

Mike: Yeah. Again, I think you put it quite well there. We walk into a REIT likely almost every day, the familiarity of it. Shopping malls, office buildings, those types of things, and again, people like to see their investment. It’s not as if, if you own a piece of a company in the form of a stock, you don’t own tangible things as well. But it’s just it’s a little bit different of a feeling, right?

All of that sounds great. So there is definitely some performance measures there where it’s like, “Yeah, why wouldn’t I be investing in REITs?” I think when you combine that, again, with their lower volatility in comparison to stocks in this case, as well as just low correlation, you’re like, “Why wouldn’t I put half my money into REITs? Why wouldn’t I just throw two to three times what I currently have at them?”

As always with investing, there’s some contingencies. There are some other components you have to consider. It’s very nice to create a nice story about a number of different investments. REITs? I think the big question is should they be considered their own distinct asset class? When we start looking at them as their own distinct asset class, things maybe don’t seem quite as rosy as they do when you look solely at performance and volatility.

The first is, when you consider correlation, so correlation, they’ve been less correlated. They’ve had somewhat of a non-correlation to stocks. They’re not directly correlated to stocks. Again, you look at that and you say, “Okay. Hey, that sounds great. I can gain some diversification.” But you could say the same thing about a number of different sectors. If you look at small-cap value, if you look at international growth, there’s typically going to not be a one-to-one correlation there because we’re talking about the broad market index versus real estate. We’re not breaking the broad market index into its subcomponents.

You could do the same thing with other asset classes and say, “Yeah, these are great diversifiers.” It falls apart in that argument as far as well, it is its own distinct asset class. Take a look at this… it’s not one-for-one correlated to the stock market. The other piece I think that’s worth noting is just the taxation. There’s REIT ETFs, and those are taxed differently than private placement REITs.

But the problem, when you start looking at performance, is it’s typically before taxes are taken into account because everybody’s tax situation is different. If there’s, let’s say, outperformance of 1, 1.5%, but after you take taxes into account, it’s underperforming by 1 to 2%, depending on somebody’s tax bracket, again, that’s something that changes the situation. Because REITs, their distributions are taxed at ordinary income, it’s different than maybe just if you were to buy an S&P 500 growth fund. You would be much more in the appreciation game. You would be much more looking for capital gains taxes versus just distribution and income taxes.

Taxes can greatly, we call it drag the portfolio down when you’re looking at performance. But again, that’s still not to say that you shouldn’t consider investing in REITs, that you shouldn’t consider investing in real estate in general. It’s just that there are other components there, right?

Valerie: Absolutely. I would add, too, when we’re talking about private placements, we’re going to be looking at some serious lockups. Generally, a five-, seven-, 10-year lockup is pretty standard. That just means that you’re going to be making your investment and you cannot liquidate out of it. You can’t just say, “I’m going to go sell this thing,” because again, it is not available on national exchanges. So you have a big commitment, and there’s pretty high entry fee or entry investment accounts.

Mike: Right.

Valerie: In general, we see at least $250,000 to get into it.

Mike: Right. For private placement. Yeah.

Valerie: For private placement. Exactly. Yeah. Another piece that I would add, too, as I had mentioned before, is that because it is excluded from SEC regulations, it just means that they don’t have to provide the investor nearly as much information. Going forward, the performance information is probably just not going to be available, and so there is a risk of losing 100% of it.

With the big return, there is of course, the bigger risk. Just something to be really mindful, and a big reason why we don’t just say, “Well, let’s just go all in, because it’s the biggest-returning asset class.”

Mike: Yeah. Definitely. I think, again, if we’re going to give somebody some steps to take on their own, it’s first, just gauging how much real estate you already have as a part of your portfolio. Not just your home, which is a factor you should consider as well, any personal real estate you have.

But it’s likely that your portfolio contains real estate, and it’s very rare that somebody knows the exact percentage of what they have. I think another question people have, is we mentioned at the beginning of this is just, how do they perform during rising interest rate environments, Valerie?

Valerie: Yeah. That is a big question that we’ve been getting. Again, going back to that report by S&P, Dow Jones, since the early 1970s, there have been six periods during which the 10-year Treasury bond yield rose significantly. Like right now, we are seeing a big yield or a big increase in yields. In four of those six periods, REITs earned a positive return in half of those, and it outperformed the S&P. That does seem counterintuitive in some ways because real estate is purchased with mortgages for the most part, and mortgages have interest rate costs. The more expensive it is to buy the house, the less likely people are to buy them.

But one of the things to keep in mind, too, is that higher interest rates are usually due to higher inflation, and inflation is due to a strong economy. When the economy is doing really, really well, that means that people’s wages are growing, which means that people can pay higher rents. Because real estate investment trusts, their income flow is based on those rental revenues, in large part, you are getting a higher rental revenue due to the inflation that’s currently existing. Of course, that means higher income for the owners of the real estate as well.

Mike: Yeah. What underlies all of this, if I’m hearing you correctly, is just the strength of the economy, right?

Valerie: Yeah. That’s absolutely right. It can always be argued that right now, our economy is just having problems and it’s never going to recover. The world’s always about to end. But the best that we can do is look at history, and history tells us the world is still not on the verge of ending and that we can recover. But that overall, historically, yields rising actually is a good thing when it comes to real estate in many ways.

Mike: Yeah. I think it underscores that there’s just different factors. Obviously, rates rising will increase the cost of borrow, which will increase the cost for the REIT to operate. You look at that and you might think that’s bad. But when you consider the fact that, again, as you mentioned, rents would theoretically also increase because we have high inflation and that can help combat it. I think, again, it underscores that there are a multitude of variables here. It’s not just the cost of borrowing that’s going to drive REIT performance, just like it’s not the cost of borrowing that’s going to drive the entire economy and that’s going to be the only lever, right?

Valerie: Yeah. With all things, we don’t recommend diagnosing yourself on WebMD, and we don’t recommend making financial decisions based on one piece of information. It’s just another tool to implement and discuss with your advisor and see where does this fit and what do I already have as part of that conversation?

Mike: Yeah. I think, again, it’s first, if we’re going to talk about some steps, and I’d love to hear your thoughts on this to just give somebody, as they’re considering their own investments and reviewing everything, it’s just, first step is obviously just awareness of just, what do I even have in the first place? It’s rare that people know exactly what they have within their portfolio. I think as we talk about real estate being its own distinct asset class, should it be its own distinct asset class?

What I mean by that is you have stocks and bonds, and then real estate is this third leg to the stool. Typically, what we mean by that is, again, your normal market weight within your portfolio is going to have anywhere from 2 to 6% real estate. The question is should you be adding additional real estate investments in your portfolio? Not necessarily just directly held investment properties. I’d love to hear just maybe what your just thoughts are or steps for somebody as they’re starting to think about, “Hey, should I even be considering investing in a REIT?”

Valerie: Right. I think one of the big things is just having a good understanding of your own tolerance for risk. Real estate can seem like a low-risk proposition, but just depending on the way that you access it, it could have different implications. And so, one, being really aware of that. Secondly, I think what is your situation? Are you looking more for yield? Are you looking more for growth?

Real estate, especially when it comes to ETFs, I think that that’s a good way to dip your toe. Even those, they generally come with pretty good yields. Is that going to be more of a focus of your overall portfolio because of where you’re at in life? Or is it that you’re going to be looking at growth? There’s just different ways to approach it.

Mike: Yeah. Any time you get into just more of a timing game where you’re trying to just find the best asset class of the year, you’ll probably run into challenges in the long run. But again, I think that’s really helpful because as you start to think about, “Well, why wouldn’t I just invest in real estate, or REITs in this case, that it had such strong performance, why wouldn’t I double, triple my performance or my allocation to it?” Again, it’s important to come back to the fact that there’s just other variables to this. You have to consider your taxes and the tax impact of owning them.

If you have a REIT ETF, on the other hand, you say, “Well, I might just own an ETF and maybe that’s how I get around it, because I can get qualified dividends there.” You’re likely going to have a lower expected return than maybe a lot of different private placements. It’s not direct across the board. I know that there’s going to be outliers. But if you’re just comparing them aggregate, the higher expected return would typically come with more risk.

Hopefully, you’ve found today’s episode helpful. Again, as we mentioned in the onset, we’ve had a ton of questions about, “Should I be investing more in real estate?” And some fears obviously with rising interest rate environment. In conclusion, again, there’s a multitude of variables here. They have held up in high interest rate, rising environments, which are typically coming with higher inflation.

But as always, make sure to hit that Subscribe button. If you’re listening to this on YouTube, Apple Podcasts, Spotify, wherever you might be listening, hit that Subscribe button to follow along for more industry professional content from here at Mariner. This is “Your Life Simplified.” I’m Michael MacKelvie. Valerie, thanks for joining us.

Valerie: Thanks, Mike. It’s good to talk to you.

Mike: Yep. Take care, guys.

Investing involves risk and the potential to lose principal. Risks of the REITs are like those associated with direct ownership of the real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer. Before investing in an ETF, you should read both its prospectus which provide detailed information on the ETF’s investment objective, principal investment strategies, risks, costs, and historical performance. You can find prospectuses on the websites of the financial firms that sponsor a particular ETF, as well as through your adviser. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, international securities, commodities, fixed income, and more. An ETF may trade at a premium or discount to its net asset value (NAV).

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