Are REITs a safe investment for retirement?

(Money Magazine) -- Are REITs a safe investment for one's retirement years? -- Ray H., Florissant, Mo.

There's no doubt that REITs have delivered impressive long-term gains, with annualized returns of more than 10% for the past 10 years. And with dividend yields ranging from more than 3% to almost 8% in recent years, REITs have long been a go-to investment for retirees looking for reliable income.

But make no mistake. Despite their ability to throw off income, REITS are still equities and can be just as volatile as other stocks.

The double-whammy of the collapse of the real estate market and the financial crisis sent REIT shares plummeting nearly 50% from the beginning of 2007 through 2008. REITs also lost 15% of their value in the third quarter of 2011 amid concerns that debt problems in Europe could undermine the recovery in the U.S.

So just as I've cautioned about other types of dividend-paying stocks and mutual funds, it would be a mistake to underestimate the risk of owning REITS. Just because they make regular income payments, they are not higher yielding substitutes for bonds or CDs. REITs are far more volatile and should be considered part of the equity portion of your portfolio.

If you're considering REITs, understand that there are many different types. The stats I mentioned above apply to the FTSE NAREIT All Equity REIT Index, a broad REIT benchmark. But performance can vary greatly depending on what type of properties a REIT owns.

Last year, for example, while the FTSE NAREIT Index returned 8%, REITS that invested in self-storage facilities gained 22% while lodging and resort REITs lost 14%.

Two types of REITs you need to be especially wary of are non-traded REITs and private REITs. These REITs do not trade on an exchange, which makes it much more difficult for investors to assess their value. That alone is reason enough to give these REITs a pass in my opinion. But if you're tempted to take a flier on them, perhaps reading the Financial Industry Regulatory Authority's Investor Alert on non-traded and private REITs will convince you to steer clear.

REITs can still be a good complement to a core portfolio of stocks and bonds for retirees as well as other investors.

That's not just because of the reliable dividends they pay. Equally important is the diversification they bring to a portfolio. Even though REITs themselves can be volatile, they don't always move in synch with the rest of the stock market. As a result, adding REITS can actually dampen the ups and downs of your overall portfolio.

There are two keys to reaping that smoothing effect. The first is moderation. Keeping 10% or so of your portfolio in REITs is sufficient to lower volatility while possibly increasing return at the same time.

The other key to harnessing the benefit of REITs is to stick to mutual funds that own a broadly diversified mix of REITs or, better yet, a fund or ETF that invests in an index of REIT shares. That way, you'll avoid the risk of pouring your money into the wrong type of REIT at the wrong time. You'll find REIT fund and ETF choices on our MONEY 70 list of recommended funds.

One more thing: REITs do not typically pay corporate income taxes, so their dividends don't usually qualify for the preferential 15% maximum tax rate for qualified dividends. Rather, REIT dividends are for the most part taxed at ordinary income rates that currently can run as high as 35%. So to the extent possible, you'll probably want to keep any REITs you buy in a tax-advantaged account like a 401(k) or IRA to minimize the tax hit.

Bottom line: REITs can be a good choice if you're looking to add investments that can generate dividend yield and make your overall portfolio a bit less volatile. But they are not safe havens that can immunize you against losses.

Do you know a Money Hero? MONEY magazine is celebrating people, both famous and unsung, who have done extraordinary work to improve others' financial well-being. Send an email to nominate your Money Hero.