REITs: in it for the long haul

NEW YORK (Money) -- Question: Since the real estate market is down, I figure I might be able to pick up some REITs (real estate investment trusts) at low prices. So I've been thinking about investing in REITs in a taxable account. Do you think this is a good idea? - Mike Lichtfuss, Chicago, Ill.

Answer: When asked for advice about hitting, old-time baseball Hall of Famer Wee Willie Keeler famously replied, "Keep your eye clear and hit 'em where they ain't." If there were an investing counterpart to that advice, it would be something like, "Keep an eye on the markets and invest where your fellow investors [not to mention the best current returns] ain't."

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Or, to put it in more conventional investing lingo, think like a contrarian and invest in sectors of the market that are being shunned and therefore may be undervalued.

Well, there's no doubt that once red-hot REITs have cooled over the last year or so now that investors are no longer ga-ga about real estate. You can get different numbers depending on which REIT index you look at.

But one good proxy - the Dow Jones Composite All Equity REIT index - was down roughly 3 percent year to date as of last week. That's quite a comedown from the 19.8 percent annualized return the index churned out over the past five years.

But even though I generally think you're likely to find more value in an asset class after it's taken a hit and investors are no longer tripping over themselves - and paying almost any price - to get in, I also have to urge caution.

Just because REITs - or any investments, for that matter - are down, it doesn't mean they can't go down further. Even if they have hit bottom, that doesn't guarantee they'll rebound anytime soon. All of which is to say that if your intent here is to time the REIT market - get in while they're down in hopes of making big bucks when they recover (preferably soon) - then I can't offer you much encouragement.

Even if you were approaching this like a true value investor and figuring you might have to wait several years for a nice payoff, I'd recommend thinking twice, if only because most investors don't have the expertise to do the in-depth research that's required to determine whether an out-of-favor asset is truly undervalued or fairly priced.

If, on the other hand, you're thinking of devoting a small portion of your holdings - say, 10 percent or so - to REITs because you feel they can increase diversification within your portfolio and enhance returns without boosting risk, then I'd say go for it.

There's decent evidence showing that since REITs don't always move in synch with the rest of the stock market, they can modestly improve the long-term performance of a portfolio. But if you're going to buy REITs for this reason, then you shouldn't be buying them just because you believe they're attractively priced at the moment.

You should own them as part of a long-term investing strategy that involves rebalancing your portfolio each year to maintain the same exposure to REITs over time. So, for example, if you decide to make REITS 10 percent of your portfolio and they experience a big run-up one year, you would sell some shares at a profit and put the proceeds into other assets that have lagged, bringing your REIT position back to 10 percent.

Conversely, if REITs have a bad year, you would buy more to bring them back to their normal 10 percent position. By taking this approach you'll end up selling some REITs when everyone else is crazy about buying them, and you'll be buying when others are more interested in selling. That's similar to what you're thinking of doing now, except that it's a more disciplined approach than getting into REITS because you think they might be a bargain.

One more thing. Since REITs generally don't pay corporate income taxes, most of the dividends they pay don't qualify for the maximum 15 percent tax rate that applies to qualified dividends. Instead, their dividends are generally taxed at ordinary income rates that can go as high as 35 percent.

That said, some gains from REITs - for example, profits you reap from selling shares that have appreciated in value and that you've held longer than a year - are taxed at more favorable long-term capital gains rates. So while I think you're generally better off holding them in tax-advantaged accounts like 401(k)s and IRAs, I wouldn't go so far as to say that REITs should never be held in taxable accounts.

Wherever you envision holding REITs, however, I'd still say you should buy them only if you plans to make them a part of your long-term investing strategy, not on a hunch that their recent slide in performance means they're undervalued.