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REITs: The Great Diversifier

March 2003
REITs: The Great Diversifier

If you listen to most financial advisors, you already know that one of the secrets to successful investing is diversification. It?s perhaps the single most important strategy an investor can follow. While a diversified portfolio may not produce skyscraper returns, history shows us that it?s slow and steady that wins the race. The idea is that gains from some investments will offset the losses of other investments, thereby improving the bottom-line performance of your portfolio while reducing your overall risk. Because there are never any guarantees with investing, being diversified prepares you for both the good years and the not-so-good years. In fact, studies have found that over the long-term, diversification is even more important than individual investments to the overall performance of investment portfolios.1

One way to effectively diversify your portfolio is by investing in real estate investment trusts, more commonly known as REITs (pronounced ?reetz?). REITs are companies that own and manage commercial real estate and, by law, must pass on 90% of earnings to investors in the form of dividends. Because REITs have what economists call a ?low correlation? to stocks and bonds, they bring balance and stability to portfolios. In fact, a study conducted last year by Ibbotson Associates of Chicago, a leading authority on asset allocation, found that a 10% to 20% allocation to REITs can lower overall portfolio risk while bolstering returns.

Take a look at the chart below which illustrates Ibbotson?s findings by comparing the performance of a diversified portfolio including 20% REITs with the performance of a portfolio consisting of stocks, bonds, and cash equivalents only. (Chart based on risk and return data from 1972 through 2001.)

Most notably, this comparison of long-term results reveals that a diversified portfolio including REITs can perform competitively with a portfolio consisting of domestic stocks and bonds while incurring less risk. However, past performance does not guarantee future results.

REIT benefits are not limited to portfolio diversification. REITs offer unique opportunities for dividend income, potentially high total returns, and tax-related benefits. Here?s how:

It Pays to Own REITs

Investors today tend to think of dividends as a thing of the past. And in most cases, they?re right. In the 1950s, 80% of corporate earnings were paid out to investors in the form of dividends, resulting in higher dividend yields. Today, less than 30% of corporate earnings are paid out to investors. In fact, stocks have increasingly proven not to be a reliable source for dividend income, evidenced by their paltry average dividend yield of only 1.5%2.

And now that interest rates have dropped to their lowest levels in forty years, so have the dividend payments to fixed-income investors who rely on bonds, CDs, and money markets for income. If you are a retiree, you know what this has meant for you. It means you?ve watched your monthly income get slashed every time the Fed cuts interest rates.

So where can investors turn when they find themselves wealthy on paper but poor in cash? The answer may be REITs. REITs can typically pay income you can count on, even in a low interest rate environment. That?s because REIT dividends are determined by earnings from properties based on long-term leases with tenants ? not by current interest rates or the ups and downs of the stock market. In fact, REITs are currently paying an average dividend yield of 6.35%.3 While no substitute for your CD investments and money market accounts, REITs can provide an additional source of higher income to help you maintain your standard of living.

But what if you aren?t on a fixed income, you ask? Dividends can help cushion your portfolio, especially in declining markets. And although you may not need dividend income to meet your day-to-day living expenses like many fixed-income investors, you can still use dividends to help pay for insurance premiums, a child?s education, estimated quarterly taxes, family vacations, and more. Or, you can simply have your dividends automatically reinvested, which allows you to continue building that nest egg and diversifying your investment portfolio for the long-term.

REITs Stand Up in Down Markets

If the disappointing stock market is dragging your portfolio down, here?s some more good news about REITs: they also offer the potential for high total returns. In fact, for the last 30 years REITs have produced a 12.50% average annual total return competitive to the average total return of 12.24% for the S&P 500 during the same period.4

Within the past two years, REITs have been one of the few financial sectors keeping portfolios afloat. While the NAREIT total annual return was 26.36% in 2000 and 13.93% in 2001, the S&P 500 struggled in negative territory with a total return of ?9.11% and ?11.88% respectively. As you can clearly see, REIT investors may have been able to successfully balance the risks of investing by offsetting the losses of their corporate stock holdings during this period.

Tax Advantages Have Their Advantages

If there?s one thing we all have in common, it?s that none of us like paying taxes. High taxes eat away at total returns. But REITs offer two tax-related benefits to help you keep more of what you earn.

First, REITs do not pay income taxes the way regular corporations do. It?s astonishing, but corporations can pay as much as 48% in corporate taxes! That may mean 48% less that is actually funneled down to you, the investor. On the other hand, REITs have no corporate tax liability, giving them the ability to pay out more real earnings to investors in the form of dividends5.

On top of this, REITs also offer an additional tax benefit in the form of a non-taxable return of capital. While the details get a bit technical and the number crunching a bit complex, suffice it to say that as a REIT investor, you benefit from a depreciation pass-through on the properties in the REIT portfolio, allowing you to receive an annual tax deferral against the current income you have received from your REIT investment. The net effect is that depreciation can shave as much as 25% to 30% off a REIT investor?s 1099 Form reportable income under current IRS Regulations.6

If you?ve never considered REITs as a valuable investment for your portfolio, now is a great time to talk to your financial advisor about how an investment in REITs might make a difference in your long-term financial plan. It is imperative, however, that you consult your financial advisor before making an investment in REITs as they are subject to risks which may include fluctuation in value based on general and local economic and environmental conditions and possible illiquidity of the investment. Other risks of investing in real estate may also include possible devaluation of holdings if properties lose tenants and become difficult to re-lease. Performance of REITs cannot be guaranteed and should be considered long-term investments. As with any investment security, shares may be worth more or less when sold than what was originally paid for them.

As the great diversifier, REITs have already earned a place in thousands of investor portfolios. Now what about yours?


*Portfolio Mix- 50% Stocks, 40% Bonds, 10% T-Bills

**Portfolio Mix- 40% Stocks, 30% Bonds, 10% T-Bills, 20% REITs

Source- Ibbotson Associates. For the period December 1972 through December 2001, the index information used for each asset class was as follows: Stocks: Standard & Poor?s 500, Bonds: 20-year U.S. Government Bond, Cash: U.S. 30-day Treasury Bills, REITs: NAREIT Equity Index. As with a portfolio of all stocks or bonds, a diversified portfolio gives no guarantee of safety of principal which is subject to fluctuate. Past performance does no guarantee future results. This data does not represent a particular fund.

7 This is not an offer or a solicitation to purchase securities which can only be done by prospectus.

Date of First use: July 15, 2002

6 IRS regulations are subject to change. Please discuss your specific tax situation with your tax advisor.

5 Investor is required to pay ordinary income tax on any dividends received at the shareholder level.

4 Source: National Association of Real Estate Investment Trusts (NAREIT). Based on the 30-year return 1972-2001 of the NAREIT Equity Index and S&P 500. These performance results do not include investment management fees or sales charges. The S&P 500 is widely regarded as the standard for measuring large cap U.S. stock market performance. This popular index includes a representative sample of leading companies in leading industries. The NAREIT Equity Index represents the total U.S. publicly traded Equity REIT market. They do not put any parameters on their selections of REITs to track except that they be domestic and publicly traded equity REITs. Past performance does not guarantee future results. This data does not represent a particular fund or the performance of that fund.

3 Based on the NAREIT Equity Index Yield as of May 31, 2002. During the 30-year period 1972-2001, the NAREIT Equity Index produced an average dividend yield of 7.98% while the average annual dividend yield for the S&P 500 was 3.45% for the same period.

2 Based on S&P 500 statistics as of May 31, 2002.

1 Source: Morningstar, ?Determinants of Portfolio Performance?, Gary Brinson.

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