REITs enjoy the dual benefit of providing current income while also hedging against the risk of inflation. The additional benefits of tax shelters and portfolio diversification make REITs a tailor-made solution for those approaching or in retirement.

• Real estate investment trusts (REITs) are an ideal investment product for an aging population. For retirement-focused investors, REIT ownership provides the key benefits of current income, diversification, potential inflation protection and a tax shelter.

• Studies have shown that retirement portfolios that include REITs provided greater annualized returns with less volatility than similar portfolios without REITs. Based on contributions made over a full career, the excess returns of the retirement portfolio with REITs compounded to 20.4% greater portfolio value.

• Aging investors who directly own real estate are in a highly advantageous position to transition to REIT ownership. Working with a REIT sponsor, these investors can perform a fully tax-deferred exchange process into a more liquid, passive REIT ownership that will provide current income in retirement.

The benefits of REIT ownership for an agining population.

Are you adequately saving to be able to afford your retirement? This often guilt-inducing question is constantly asked by financial advisors, personal finance gurus and those in the media. Larry Fink, chief executive of BlackRock, the world’s largest money manager, recently attached alarm bells to this question by making the argument that a lack of retirement savings represents a potential social crisis for an aging population. In Fink’s annual letter to investors, he writes, “As a society, we focus a tremendous amount of energy on helping people live longer lives. But not even a fraction of that effort is spent helping people afford those extra years.” Fink’s broad answer to this retirement crisis is that investing in assets within the capital markets is the best way to achieve a comfortable retirement.

We will take Fink’s argument a step further and provide an overview of why investing in a real estate investment trust (REIT) represents such a powerful tool for retirement-focused investors. REITs provide an important diversification component to a portfolio but also offer many benefits around inflation protection and income creation that are of particular interest for retirees. The “super charge” to these benefits can be realized by the many investors that personally own real estate. Direct real estate ownership provides similar advantages to a REIT; however, active management and the classic issues of “toilets, tenants and trash” can begin to seem overwhelming for many owners picturing a relaxing retirement. Direct real estate owners can utilize a fully tax-deferred process of selling their existing property in a 1031 exchange to acquire a professionally managed Delaware statutory trust (DST), which then may be contributed to a REIT through an UPREIT transaction. We will look at these steps in more detail below; however, this process allows property investors a tax-deferred method of gaining passive ownership of a REIT product that provides numerous benefits specifically serving those approaching or in retirement.

REITs are tailor-made for retirement-focused investors.

REITs own, operate or finance a portfolio of income-producing real estate. Investors pool their capital in a REIT, contributing money in exchange for ownership of the organization, similar to a mutual fund. There are several key requirements that a REIT must abide by in order to maintain its tax-advantaged status; however, of chief importance for retirement-focused investors is that a REIT must pay a minimum of 90% of taxable income as dividends each year. With this knowledge, we can highlight several benefits that make REITs a tailor-made investment for those focused on retirement:

• Income: REITs generally own a high-quality portfolio of properties that generate rental income from necessity-based housing renters or creditworthy commercial tenants. As mentioned above, the REIT is obligated to pass along these cash flows as dividends to investors. To provide an example of the income potential, Capital Square’s REIT, which provides top-quality housing solutions, offers current income of 5.0% (not inclusive of appreciation potential).

• Diversification: Diversified assets and income streams are valuable in balancing the ups and downs that are part of an investment portfolio. JPMorgan analysis shows that REITs range from a correlation of -0.31 with currencies (meaning that it is generally expected that values of the two assets will move in opposite directions), to 0.51 with bonds and 0.78 with large cap stocks. Diversified holdings become more important for retirees, who are dependent on maintaining principal value in the near term.

• Inflation Protection: REIT sponsors are generally able to raise rents and increase property-level incomes in response to rising prices. This makes REITs a rare investment with many of the recurring income benefits of a fixed-income security, while also serving as an inflation hedge. A study found that over a 43-year period ending 12/31/2018, REITs as an asset class provided a better inflation hedge than either fixed-income, equities or commodities:

• Tax Shelter: REITs are able to benefit from numerous tax deductions available to real estate owners, importantly with the large reductions to taxable income provided by depreciation. REIT owners’ distributions (excluding capital gains) are classified as one of two types of income depending on the tax shelter: 1) Ordinary Income, which is taxed at an investor’s marginal tax rate, and 2) Return of Capital, which is nontaxable. When depreciation deductions allow for a distribution in excess of earnings (because the deductions allow for cash distributions that are greater than reported taxable earnings), these distributions are nontaxable for investors.

REITs increase retirement portfolio returns while diversifying risk.

Many investors preparing for or in retirement use “Target Date Funds” (TDFs) as a way of letting the professionals handle asset allocation for their retirement assets. These TDFs hold a mix of asset types that gradually shift from more aggressive and growth-seeking when an investor is many decades from retirement to more conservative and income-focused when the investor is near or in retirement. Vanguard is a popular money manager offering these TDF strategies and currently has funds spanning those marketed to investors already in retirement to those planning to retire in 2070. However, an observation of the components of these TDFs shows that they hold a mix of stocks, bonds and short-term, inflation-linked securities. Even with a prudent investment vehicle like a Vanguard TDF, investors can miss out when REITs are not a specific component of their retirement portfolio.

A study performed by Wilshire Funds Management found that portfolios with a dedicated allocation to REITs earned higher returns while also experiencing less volatility than other so-called optimal target date portfolios that did not have an allocation to REITs. Wilshire found that the optimal allocation to REITs ranged from 15.3% for those looking to retire in 2065 to 6.3% for those who have already been in retirement for 10+ years. See the chart below:

Wilshire calculated that retirement portfolios optimized with REITs experienced higher annualized returns over a long-time horizon. Calculated annual returns over the period 1975 to 2019 for the Optimal Portfolio including REITs were 10.49% versus 10.02% for the Optimal Portfolio without REITs. While this difference may appear de minimus at the outset, consider that with the effects of compounding over a long time period of saving for retirement (44 years in the data shown), this resulted in a 20.4% higher portfolio value. With a hypothetical $10,000 investment, retirement savings were $804,644 in the portfolio with REITs and $668,382 in the portfolio without REITs.

The breakdown of Wilshire’s findings is below:

Tax-favored retirement accounts provide even greater benefits to REIT ownership.

The previous section made clear the potential benefits for a retiree of adding REITs to the portfolio of assets held in retirement. Additionally, however, there are bonus advantages realized by those who are still saving for retirement and make REITs a part of their retirement accounts. Tax-deferred retirement accounts such as Individual Retirement Accounts (IRAs) and 401(k) accounts allow contributions to grow free of income taxes. Because REITs are required to pass along most of their income to investors as dividends, this means that retirement accounts allow investors to realize the enormous advantage of watching these REIT dividends grow tax-free.

It is a powerful tool to be able to grow REIT dividends in a tax-deferred retirement account, but the benefits are extended further when considering REIT performance relative to inflation. Unlike bonds with fixed interest payments, REITs are able to respond to price increases in the general economy by raising rents and lease rates. The relative pricing power of REITs to increase rental rates on necessity-based housing solutions and highly demanded properties affords REITs the ability to consistently outpace the annual consumer price index (CPI) (as a measure of inflation).

The chart below, provided by the industry group NAREIT, shows that REIT annual dividend increases per share have outpaced CPI in all but three of the 20 years ending in 2020:

Aging property owners can reap huge rewards with a tax-deferred exchange into a REIT.

Many investors have created wealth over their lives through the direct ownership of a collection of rental homes, a couple commercial buildings or some other portfolio of real estate assets. These properties may have produced excellent financial results over the years, but they undoubtedly require time, money and attention. At some point, the aging investor may wish to transition to more passive ownership that allows for greater time to enjoy their family and their hobbies. There are a couple of manageable steps that provide the opportunity for these investors to have their cake and eat it too.

These investors can move through a fully tax-deferred exchange process to gain passive ownership in a high-quality REIT. Fully integrated real estate investment firms such as Capital Square provide investors with Delaware statutory trusts (DSTs) that will be optionally exchanged into a REIT in order to offer such an opportunity. The following steps provide an overview of the process:

1. An investor sells directly owned real estate in a tax-deferred 1031 exchange;

2. Proceeds from the sale of the real estate are applied through the 1031 exchange to investment in a Delaware statutory trust (DST), which owns professionally managed, commercial property such as multifamily apartment communities. These DSTs provide both current income and appreciation potential;

3. The DST/REIT Sponsor notifies the investor that the assets held in their DST will be contributed to the Sponsor’s REIT. The investor approves of their interest in the DST being exchanged into Operating Partnership (OP) units in the REIT in a tax-deferred UPREIT transaction.

Through a fully tax-deferred process, the former property owner now enjoys a more liquid, passive ownership in a REIT. The opportunity to utilize the guidance of a real estate sponsor firm such as Capital Square to seamlessly shift into such a retirement-friendly asset like a REIT represents a major advantage for these aging property owners.

An aging population cannot afford to miss out on the benefits of REIT ownership.

In an age when the leader of the world’s largest money management firm exclaims that a retirement savings crisis is brewing, REITs offer a solution that aging investors cannot afford to pass up. Many of these investors are seeking to switch into a more conservative retirement portfolio focused on fixed-income strategies, but this often leaves their portfolio vulnerable to inflation eroding the purchasing power of their hard-earned savings. REITs enjoy the dual benefit of providing current income while also hedging against the risk of inflation. The additional benefits of tax shelters and portfolio diversification make REITs a tailor-made solution for those approaching or in retirement. Finally, the opportunity for property owners to make a tax-deferred transition to more liquid, passive REIT ownership makes REITs an enhanced investment product for an aging population.

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This article originally appeared on Capital Square's website.