The Right REITs

11/30/2015 9:01 am EST

Focus: INCOME

As long-term investors, we don't advocate jumping in and out of REITs; rather they should always be part of your investment repertoire because they don't move in lock step with the overall stock market and that can smooth out volatility in a portfolio over time, suggests Tim Begany in Personal Finance.

The economic recovery has been good to our recommended investment in the real estate sector, the iShares Residential Real Estate Capped ETF (REZ). This exchange-traded index fund, which consists of 37 REITs, gained 87% in the past five years, outpacing 99% of its category.

The fund holds REITs that invest in manufactured homes, apartments, and storage space.

One factor in REZ's outperformance is that a third of fund assets are in REITs that own nursing homes and other residential facilities for seniors requiring a high level of care. An aging population keeps the demand growing for such facilities.

The question now is what will REITs do next? Current projections suggest REITs will still offer healthy returns, barring any serious shocks like a recession or even an unexpectedly strong economy, which might prompt the Fed to raise interest rates aggressively.

But those threats seem unlikely. All signs point to unspectacular growth for the next few years. So the powerful catalysts that aided REITs in recent years should remain intact.

Meanwhile, REITs are required by law to distribute at least 90% of their income as dividends, REITs frequently offer above-average yields. REZ, for example, yields 3.4%, compared with 2.2% for the S&P 500.

Based on surveys of 48 economists and 36 leading real estate investment firms, the Urban Land Institute sees single-family housing starts rising to 900,000 in 2017 from an estimated 745,000 this year.

The Urban Land Institute foresees a similar pattern for commercial real estate prices but with even stronger annual gains

Although we don't believe in timing, rebalancing is another matter. With REIT stocks up so much, consider reducing the proportion of REITs in your portfolio to a reasonable percentage, say 5% to 10%.

With commercial real estate set to pull ahead, consider dividing your real estate allocation between REZ and a REIT fund investing in commercial properties.

For that strategy, we would add the Vanguard REIT ETF (VNQ), which has a 4.1% yield, a five-year record besting 55% of peers, and an expense ratio of only 0.12%.

The fund—consisting of 145 REITs—is a dirt-cheap play on commercial real estate, as it mirrors the MSCI US REIT Index. So between REZ and the Vanguard REIT ETF, investors can thoroughly cover all their bases in the real estate sector.

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