Real estate investment trusts (REITs) and exchange-traded funds (ETFs) both offer the potential to earn passive income during retirement. There are even REIT ETFs for investors who want the best of both worlds. Let’s consider why you might want to choose or avoid each of these types of investments if you’re retired.
The Case for REITs
“A real estate investment trust, or REIT, is a type of investment fund that owns income-producing real estate and is required to pay out most of its taxable income as dividends,” explains Robert R. Johnson, former president and CEO of the American College of Financial Services, a nonprofit, accredited, degree-granting institution based in King of Prussia, PA. “REITs are considered income investments because of their high dividend yields,” he says, and there are many varieties available, including retail, residential, healthcare, office and mortgage. “An investor should consider REITs if he or she wants exposure to the real estate asset class,” Johnson says.
REITs can also make sense if you’re looking for an investment that provides income while you’re holding it and not just if you manage to buy it and sell it at the right times. REITs are able to pay dividends based on rent and property appreciation. A drawback is that much of this REIT income is taxed as ordinary income, which carries a higher tax rate than dividends from stocks, ETFs and many other asset classes.
“Retirees should look for REITS that invest in commercial buildings that have mainly AAA tenants or big companies, or residential buildings that have low vacancy rates,” says Mike Ser, cofounder of Ser Man Traders, a company that trains people to become professional traders. These types of buildings generate much more stable cash flow, he says.
But REITs may not offer enough diversification for your portfolio. “By investing in a REIT, you are focusing your investment in one very narrow sector of the market,” says Charles J. Stevens, former financial advisor. “When this sector is out of favor with investors, your REIT price will not reflect true value should you need to sell it.”
That being said, if you want more exposure to real estate, a REIT offers greater diversification and liquidity than, say, buying a rental property. With a REIT you’ll own a small share of many properties, and as long as you invest in traded REITs (as opposed to nontraded REITs), you’ll usually be able to quickly sell your holdings on an exchange if you want to exit your position for whatever reason.
The Case for ETFs
“An exchange-traded fund, or ETF, is a type of investment fund that trades like stocks on an exchange,” Johnson explains. “ETFs can hold a variety of assets such as stocks, bonds, commodities and real estate.” If ETFs sound like mutual funds, you’re on the right track, but there’s a key difference. “ETFs differ from mutual funds in that they trade continuously throughout the trading day, while mutual funds are bought and sold at net asset value at the end of the trading day,” Johnson says.
Stevens favors passively managed ETFs over REITs. He says that ETFs allow investors to tailor a portfolio to almost any risk parameter or tolerance. “The sheer size of the ETF market in most cases can create liquidity for the investor that REITs cannot match,” Stevens says. “ETFs have a cost advantage at the management level that REITs cannot match.”
Ser says that retirees should look for ETFs made up of solid, stable companies that consistently pay dividends at least quarterly.
ETFs, like REITs, can leave your portfolio insufficiently diversified. If you put half of your money in an information technology ETF, you’re not getting the diversification you would get with an S&P 500 ETF, which would be allocated 20% to IT stocks in today’s market. But in general ETFs offer a greater opportunity for diversification because, with a single ETF, you can track multiple stock indices.
Want the best of both worlds? You’ve got it. “ETFs and REITs are not mutually exclusive, as there are many REIT ETFs,” Johnson says. “That is, there are exchange-traded funds that invest exclusively in REITs. For instance, the S&P REIT index fund FRI is a passive ETF that seeks to replicate the return on the S&P United States REIT index.”
The Bottom Line
Either or both of these investment types can be right for retirees as long as they fit into an overall portfolio strategy. Retirees should understand the expenses and risks associated with any specific REIT or ETF they’re considering, as well as what level of income to expect and how it will be taxed. “Retirees should be looking for solid investments that generate a stable yield or income for them during their retirement years,” Ser says. “Both REITS and certain ETFs can accomplish that.”