To REIT or Not to REIT

06/25/2009 1:00 pm EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of exchange traded fund analysis, and analyst Mitch Corwin write in Morningstar ETFInvestor that REITs may not offer much diversification.

Investors looking for direct exposure to a broad portfolio of commercial real estate can get it with the iShares Dow Jones US Real Estate (NYSEArca: IYR). Real estate has traditionally been viewed as a way to add stability to a diversified portfolio through lower correlations with stocks (though we are dubious about this assertion) and an inflation hedge when compared with bonds.

This traditionally stable asset class has become volatile lately. REITs are currently enduring the perfect storm: a lack of credit and weak economic fundamentals. Even lenders who have the capacity to make loans are skittish to do so, given worsening economic fundamentals and deflating asset values. The commercial real estate market may not have gotten as frothy as the residential market, but the deleveraging process is not as far along and is proving quite damaging to even the largest REITs.

REITs are highly leveraged and have little cash on hand as they are required to pay out at least 90% of their annual earnings to shareholders as dividends. This year, many REITs have replaced all cash dividends with combination cash and stock dividends and have sought to build capital levels further through stock issuances.

REITs underperformed the Standard & Poor’s 500 index in 2007 and 2008. In one of the worst bear markets in history, investors seeking diversification in REITs have realized poorer performance. Longer term, REITs may offer little asset-allocation benefit. Correlations to the S&P 500 had been increasing even before the economy worsened. Also, the outperformance versus the S&P 500 that REITs enjoyed during the last recession may have simply mirrored the performance of value stocks, meaning that investors could have just as easily benefited from diversification into other classes of stocks as into REITs.

Most importantly, while REITs have historically generated returns similar to equities, that may not be the case going forward. Prices for these stocks benefited from increasing leverage, lower borrowing rates, rising property values, and strong growth in demand for properties. We think that investors looking to diversify a stock and bond portfolio should carefully consider these factors before looking to invest in a REIT ETF.

We [also] advise potential investors to consider the unique tax implications of owning REITs in a taxable account. A portion of the dividend income from a REIT is subject to ordinary tax treatment. According to the National Association of Real Estate Trusts, about 53% of REIT dividends for the 2007 tax year qualified for ordinary tax treatment. These dividends are taxed whether they are paid in cash or stock.

While comparable REIT offerings like the Vanguard REIT Index ETF (NYSEArca: VNQ) limit themselves to primarily conventional REITs, IYR casts a wider net. IYR contains mortgage REITs and more unconventional holdings like timber REITs and real estate services firms.

This fund’s 0.48% management fee is relatively high [in comparison to] VNQ and SPDR Dow Jones REIT (NYSEArca: RWR), which sport much more reasonable management fees of 0.15% and 0.25%.

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