Don’t Waste Your Time on REITs

Real Estate Investment Trusts (REITs) are all the rage with personal finance bloggers. It’s probably controversial, but I’m here to say it loudly and clearly: don’t waste your time on REITs.

There are much worse ways to invest your money, to be sure. But keep in mind that even a boring S&P 500 index fund will outperform the average REIT. And an S&P 500 index fund is less risky than most REITs because it is a lot more diversified. If you are already invested in index funds, I don’t think there’s any reason to invest money in REITs.

In short, don’t waste your time on REITs.

The History of REITs

A Real Estate Investment Trust is an investment vehicle first introduced in 1960. It enables individual investors to own shares in large income-producing real estate properties. But what we know today as “modern” REITs really only got started in 1992. Since then, REITs have become mainstream among investors.

Today, REITs aren’t all that dissimilar from crowd-funding. The real estate trust pools the resources of individual investors to afford properties that the individuals would not have been able to invest in otherwise. 

Prior to 1960, if you wanted to invest in real estate, you you had to stick to affordable opportunities. Large apartment complex and commercial buildings weren’t accessible. Most real estate investors focused only on properties they could get a mortgage for. 

Bigger properties are often quite lucrative income generators, but pre-1960, only the wealthiest people could afford to invest in them. There we hacks around this, but they were risky. You could form a small business or informal syndicate, for instance. But doing that was time-consuming and the resulting ventures were as risky as any small business. You had to really trust your partners and there were far fewer legal protections. If your neighbor suckered you into investing your money in a scam, you were SOL.

With REITs, making small investments in big projects became more transactional and safe. Meanwhile, the entities that manage the trusts were able to earn returns for managing the money. Finally, liquidity was injected into profitable real estate projects that would have otherwise gone unfunded. Everyone wins!

Today, there are more than 190 public REITs listed on stock indexes in the US. 30 of those funds are listed in the S&P 500. [source] [source] Globally, REITs have a market capitalization of $2.5T dollars.

How Does a REIT Actually Work?

There are a bunch of different combinations of REIT types. Not all REITs own and operate investment real estate outright. Some own real estate debt. Some are focused on particular market verticals (commercial vs residential for instance). Some are focused on specific geographies. 

At the end of the day, though, REITs work the same way any investment fund works. Fund managers market their fund to investors, then use those funds to try to generate profit. Every REIT seeks to turn $1 into $2 in as short a period of time as possible.

And compared to other ways to invest your money, REITs aren’t that expensive. Unlike actively managed funds, management fees for most REITs tend to be pretty low around: 1-2%. [source] For large REITs, investors have all the assurances of other mainstream investments. These funds offer the ability to buy and sell shares, tax advantages, and a referee in the form of the SEC.

Most REITs are focused on cash generation. It’s not super difficult to ensure you record this income as a long-term capital gain. Doing that can reduce your overall tax burden, but if you want to avoid taxable events, REITs aren’t a great option. I discuss this in more detail below, but even long-term capital gains can negatively impact the taxes you owe.

How Have REITs Performed Historically?

Unlike newer and more speculative assets like cryptocurrencies, REITs have been around for more than half a century. As a result, there’s a lot of data about how well the asset class performs.

The National Association of Real Estate Investment Trusts (Nareit) was formed in 1960 alongside the legal creation of REITs. NAREIT started tracking returns in 1972. Here’s how REITs stack up against stocks:

It’s worth pointing out that the S&P 500 column above is a bit misleading. Returns for any stock, fund, or ETF, will be heavily influenced by timing effects. It matters a lot when you start and stop measuring. 

For instance, you could easily cherry-pick a time period for the S&P 500 that shows it had no long-term growth. You could also pick a time period that makes it look like investing in the S&P 500 is the best thing since sliced bread. 

In the above chart, the time period comparisons don’t make a lot of sense. Just because NAREIT started measuring REIT performance in 1972, that doesn’t mean we should measure returns for the S&P over the same time period. What makes more sense is to rely on the law of large numbers and use the longest available measurement.

The S&P 500 first assumed its present form in 1957. Since that time, it has returned a historic average annualized return of 11.88%. [source] Comparing that to the 11.9% for REITs gives us nearly identical rates of return: 11.9% vs 11.88%. 

So, REITs have no clear advantage in terms of return on investment.

Don’t Waste Your Time on REITs Reason #1: Management Costs

Way back in the day, if you wanted to own stocks, you had to pay a lot of middlemen to shuffle paper on your behalf. That started to change when Vanguard was founded back in 1975 with the promise of low-overhead index funds. 

Today, if you want to own an S&P 500 index fund, management fees are insanely low. The Vanguard 500 index fund has a management fee of only .04% [source]. Compare that to .41% for most ETF REITs listed on the S&P 500 [source], or the 1% charged by one of the most popular REITs, Fundrise [source]. REIT mutual funds tend to have higher management fees that cluster around 1%. REIT ETFs have lower management fees, ranging from .08% to .6% [source].

So let’s adjust the REIT long-term returns table above for cost and compare again. For this comparison, I’m assuming you a low-cost ETF like Vanguard with a .04% management fee. For the REITs, I assume you own a middle-of-the-road REIT with a yearly management fee of .6%. I arrived at .6% by taking a the midpoint between REIT ETF and REIT mutual fund fees.

So when we adjust for management fees, the difference skews towards the S&P 500. And we aren’t even done adjusting down the returns from REITs!

Don’t Waste Your Time on REITs Reason #2: Tax Disadvantages

Many REITs distribute their returns in the form of dividend payments.

This is a substantial tax disadvantage for people that are in their prime earning years. Taking dividend payments from a REIT – even as a long term capital gain – can have negative tax ramifications.

Although capital gains won’t push your ordinary income into the next tax bracket, it will increase your adjusted gross income (AGI). As your AGI goes up, you will be phased out of itemized deductions, some tax credits, and lose your eligibility for Roth IRA and deductible IRA contributions. These disadvantages may not be a big deal for you and your family, depending on your current household income. But if your income puts you on the cusp of losing some itemized deductions, a .6% management fee will be the least of your problems. Losing a key household deduction could cost you 4 or even 5-figures.

Don’t Waste Your Time on REITs Reason #3: Time and Effort

Like ETFs, REITS can be passive investment vehicles. There are plenty of REIT ETFs that operate just like an index fund. But if you want a completely passive investment that performs mostly like an index fund, why not just own an index fund? If the returns were obviously better, you might opt for the REIT, but based upon the data above, that just isn’t the case.

You could instead choose to more actively manage your REIT investments. You could individually pick and choose the REITs you invest in, for instance, hoping to pick out a fund that realizes returns far above the average for those tracked by NAREIT. It should be possible, just take a look at some of the highest-performing REITs in May of 2023, courtesy of NerdWallet:

But remember that if you want to actively pick and choose REITs, you’re essentially just stock picking. Even if you have information that makes it more likely that you are right twice (gotta know exactly when to buy and when to sell), doing that will take time. You’ll need to figure out a market hypothesis, research funds, execute the trades, and calculate your return.

A Timing Example

For the sake of an example, let’s say that you have $100,000 that you can either invest in REITs or the S&P 500. On average, you can expect to spend less than an hour parking your money in the S&P 500 index of your choice and earning 11.84% for the year. At 1 hour of work, you would earn $100,000 * .1184 = $11,840 per hour. 

Now let’s say that you choose to actively manage that $100,000 instead. Realistically, there’s no way you can hope to beat the hourly return on your S&P 500 investment. Nearly $12,000/hr is the equivalent of a yearly salary of $25M. 

But if you are savvy, you could turn your time into money. The idea here is that you don’t seek to compete with the S&P 500 hourly rate of return, but instead just try to make more money in absolute terms. 

Let’s say that you are able to trade REITs profitably and you manage to achieve a top-of-the market return of 50%. It still takes you 4 hours a week, however. So you earn $50,000 for the year, but you spent 208 hours realizing that return for an hourly rate of ~$250. That’s not bad. Most people would probably do that if they could. Unfortunately, your returns are far more likely to regress to the NAREIT long-term average over time (11.3%). At that rate of return, your 208 hours of time is only compensated at $54/hr, which isn’t super compelling.

Don’t Waste Your Time on REITs Reason #4: You Probably Already Own REITs

Another nail in the REIT coffin is that if you own any major stock indexes, you likely already have exposure to REITs. Recall from the introduction that there are 30 REITs that are in the S&P 500 index. So if you own any major index, you already have some exposure to the risks and upside of the asset class.

There’s a valid question to ask here. If you already own examples of the most successful form of an asset, what do you hope to gain by doubling down on less successful examples of the same thing?

Don’t Waste Your Time on REITs Reason #5: Commercial Real Estate is Tanking

I didn’t include this in my predictions about the coming decade, but let’s talk about current real estate trends for a moment. While the residential real estate market continues to buck Jerome Powell’s expectations and resist substantial price correction, commercial real estate seems poised to suffer a major correction. 

With work from home stubbornly resisting company’s bid to get workers to come back to office spaces, office occupancy rates in America’s biggest cities remain much lower compared to pre-pandemic [source]:

The trend looks similar at the national level:

In the US, the total value of commercial real estate is thought to be around $16 trillion. That’s about half as large as the roughly $33 trillion residential real estate market [source]. Ignoring industrial property, that means commercial real estate represents around ~32% of all real estate assets in the US. 

With defaults and write-downs looming for commercial property owners, I would be especially skeptical about investing REITs with any exposure to commercial real estate. The WSJ recently reported on a ~80% writedown of an office building in San Francisco. Yikes!

You could still invest in residential-only REITs, but with big REITs it can take a while to verify exactly what’s in the fund. And as outlined above, even residential-only REITs aren’t likely to outperform the S&P 500.

What’s Next?

REITs, like literally any other asset in existence, can be lucrative if you are a disciplined active investor. But to meet that bar requires a lot of time and skill development. It’s also a lot riskier than bloggers, analysts, and other supposed financial gurus would have you believe. For every person who strikes it rich with REITs or any other asset type, there are 10s or 100s of people who lose their shirt. The person who wins the lottery is very likely to brag about it. The people who lose? Not so much. 

So, if you are at Thanksgiving dinner and you hear that your uncle made $20,000 this year investing in REITs, that’s exactly the wrong reason to rush out and put money into Fundrise.

One last aside about active investing. If you aren’t already doing it with your own money, chances are you won’t like it. Why is that? We all gravitate to activities that we find enjoyable. If you’ve reached the point in your life when you have assets to invest, and you haven’t already done it, that’s probably because you don’t like it. To get good at investing, you have to make mistakes. Making mistakes when investing means losing money. It takes a special kind of person to watch your hard-earned money disappear and keep going.

And I’m no different. I hate losing money. I’d much rather put my money into the S&P 500 and rest easy. That enables me to do stuff I actually enjoy like playing with my kids, gaming, and going on dates with my wife.

Happy overthinking!