Week 274 - Alternative Investments: American REITs

Situation: You need to hold assets other than stocks and bonds in your retirement portfolio. Stocks can become too volatile, and credit-worthy bonds can become unworthy credits. Both problems are plaguing investors these days, so we need to look at alternatives. Alternative investments usually relate to either real estate or natural resources. The idea is to combine the best feature of stocks (good dividends) with the best feature of bonds (good collateral). 

Mission: Introduce readers to Real Estate Investment Trusts (REITs) based in the US, taking care to separate “the wheat from the chaff”.

Execution: REITs are mutual funds of rental properties, but with a difference. The SEC requires REITs to transfer at least 90% of income to investors as dividends. While these payouts are taxed as ordinary income instead of being taxed as capital gains, part of the payout “. . . comes from depreciation and other expenses and is considered a nontaxable return of capital.”

The largest REIT index fund is marketed by Vanguard Group as The Vanguard REIT Index Fund Investor Shares Fund (VGSIX). 

Given that REITs are “real assets” in the ground, the BENCHMARK section of this week’s Table compares REITs to other investments that depend on real assets in the ground: 1) the leading oil company (XOM), 2) the leading corn processor (INGR), and 3) the NYSE ARCA Gold Bugs Index (^HUI). 

Administration: We have identified 9 REITs with above-average quality (see Table), of which 5 are Dividend Achievers (10+ years of annual dividend increases). Column D in the Table shows returns that span the 4.5 year housing crisis (7/1/07-1/1/12). Specifically, the Federal Housing Finance Agency’s “seasonally-adjusted” Home Price Index (HPI) indicates that the year-over-year (YOY) median price for houses purchased with a conforming mortgage started falling in the Q3 of 2007 and began rising in Q1 of 2012. That number from Column D is added to long-term returns (i.e., since the S&P 500 Index bottomed on 10/9/02) from Column C to yield Finance Value in Column E. 

You’ll notice that only two BENCHMARK investments beat their long-term returns during the 4.5 year housing crisis: 20+ year US Treasury Bonds (TLT at Line 15 in the Table) and the Gold Bugs Index (^HUI at Line 27). This is typical of recessions originating in the Finance Sector and represents the main rationale for owning long-dated sovereigns and gold.

Bottom Line: Houses and shopping centers are illiquid assets but their REITs can be bought and sold like stocks. Over the long term, returns from REITs are better than returns from Treasuries but REITs lose value in a recession whereas Treasuries gain value. In summary, REITs are moderate-risk high-reward investments. To invest in REITs, start with an Index fund (VGSIX). If you’re not distracted by the ups and downs, graduate to a low-risk REIT like Public Storage (PSA).


Risk Rating: 6 (where 10-Yr Treasury Notes = 1, and gold = 10).

Full Disclosure: I own units of TIREX in a retirement fund.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 19 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = moving average for stock price over past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H in the Table. Price Growth Rate is the current 16-Yr CAGR found at Column L in the Table (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% is based on returns from a stock index of similar risk to a portfolio of individual large-cap stocks, i.e., the S&P MidCap 400 Index at Line 28 in the Table. The investment vehicle for that index is the SPDR S&P MidCap 400 ETF: MDY at Line 17.

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