From the September 2004 issue of Investment Advisor • Subscribe!

Real Estate for Retirement

In these days of rising interest rates, it's a good idea for retirement plan sponsors to consider adding a REIT mutual fund to their 401(k) plans because, contrary to popular belief, the value of REITs and REIT mutual funds don't plummet when interest rates rise, according to Richard Imperiale, manager of the Forward Uniplan Real Estate Fund in Milwaukee.

Far too few plan sponsors offer a REIT fund option today, says Chuck DiRocco, VP of research and investor education at the National Association of Real Estate Investment Trusts (NAREIT) in Washington. That's a shame because funds that invest in real estate also increase returns and decrease risk "because they're not volatile investments," he says. When equities take a nosedive, REIT funds stay steady because there's little correlation between the two. REITs also have a low correlation to bonds. "When you add a REIT fund to your portfolio, you will see increased returns and reduced risk, and that's with an asset allocation anywhere from 5% to 15%," DiRocco says. "REIT funds add diversification [to a portfolio], which is what a defined benefit or defined contribution plan should be about."

Imperiale recently authored a white paper called "Ending the Myth of REITs and Interest Rates," which examined the long-term correlation of REITs to various fixed-income assets. What he discovered, he says, should help debunk the popular notion that because REITs have high dividend yields, their prices fall in a rising interest rate environment.

Using the NAREIT Equity Index, Imperiale studied the correlation between interest rates using 5-year and 10-year U.S. government bonds. The result: "When you look at REITs relative to bond indexes, there is a very low correlation over most time periods," he says.

REIT funds are also a "good inflation hedge because REITs have to pay out 90% of their taxable income in the form of dividends to their shareholders," DiRocco says. "The income return is really what keeps the REIT security above pace with inflation." As further support for this argument, DiRocco cites Merrill Lynch, which recently screened 1,600 stocks to find the best equities for inflation protection. Of those 1,600 stocks, 59 companies made the cut, DiRocco notes, and 34 of those were REITs.

Jay Hyde, a VP at NAREIT, notes that "although the majority of REIT dividends continue to be taxed as ordinary income," and not at the newly lowered 15% capital gains rate for corporate dividends, REITs "do qualify for a lower rate in a number of instances." In reviewing REITs' 2003 distributions, NAREIT found that about one-third of REIT dividends qualified for the lower 15% rate, "which is a significant number, and may come as a surprise to most planners," he says. REITs paid out approximately $11 billion in dividends in 2003.

Over the last three decades, the NAREIT Equity Index has outperformed the Dow and Nasdaq, DiRocco says. And for the last three years, equity REITs have returned 17% annually, he says. As of June 30, the NAREIT Composite Index was up 5.17% for the year, and the NAREIT Equity Index was up 5.51%.

According to NAREIT, the number of defined benefit and defined contribution plans that have added a REIT option has doubled in the last five years, but that still amounts to less than a 12% rise, DiRocco says, which is "far too low." That's why NAREIT has been knocking on the doors of plan sponsors and plan providers for the last three years explaining the benefits of using REIT mutual funds as an investing option.

Plan providers are just now waking up to the benefits of investing in REITs, DiRocco says, mainly because of the industry's overall growth. The REIT IPO boom took off in 1992 when the industry had only $8 billion in market capitalization, he says, and that "really started the boom of the REIT industry." Today, the REIT industry weighs in at a hefty $244 billion in market cap.

Hyde of NAREIT says far too few plan providers actually take the initiative to add a REIT option on their own, and usually end up doing so only after a plan sponsor has requested it.

Offering a REIT fund option in a 401(k) also gives folks with a lower risk tolerance a chance to dabble in real estate indirectly, Imperiale argues. Now is a particularly good time for investors to redirect some of their bond allocations to REITs, he says. "I tell my clients that if they have a diversified portfolio of stocks and bonds, [they should] lean toward taking the money out of the bond side of the portfolio because it's more likely that rates will go up and bonds won't perform as well," he says. But "now would not be a time to bail out of stocks to get into REITs."

Got a question about retirement planning that you'd like Retirement Plan Advisor columnist Melanie Waddell to explore in more detail? Please contact her at mwaddell@ia-mag.com.

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