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Real Estate Investment Trusts

Why REITs could help balance your investment portfolio

A Wells Fargo investment strategist explains that a real estate investment trust, or REIT, may enhance a portfolio’s returns — but the extra returns can come with added risk.

August 30, 2016

In September, the number of industry sectors tracked by the Standard & Poor’s 500 Index expands from 10 to 11. The new sector is Real Estate, and includes two new industries within it: Real Estate Management and Development, and Equity REITs for Real Estate Investment Trusts*, so we asked John LaForge, head of Real Asset Strategy for Wells Fargo Investment Institute, about this investment option.

Q: What is a REIT, and how does it work?

John LaForge of Wells Fargo Investment Institute

LaForge: A REIT, or real estate investment trust, is a company that owns (and typically manages) income-producing real estate for investors. There’s broad interest in REITs because buying and managing properties can be lucrative but also confusing, expensive, and time consuming. In fact, the only experience many people have with purchasing real estate is when they buy a home, and that certainly isn’t an income producer!

REITs trade like stocks on stock exchanges, offering investors a way to own commercial and residential real estate and thus get consistent income, inflation protection, and growth. When you buy a REIT, you are pooling your money with other investors to buy a portfolio of real estate holdings.

The two main differences between a traditional corporate stock and a REIT are that REITs, by law, must generate 75 percent of their value from real estate-related sources. And second, 90 percent of a REIT’s income must be distributed back to investors. That’s normally done through dividends.

Q: Where do REITs fit in an investment portfolio?

LaForge: We believe REITs are considered real assets in the investment world because their income and value are tied directly to the properties. But REITs also can have stock and bond characteristics — offering growth potential (like stocks) and the potential for consistent income (like bonds). Since REITs don’t always follow the price moves of stocks and bonds, they can help diversify a portfolio. REITs can enhance a portfolio’s returns, but the extra returns can come with added risk.

And there are hundreds of REITs. Some can be diversified, while others specialize in specific categories such as office buildings, health care buildings, retail shopping centers, hotels, and industrial plants.

How REITs work infographic

Q: What’s the history of REITs?

LaForge: REITs were first introduced as an asset class in 1960, but they were not broadly embraced by Wall Street until much later. They officially joined the S&P 500 Index in 2001, within the Financials sector. But in September 2016, the S&P 500 is creating an 11th sector, called Real Estate, which includes the REITs industry group.

Wall Street believes REITs are truly different from the average corporate equity and should be treated as such, and Wells Fargo agrees.

Mortgage REITs will remain in the Financials sector because they manage loans versus properties.

REITs have been one of the most consistent outperforming major asset groups in recent years. In fact, their average annualized gain from 2001 to 2015 was more than 8 percent — besting both stocks and bonds.

REITs can go up or down in the short term, so it’s important for investors to remember that having REITs in a portfolio is a long-term proposition. While they carry added risk, investors historically have been paid for taking that extra risk with greater returns.

Recently, apartment REITs have fared well as millennials who are unable to afford homes rent apartments instead, while mall REITs haven’t performed as well as shoppers increasingly go online.

Q: What about the impact of low interest rates and a slow-growing economy?

LaForge: Like other major asset groups, REITs can be affected by the economy. Should interest rates rise quickly and significantly, REITs could become more volatile than other investments. And since REIT values revolve around their underlying real estate holdings, economic downturns can negatively affect REIT values.

*For more about real estate investment trusts, see the Wells Fargo Investment Institute reports “How do Real Estate Investment Trusts Work?” (PDF) and “Global Real Assets Strategy Report: REITs – Attention Everyone” (PDF).

Wells Fargo also has a dedicated REIT Finance Group in Wells Fargo Commercial Real Estate to serve the banking and financing services needs of REITs.

Risk Factors

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Mortgage REITs specialize in mortgages and will be subject to interest rate fluctuations and to the spread between short-term and long-term bond rates.

Wells Fargo Investment Institute, Inc. (“WFII”) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates.

Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.