Buy REITs to diversify into real estate?

November 7, 2013, by

shopping center.jpgLars as trustee has invested in an indexed REIT fund offered by Vanguard. Lars likes real estate. He has watched Uncle Nils get rich in real estate. He has seen a number of other clients do the same. He doesn't fool himself that it's easy, but it does seem to be the most common way in his medium-sized city to build a big net worth.

So in the $500,000 family trust he has 20% in the REIT fund. It's easier than buying and managing apartments, or a building with commercial tenants. Because it's less painful Lars wonders whether it's less effective.

There certainly are reasons not to buy a REIT fund. They are expensive in a couple of ways. First, the price is probably high relative to the underlying real estate. When actual tangible real estate was still mired in the recent recession, REITs took off in value. This difference seems to be mostly a premium for liquidity. And second, there are the fees. The Vanguard fund itself doesn't charge much, but Lars senses there are layers of management between him as trustee and the hard cold ground he owns so indirectly.

There are more reasons to shy away. Liquidity doesn't seem to rule out volatility: the Vanguard fund was down almost 50% in the awful year of 2008. And REITs must pay out 90% of their taxable income. Lars prefers to see income plowed back into an investment, although that's kind of what he's doing by putting the trust's distributions back into more shares. And finally among negative considerations, Lars is surprised to find out that less than 20% of the index fund is in residential properties. He likes apartments better than commercial rentals, for steadiness of income.

But Lars still feels right about having 20% in REITs. Why?