Real estate in your retirement portfolio

By Walter Updegrave, senior editor


(Money Magazine) -- Question: How do REITs work? And is it prudent to have them in a diversified retirement portfolio? --M. C., Indianapolis, Indiana

Answer: After going from rock stars of the investing world during the real estate boom to candidates for a VH1"Where Are They Now" episode the last two years, REITs are generating some interest again.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

Gee. Could it have anything to do with the fact that, after slumping badly in 2007 (-17.8%) and 2008 (-37.3%), REITs have been on a bit of a roll again with a year-to-date return of more than 25% through mid-December?

Well, whatever has spurred your interest, the answer to your first question is that REITs, or real estate investment trusts, are essentially companies that own and operate income-producing properties that could range from office buildings to hotels to malls to apartment buildings or a combination of these or other facilities.

Since you can buy many REITs just like stocks, investing in them allows you to gain exposure to the real estate market without the hassle of having to buy, manage and sell actual bricks and mortar. And because for tax reasons REITs must distribute 90% or more of their taxable income to shareholders annually as dividends, many investors looking for steady income from their investments also gravitate toward REITs.

As for whether it's prudent to include REITs in a diversified retirement portfolio, I'd say the answer depends on why you're buying them.

If you're considering REITs now because you think their recent gains might be a prelude to another real estate feeding frenzy, I would urge extreme caution. Much of the REIT rebound this year is what you might call a "relief" rally. Things were looking so bad both in terms of property values and availability of financing in the commercial real estate market earlier this year that many REITs were knocked down to Armageddon prices. As investors came to believe that maybe conditions weren't quite so horrendous and that the correction in REIT values had perhaps been overdone, REITs enjoyed a nice little pop.

But the residential and commercial real estate markets still face daunting challenges. That's not to say that REITs don't have the potential to deliver decent returns from here. Indeed, some have been able to raise capital that may allow them to pick up properties at bargain-basement prices. I think it would be foolish, though, to buy into REITs expecting them to retrace their recent trajectory.

But if you want to invest a portion of your retirement savings in REITs as part of a long-term strategy to improve your portfolio's performance by enhancing its diversification, then I'd say yes, it could be prudent to find a place for them. That's because research shows that adding a small helping of REITs to an already diversified portfolio may be able to slightly boost returns without increasing volatility.

Be aware, however, that this approach assumes you'll invest a modest portion of your assets in REITs and that you'll hold them during good and bad periods. And to get the full benefit of the additional diversification they offer, you must be willing to rebalance periodically so REITs continue to account for the same percentage of your portfolio that you set originally.

That means you'll probably be selling off part of your REIT stake after years in which they've soared (like 2003 and 2004), and adding to it after lousy years (like 2007 and 2008). If you don't have the discipline, or the stomach, to do this, then adding REITs probably isn't such a hot idea.

Keep in mind too that while REITs' dividends can be a plus for investors looking to draw income from their retirement portfolio, those dividends can be cut in hard times. Some REITs did exactly that during the financial crisis. What's more, a December 2008 "revenue procedure" from the IRS gave REITs the option of paying out up to 90% of their dividends in stock rather than cash this year. I think it's fair to say most income investors would prefer hard currency to more shares of stock. It's unclear whether, one way or another, REITs will have access to that option again in the coming year.

You should also know that, unlike payouts from most companies, REIT dividends do not generally qualify for the 15% maximum tax rate for qualified dividends. So if you do opt for REITs, you may want to hold them in a tax-advantaged retirement account such as an IRA or 401(k).

All things considered, though, I think REITs can still play a role in a well-rounded retirement portfolio. But unless you know how to analyze the prospects for individual REITs, I'd recommend investing in them through a mutual fund or ETF that owns a diversified portfolio of REITs. You can find both on our Money 70 list of recommended funds.

Bottom line: If you want to make REITs part of your long-term investing strategy for your retirement savings, go ahead. Just be sure to take a prudent approach, as I've outlined. To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.36%4.24%
15 yr fixed3.39%3.26%
5/1 ARM3.36%3.27%
30 yr refi4.34%4.22%
15 yr refi3.38%3.24%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 16,408.54 -16.31 -0.10%
Nasdaq 4,095.52 9.29 0.23%
S&P 500 1,864.85 2.54 0.14%
Treasuries 2.72 0.08 3.19%
Data as of 3:07pm ET
Company Price Change % Change
Bank of America Corp... 16.15 0.00 0.00%
Facebook Inc 58.94 0.00 0.00%
General Electric Co 26.56 0.00 0.00%
Cisco Systems Inc 23.21 0.00 0.00%
Micron Technology In... 23.91 0.00 0.00%
Data as of Apr 17

Sections

General Mills has scrapped a controversial change to its fine print that some read as eliminating customers' right to sue the company. More

Obamacare sign ups hit 8 million, though final enrollment remains to be seen. More

Office for iPad move is a symbolic victory for Nadella's Microsoft, but the company is still weighed down by many of the same old issues. More

Schwinn, Trek and Cannondale are all iconic American bicycle brands. But none of them are made in the United States. More

As Detroit moves closer to reaching a bankruptcy deal, retired civilian workers are poised to be left worse off than firemen and police officers. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.