Real estate that pays dividends

Funds that invest in REITs can provide income in a yield drought

Though the housing market remains in the doldrums, real-estate investment trusts, or REITs, have been a bright spot in an otherwise weak stock market over the past decade. U.S. REITs that own property have delivered an annualized total return of 10 percent in the 10 years ended Aug. 31, as measured by the FTSE NAREIT All Equity REIT index. Over the same period, the S&P 500 returned only 2.7 percent.

Most REITs are classified as "equity," meaning they own properties. A small portion of the market consists of mortgage REITs, which own loans on properties. You can buy REITs that specialize in hotels, office buildings, shopping malls, or self-storage facilities, for example. The National Association of Real Estate Investment Trusts identifies eight distinct sectors.

Part of the attraction of REITs is their dividend yields, recently averaging 3.7 percent. By law, REITs must pay out 90 percent of their earnings to shareholders. The downside is that REIT shareholder payments are not eligible for the 15 percent maximum tax on "qualified" dividends, and are usually taxed as ordinary income.

Yields draw investors

Because equity REITs own real estate, they generally tend to do well in periods of inflation. With the economy weak, few observers expect rampant inflation in the near-term. But the Federal Reserve has indicated that it will continue to keep interest rates low for a while, which will probably boost investor interest in REITs.

"When you have low interest rates, people seek out higher-yielding alternatives," says Jon Cheigh, a manager of Cohen & Steers Realty Shares, a no-load REIT mutual fund. Cheigh estimates that cash flows of real-estate companies are likely to rise 6 or 7 percent annually over the next three to five years. REIT dividends, he contends, should rise slightly faster because some REITs cut their shareholder payouts to conserve cash during the financial crisis.

And the sluggish economy might not have caused commercial real-estate income to slide. "Real estate is always about supply and demand," Cheigh says. "The fortunate thing in the market today is that there is very little new supply." So even modest growth in demand creates positive conditions, he says. On the other hand, if the economy were to slip back into recession, cyclical sectors, such as hotels, warehouses, and shopping malls, would be hurt.

Apartment REITs are considered one of the more defensive sectors, since consumers might cut their spending but they will continue to pay their rent. But Peter Rothemund, an analyst at Green Street Advisors, a research firm that specializes in REITs, doesn't advise buying just one sector. "Own a basket of them," he says. "There are good companies in all those sectors."

Even good companies can have rough periods, of course. During the 2008 financial crisis, the value of equity REITs plunged 41 percent, leading to weak three-year and five-year returns.

Spreading the risk

REIT index funds are a low-cost way to invest in a diversified portfolio of properties. The Vanguard REIT Index Fund Investor Shares, for example, holds more than 100 REITs and requires a minimum initial investment of $3,000. There's a 1 percent redemption fee if shares are sold before they're held for at least a year. It's also available as an exchange-traded fund with an expense ratio of 0.12 percent. Remember that you might incur brokerage fees buying and selling ETFs.

Two other large REIT index ETFs are the SPDR Dow Jones REIT ETF, which holds about 80 U.S. REITs, and the iShares Cohen & Steers Realty Majors Index Fund, which owns 30 large U.S. REITs.

While indexing can provide the average return of the REIT universe, in some circumstances active management might produce better results. Cheigh argues that active funds can evaluate REIT management, portfolios, and balance sheets. "That's where we add value," he says.

A sampling of REIT funds

These mutual funds and ETFs allow you to invest in a cross section of REIT sectors.

This article appeared in Consumer Reports Money Adviser.