Should you buy REITs when you’re young?

Hey fs quick question, love your blog. I see you recommend real estate reits a lot and I did invest in your top 3 picks. However I wrote to a stock analyst and he commented back that you shouldnt buy Reits when you’re young……… That you should go for high-growth instead……. What do you think about that?

To be honest, I can kind of see his point. Without reading what he wrote, I have to assume he suggested a high-growth strategy in lieu of Real Estate Investment Trusts, the logic being that high-growth companies will grow up by 15-20% over the long term, while REITs will grow by 2-3% per year (average growth of real estate) plus their 4-5% distribution.

Over the long term, a high-growth strategy will definitely beat a REIT portfolio. It is also true that REITs are not necessarily safer than those high-growth companies. Finally, if your horizon is long enough, your odds of losing money with solid, high-growth companies. are extremely low.

In other words, if you invested 100% of your money in GOOGL, AMZN, NVDA, AMD, STX and a few others, you will absolutely demolish any portfolio composed of REITs (over the long term). If you are young and thus have a long investing strategy, investing in growth definitely beats REITs. So he is right there.

There are, however, a couple of points I’d like to bring:

Dividends

I spent quite a fair amount of time on this blog repeating that you should not invest in dividend-based companies, no matter your age (except sometimes in tax-free accounts or if you do not pay taxes anyway). The logic is that dividends are taxed to death. To bring $0.50 in your pockets, the company has to pay $2, i.e. it costs them $2 to send you a dollar due to taxes, and from that dollar, you only keep $0.50. While a gross approximation, you get the idea: dividends are terribly tax-ineffective.

However, once again, REITs do not have that problem because REITs do not pay a dividend, they pay a distribution AND they do not pay taxes in the first place. To put $0.50 in your pockets, REITs only have to pay $0.50. In other words, REITs are very efficient tax structures. I’ve had REITs that have been paying me every month for 10+ years and I never paid a cent in taxes on them. Now, I will pay taxes when I sell, but that is also the case with growth companies.

Growth

I’ve always hated the expression “high-growth” companies because it’s kind of a misnomer. After all, who wouldn’t want to invest in high-growth companies? Who’s going to say, “Damn, I want to invest in low-growth companies?”

A better name for those high-growth companies would be “high-risk companies.” Sure, high-risk outperform low-risk over the long term (because more risky assets pay more, e.g. Venezuela bonds pay a higher yield than Canada’s), but the comparison with REITs is a bis misleading.

With REITs, your risk gets reduced every month. Say you invest $100,000 in a REIT paying a 6% distribution per year; every year, you receive $500 cash. After one month, your risk is no longer $100,000, but rather $99,500. After a year, your risk is no longer $100,000, but $94,000. That is because even if the company goes bankrupt after a year, you wouldn’t lose your full, original investment since you got some money back since.

Given that, comparing REITs to “high-growth” is a fallacy; a better comparison would be to compare REITs to the general market, aka the S&P 500. The S&P500 moves up by 8-10% on average every year (some years much better, some years much worse). Given that comparison, the 2-3% + 5-6% =7-9% of REITs looks much better.

The fallacy of high-growth

I’ve said before that targeting high-growth. Let’s look at Chipotle, a high-growth company if there is ever such a thing:

From mid 2015 to mid 2016, the stock crashed by roughly 50% and this kind of move isn’t rare when it comes to high-growth companies. Even Apple fell victim to it:

Yes, Apple did indeed recover (and I’ve been recommending them ever since), but such big swings are not rare with high-growth stock. Many growing companies went bankrupt, leading to a 100% loss. Thus, with a high-growth strategy, it is not rare to see or even expect a -30% year, for instance, even with full diversification.

And if you’ve never stomached a -30% year before, or maybe even a -30% month, you have no idea how painful it can be. It takes immense discipline not to sell when your stocks are down 30%.

REITs, on the other hand, do not have that kind of problems. As long as you buy quality REITs, your investment is backed by one of the safest classes of assets there is: land and buildings. Even if the REIT goes bankrupt, your investment is unlikely to go to zero because the buildings are still there. Most REIT trade at or below their Net Asset Value, meaning that when you are buying $1 of a REIT, you are getting $1.05 or more of assets.

Similarly, once a lease is made, it can only be broken by bankruptcy. Thus, when a REITs rents something, as long as they rent to reliable tenants, you can expect the rent to be paid.

For all those reasons, I would argue that REITs are as risky as the general market and, thus, less risky than “high growth” strategies. Sure, there is a risk there could be a massive real estate crash that blows everything out, but if that happens, your high growth investment is going to gravitate around $0 as well.

Convenience

As mentioned before, most REITs pay a monthly distribution. This means having money in your pockets every month. A high-growth strategy is unlikely to pay dividends as they need all the money they possibly can to grow. This means that unless you sell stock regularly – which comes with its own problems, for instance, you might not elect to sell if the company crashes, plus you might pay taxes – you won’t see a penny until many, many years.

With REITs, however, you get a paycheck every month, under a very optimized tax structure. The convenience of that regular, steady stream of cash flow, has undeniable advantages, amongst other things, predictability, flexibility to reinvest, risk reduction, etc. Plus, many REITs grow their distribution, meaning your paycheck might increase year after year.

REITs vs S&P500

All in all, I am not convinced that REITs significantly underperform the general, broad market like your “analyst” seemed to imply. Looking at the biggest REIT ETF and the SPY:

Sure, the REIT sector only went up 60% while the SPY went up 110%, but people tend to forget the distribution: VNQ pays around 4% right now while SPY pays around 2%. And the SPY’s dividend is mostly considered of fully taxable distributions while the VNQ is mostly tax-free. All-in all, looking at this graph, it’s not obvious to determine that the SPY is definitely better; sure, there is a big crash in 2008, but it just so happened to be a housing crash, i.e. the worst possible thing for REITs. Had there been a technological crash instead, or perhaps an industrial crash, we might be looking at a very different graph with VNQ far ahead of the SPY. In other words, it just so happens that, in the last 12 years, we got one crash, and it happened to be a real estate crash.

Conclusion

There is definitely some merit to that analyst’s comment, but it doesn’t paint a complete story. REITs have advantages that almost no other class of assets are. As a young investor, should 100% of your investing money be devoted to high-growth companies? Maybe, depending on what you want. You might find that the safety of a reliable 6% per year distribution beats the nights of losing 10, 20 or 30% of your money. Or you might find that you prefer those years where your high-growth stocks perform really well and you double or even triple your money. It’s up to you.

 

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