Tax loss harvesting could be used to tactically enhance REIT allocation in a dislocated market environment while also positioning for future tax benefits
With 2022 shaping up to be an extremely challenging year for investors across the risk spectrum from stocks to bonds, to crypto, we would like to reacquaint readers with the concept of tax loss harvesting and how the strategy could potentially be used to tactically enhance their REIT allocation in a dislocated market environment while also positioning for future tax benefits.
Tax-loss harvesting is selling stocks, bonds, mutual funds, ETFs, or other investments in taxable accounts that have lost value since purchased to offset realized gains elsewhere in your portfolio. An unrealized gain/loss is the difference between the current market price of a position you currently hold and the original purchase price (cost basis). A realized gain/loss is the difference between the price at which a position was sold and its cost basis. Should you wish to maintain the characteristics provided by the investments you are considering selling for tax-loss harvesting purposes, they can be replaced with similar, but not substantially identical, securities in order to maintain a similar risk/return profile. [1]
The U.S. federal government allows investors to use capital losses to offset capital gains in the current tax year or carry the loss forward into future years, where losses can be kept in perpetuity. After realizing losses, investors may want to reinvest proceeds to maintain their desired exposure or asset allocation. To ensure that investors don’t get a tax break and then instantly buy back their original investment, the government has what’s known as the “wash sale” rule. The rule mandates that an investor cannot claim a loss on the sale of an investment and then buy a “substantially identical” security for the period beginning 30 days before and ending 30 days after the sale. [2]
The year-to-date (YTD) correction in equity markets has crossed over into “bear market” territory implying losses of 20% or greater for many major indexes. The concerns that precipitated the most recent selling pressure revolve around unabated inflation which is showing no sign of moderation and is forcing the Federal Reserve to shift to a more aggressive policy for raising interest rates in hopes of stabilizing prices. We believe this more aggressive strategy raises the risk of recession in 2023 and beyond.
The REIT sector is not immune from stock market corrections as it is itself in a bear market for 2022, experiencing total returns approaching –24%. The selling in REIT shares has been broad-based with office and industrial sub-sectors down approximately –30% YTD and regional malls down closer to –40%. The residential sectors including apartments, manufactured housing and single-family housing are all down roughly –23.5%. [3] In considering the fundamental outlook for the various property sectors and given the consensus view that the economy will slow from here (or worse enter a recession over the coming year) we believe that residential sectors are uniquely positioned for outperformance on an absolute and relative basis versus other property types. The defensive characteristics of residential real estate should provide a buffer to landlords in an environment in which house price appreciation slows or even retraces some recent gains. Resident turnover has been low and would likely remain low if the economy slows. Landlords are also positioned to benefit from in place rents which are 10-15% below current market rents, thus providing material growth in portfolio-level rents even if market rents stay constant. By way of example, Equity Residential (EQR), the large and diversified apartment REIT which owns 80,500 units across 12 U.S. markets recently reported a loss to lease of 13.5%, creating a runway for rental revenue increases over the next year.[4]
Finally, supply shortages across all forms of housing make it more likely that margins can be maintained and supportive of earnings and dividend growth. We believe other property sectors are not as well positioned and the economic slowdown is already leading to signs of overcapacity for major property sectors such as industrial, office and retail.
Putting the apartment sector outlook into the context of large, diversified and passively managed REIT ETFs with constituent holdings in excess of 150 names and track diversified benchmarks, but with only limited exposure to the residential sector and material exposure collectively to industrial, retail and office raises the question of whether now might be a good time for a tactical pivot to an ETF such as the Home Appreciation U.S. REIT ETF (HAUS), which provides 100% exposure to the residential sector, is actively managed and contains a curated portfolio of 26 names.
The large, diversified and passive REIT ETFs are a cost-effective way for individuals and institutions to gain broad exposure to the REIT asset class which has proven to be a strong performer and diversifier over the years. 5 However, we believe that the recent stock market correction presents an opportunity to take a more tactical (and potentially tax efficient) approach to the industry with at least a partial pivot from a broadly diversified REIT ETF to one with pureplay exposure to the residential sector.
Footnotes:
[1] www.fidelity.com/viewpoints/active-investor/tax-loss harvesting-using-ETFs
[2] Blackrock: Tax Loss Harvesting At A Glance
[3] FTSE NAREIT performance June 17, 2022
[4] Seeking Alpha: Philip Eric Jones; June 16, 2022; Equity Residential (EQR) - Almost Recovered From Covid
[5] Armada ETFs (HAUS) – Investment Case
Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.
Armada does not provide tax, legal or retirement advice. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
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