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How REITs Can Produce Retirement Income

In this second article in a series about pass-through securities, investment analyst Ryan Giannotto examines REITs and their potential for retirees seeking income.

By Ryan Giannotto, CFA

Few resources are as essential as income: no one cannot live without it. The experience of 2020 illustrated the wisdom behind holding diversified streams of income—between falling bond yields and cut dividends, opportunities for yield became scarce, if not unsustainable altogether.

Ryan Giannotto, CFA, is the Director of Research at GraniteShares, a New York-based independent exchange-traded fund issuer that seeks to launch innovative and disruptive ETF investments. At GraniteShares, Ryan focuses on portfolio construction, indexing strategies and the use of non-correlating assets. He graduated from the Honors Program at Boston College with a B.A. in economics and philosophy.

Ryan Giannotto, CFA

This unprecedented income crunch has yield-focused investors taking a renewed interest in pass-through securities, a unique investment category that can offer powerful advantages to income generation. Not only are these assets exempt from corporate taxes, but they are required to pay out substantially all (+90%) of their cash flows directly to end investors.

While there are four categories of pass-through securities, here we cover real estate investment trusts (REITs), the largest and most well-known of the group. From a retiree’s perspective, let’s examine the income potential of REITs, the risk factors involved and the role of REITs within a broader yield-generating portfolio.

Three Rules of Real Estate (Yield, Yield, Yield?)

Fundamentally, REITs offer a tax-efficient vector for investing in real estate without having to purchase and manage specific properties. Compared to direct investment, REITs enable investors to better target their ideal investment size, to access far greater liquidity, and they offer a hands-off experience. Effectively, the REIT structure transforms one of the most illiquid private investments (property) into a diversified vehicle that trades like a stock.

This ease of access was precisely why President Eisenhower first authorized REITs in 1960, as an earmark to the Cigar Excise Tax Extension Act—some aspects of politics never change.

While additional restrictions apply, the basic requirements of operating a REIT are that at least 75% of assets and income must be tied to real estate, and over 90% of their earnings must be distributed to shareholders. In a business based on regular and predictable cash flows such as real estate, these restrictions actually serve investors’ interests by ensuring management discipline. In other words, the priority is paying dividends to end shareholders, not pursuing executive’s pet projects.

With the benefit of corporate tax exemption, this arrangement has been wildly successful for both business and investors. Currently, there are a total of 220 listed REITs in the U.S. market, worth in sum roughly $2.5 trillion in market cap. In fact, REITs are so prevalent that if you hold a broad-based index fund, you are likely already invested in this market segment—REITs account for 6% of the companies in the S&P 500.

What is unique about REITs among pass-through securities is that they offer the potential for capital appreciation in addition to income generation. Whereas business development companies (BDCs), master limited partnerships (MLPs) and closed-end funds are near exclusively income-producing investments, over the past 25 years, real estate saw capital growth account for roughly 40% of total return. As a point of contrast, MLPs only generated 10% of their returns through capital appreciation over the same time period—the potential for principal growth is almost incidental. This balanced approach by REITs can be useful to maintain an investment’s purchasing power through the retirement years while also providing an ongoing source of income.

Show Me the Money

In today’s market, how much income can real estate investment through REITs generate? Currently, the MSCI US REIT Index, a prominent industry benchmark for the overall REIT ecosystem, is yielding 3.78%. While in absolute terms this figure does not seem particularly extraordinary, it more than doubles the yield available through the stock market— the S&P 500 paying out less than 1.50% in dividend yields.

If this headline figure of 3.78% fails to impress, it is important to remember that REITs are an expansive and highly segmented ecosystem. From a top level, the market is divided between equity REITs, which focus on the ownership and development of real estate properties, and mortgage REITs, which concentrate on the financing of real estate. While some companies take a hybrid approach, combining ownership and lending activities, most REITs cleanly fall into one category or the other.

Beyond business model, REITs are further grouped by industry exposure and even geography. Common breakdowns include residential, office, warehouse, retail, hospitality and even medical REITs—each industry carries its own risk profile and unique drivers of return. Not only does this segmentation signal to investors a clarity of mission, but it also helps REITs differentiate themselves from one another with each approaching the market with their own investment thesis.

Equity and mortgage REITs (eREITs and mREITs in Wall Street vernacular) represent two entirely different business models, and the yields they can generate illustrate this point. For instance, the Dow Jones Equity REIT index currently yields 3.38% while the Dow Jones Mortgage Index yields 9.82%—an extreme difference. What is the factor that enables one category of REIT to generate nearly three times as much income? In a word, leverage.

When most investors envision real estate investment, it is the equity REIT model that comes to mind as a vehicle for conveying rental income to end investors. Mortgage REITs by contrast are effectively miniature hedge funds that specialize in real estate-related financial securities. Typically mortgage REITs will borrow money at low interest rates and reinvest in much higher yielding investments, capturing the difference in coupons. These companies will use leverage to magnify their returns, often many times over, and will also make derivative trades to hedge interest rate movements.

Combining all of these operations, mortgage REITs have been able to support extremely high yields for investors, but the business model by definition is speculative. These risks notwithstanding, mortgage REITs are one of the few segments in the market presently distributing very high levels of income—if investors are looking to break 4% yield, mREITs are one of the only potential strategies capable of doing such.

The Okay, the Bad, and the Ugly: REITs in 2020

After exploring the dynamics of both ends of the real estate market, what role can REITs perform within a broader income portfolio? Before proceeding further, a requisite 2020 performance disclaimer bears mentioning: real estate overall and REITs in particular were one of the most severely impacted market segments during the pandemic in 2020. Office and retail REITs experienced drawdowns of up to 56%, mortgage REITs 66% and the ecosystem overall suffered losses over 43%. While the REIT market has experienced recovery, especially following the Pfizer vaccine, the uptick in asset values has been slower than that of the market overall and the future remains ambiguous. What is the value of location in a world gone virtual?

These are difficult questions to ask without immediately obvious answers. The resumption of normal economic activity should likely prove supportive of real estate asset prices, and see a return to fuller and more complete rental payments. Nonetheless, for those aware of the risks, the opportunity is present to allocate the real estate investment at a discount to historical valuations.

With rates remaining low and inflation expectations increasing materially, including REITs can be a useful tool to broaden the scope and increase the value of a portfolio’s income stream. Frequently, real estate is cited as a diversifying investment, and while some distinction in risk factors exists, such as a higher sensitivity to interest rates, REITs still correlate strongly with the stock market overall. The overwhelming majority of risk in a real estate investment is equity risk, even if REITs have historically been less volatile (excluding 2020). Furthermore, if a retiree already owns their own home, REIT investment can be a duplicative exposure, a doubling down on preexisting risk factors. Hence, the diversification value of real estate is not as potent as widely assumed, moving as much with the stock market as companies in the energy sector do.

How Should Retirees Approach REITs?

While REITs arguably remain riskier than at any point in the past few decades, this consideration needs to be weighed against the risk of generating insufficient income. In other words, there is no safe harbor from taking risk overall in creating an income portfolio—assuming less principal risk increases longevity risk whereby retirement funds are prematurely depleted.

In this context, REITs can serve as a complement to other income-generating assets in the pass-through security ecosystem. One of the main value-adds REITs carry over conventional dividend-paying stocks is their corporate tax exemption. Furthermore, REITs may help offset the negative impacts of inflation through retirement, as historically both rents and property prices have exhibited a strong sensitivity to changes in inflation.

Perhaps the optimal REIT strategy may be to purchase a broad-based basket of REITs spanning both the mortgage and equity sectors, which can be accomplished easily through low-cost ETFs. If the foremost goal is seeking passive income streams, picking individual REITs by industry or geographic selection poses an unnecessary bet that can reasonably be avoided. Finally, retirees may wish to be skeptical of private or unlisted REITs, as these investments do not enjoy the regulatory protections of their publicly-traded counterparts, and they are also far less liquid as well.

The rules of yield generation have irretrievably changed—meaningful income and full security of investment are now mutually exclusive concepts. Indeed, risk has become the precondition for achieving sustainable cash flows that outpace inflation. Alongside other pass-through securities, REITs can be a useful vehicle for translating risk into long-term income generating potential.

Read the first article and watch the video in this series: The ABCs of Pass-Though Securities: MLPs.

About the Author: Ryan Giannotto, CFA

Ryan Giannotto, CFA, is the Director of Research at GraniteShares, a New York-based independent exchange-traded fund issuer that seeks to launch innovative and disruptive ETF investments. At GraniteShares, Ryan focuses on portfolio construction, indexing strategies and the use of non-correlating assets. He graduated from the Honors Program at Boston College with a B.A. in economics and philosophy.

Past performance is not a guarantee of future results. One cannot invest directly in an index. For full disclosure, GraniteShares manages the GraniteShares HIPS U.S. High Income ETF (HIPS), which invests in a basket of pass-through securities.

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