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REITs: What They Are and How to Invest in Them

Real estate investment trusts are a way for you to invest in commercial real estate property without actually buying and managing those properties yourself.
Jan. 16, 2020
Investing, Investing Strategy, Investments
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What is a REIT?

REIT — rhymes with “sweet”— stands for real estate investment trust, and its popularity is growing for investors who seek to expand their portfolio beyond publicly traded company stocks or mutual funds.

REITs are companies that own (and often operate) income-producing real estate, such as apartments, warehouses, self-storage facilities, malls and hotels. Their appeal is simple: The most reliable REITS have a track record for paying large and growing dividends. Still, that potential for growth carries risks that vary depending on the type of REIT.

How do REITs work?

Congress created real estate investment trusts in 1960 as a way for individual investors to own equity stakes in large-scale real estate companies, just as they could own stakes in other businesses. This move made it easy for investors to buy and trade a diversified real-estate portfolio.

REITs are required to meet certain standards set by the IRS, including that they:

  • Return a minimum of 90% of taxable income in the form of shareholder dividends each year. This is a big draw for investor interest in REITs.
  • Invest at least 75% of total assets in real estate or cash.
  • Receive at least 75% of gross income from real estate, such as real property rents, interest on mortgages financing the real property or from sales of real estate.
  • Have a minimum of 100 shareholders after the first year of existence.
  • Have no more than 50% of shares held by five or fewer individuals during the last half of the taxable year.

By hewing to these rules, REITs don’t have to pay tax at the corporate level, which allows them to finance real estate more cheaply than non-REIT companies can. This means that over time, REITs can grow bigger and pay out even larger dividends.

Types of REITs

REITs fall into three broad categories divided by their investment holdings:  equity, mortgage and hybrid REITs. Each category can further be divided into three types that speak to how the investment can be purchased: publicly traded REITs, public non-traded REITs and private REITs.

Each REIT type has different characteristics and risks, so it’s important to know what’s under the hood before you buy.

REIT types by investment holdings

Equity REITs:  Equity REITs operate like a landlord. They own the underlying real estate, provide upkeep of and reinvest in the property and collect rent checks — all the management tasks you associate with owning a property.

Mortgage REITs: Unlike equity REITs, mortgage REITs (also known as mREITs) don’t own the underlying property. Instead, they own debt securities backed by the property. For example, when a family takes out a mortgage on a house, this type of REIT might buy that mortgage from the original lender and collect the monthly payments over time. Meanwhile, someone else — the family, in this example — owns and operates the property.

Mortgage REITs are usually significantly more risky than their equity REIT cousins, and they tend to pay out higher dividends.

Hybrid REITs: Hybrid REITs are a combination of both equity and mortgage REITs. These businesses own and operate real estate properties as well as own commercial property mortgages in their portfolio. Be sure to read the REIT prospectus to understand its primary focus.

REIT types by trading status

Publicly traded REITs: As the name suggests, publicly traded REITs are traded on an exchange like stocks and ETFs, and are available for purchase using an ordinary brokerage account. There are more than 200 publicly traded REITs on the market, according to the National Association of Real Estate Investment Trusts, or Nareit.

Publicly traded REITs tend to have better governance standards and be more transparent. They also offer the most liquid stock, meaning investors can buy and sell the REIT’s stock readily — much faster, for example, than investing and selling a retail property yourself. For these reasons, many investors buy and sell only publicly traded REITs.

Public non-traded REITs: These REITs are registered with the SEC but are not available on an exchange. Instead, they can be purchased from a broker that participates in public non-traded offerings, such as online real estate broker Fundrise. (Nareit maintains an online database where investors can search for REITs by listing status). Because they aren’t publicly traded, these REITs are highly illiquid, often for periods of eight years or more, according to the Financial Industry Regulatory Authority.

Non-traded REITs also can be hard to value. In fact, the SEC warns that these REITs often don’t estimate their value for investors until 18 months after their offering closes, which can be years after you’ve invested.

Private REITs: Not only are these REITs unlisted, making them hard to value and trade, but they also generally are exempt from SEC registration: As such, private REITs have fewer disclosure requirements, potentially making their performance harder to evaluate. These limitations make these REITs less attractive to many investors, and they carry additional risks. (See this helpful warning from FINRA on public non-traded REITs and private REITs.)

Public non-traded REITs and private REITs also can have much higher account minimums — $25,000 or more — to begin trading, and steeper fees than publicly traded REITs. For that reason, private REITs and many non-traded REITs are open only to accredited investors with a net worth (excluding the value of their primary residence) of $1 million or more, or annual income in each of the past two years of at least $200,000 if single or $300,000 if married.

REITs’ average return

Nareit notes that during the 20-year period ending December 2019, the FTSE NAREIT All Equity REITs index — which collects data on all publicly traded equity REITs —  outperformed the Russell 1000, a stock market index of large-cap stocks. The REIT indexed investments showed total returns of 11.6% annually versus the Russell 1000’s 6.29%.

In 2019, equity REITs showed total returns of 28.7%, while mortgage REITs had total returns of  21.3%, according to Nareit. Equity REITs typically concentrate on one of 12 sectors. Here’s a snapshot of each and their 2019 total returns:

Equity REITs performance by sector

REIT sector2019 average returns
Source: National Association of Real Estate Investment Trusts
Industrial48.7%
Office31.4%
Retail 10.7%
Residential30.9%
Lodging/Resorts15.7%
Health care21.2%
Self-storage13.7%
Timber 42%
Infrastructure42%
Data center44.2%
Specialty27.4%
Diversified24.1%

REITs: The pros and cons

Pros

There are advantages to investing in REITs, especially those that are publicly traded:

  • Steady dividends: Because REITs are required to pay 90% of their annual income as shareholder dividends, they consistently offer some of the highest dividend yields in the stock market. That makes them a favorite among investors looking for a steady stream of income. The most reliable REITs have a track record of paying large and growing dividends for decades.
  • High returns: As noted above, returns from REITs can outperform equity indexes, which is another reason they are an attractive option for portfolio diversification.
  • Liquidity: Publicly traded REITs are far easier to buy and sell than the laborious process of actually buying, managing and selling commercial properties.
  • Lower volatility: REITs tend to be less volatile than traditional stocks, in part because of their larger dividends. REITs can act as a hedge against the stomach-churning ups and downs of other asset classes, but no investment is immune to volatility.

Cons

  • Illiquid (especially non-traded and private REITs): Publicly traded REITs are easier to buy and sell than actual properties, but as noted above, non-traded REITs and private REITs can be a different story. These REITs must be held for years to realize potential gains.
  • Heavy debt: Another consequence of their legal status is that REITs have a lot of debt. They’re usually among the most indebted companies in the market. However, investors have become comfortable with this situation because REITs typically have long-term contracts that generate regular cash flow — such as leases, which see to it that money will be coming in — to comfortably support their debt payments and ensure that dividends will still be paid out.
  • Low growth and capital appreciation: Since REITs pay so much of their profits as dividends, to grow, they have to raise cash by issuing new stock shares and bonds. But investors are not always willing to buy them, such as during a financial crisis or recession. So REITs may not be able to buy real estate exactly when they want to — but when investors are again willing to buy stock and bonds in the REIT, the REIT can grow again.
  • Tax burden: While REITs pay no taxes, their investors still must shell out for any dividends they receive, unless these are collected in a tax-advantaged account. (That’s one reason REITs can be a great fit for IRAs.)
  • Non-traded REITs can be expensive: The cost for initial investment in a non-traded REIT may be $25,000 or more and may be limited to accredited  investors. Non-traded REITs also may have higher fees than publicly traded REITs.

Investing in REITs: Get started

Getting started is as simple as opening a brokerage account, which usually takes just a few minutes. Then you’ll be able to buy and sell REITs just as you would any other stock. Because REITs pay such large dividends, it can be smart to keep them inside a tax-advantaged account like an IRA, so you defer on the distributions.

If you don’t want to trade individual REIT stocks, it can make a lot of sense to simply buy an ETF or mutual fund that vets and invests in a range of REITs for you. You get immediate diversification and lower risk. Many brokerages offer these funds, and investing in them requires less legwork than researching individual REITs for investment.

Jim Royal contributed to this article. 

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