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REITs: What They Are and How to Invest in Them

Oct. 2, 2017
Investing, Investing Strategy, Investments
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REIT — rhymes with “sweet”— stands for real estate investment trust, and it’s one of the most popular classes of stock today. REITs are companies that own and sometimes operate real estate, such as apartments, warehouses, malls and hotels. Their otherwise ordinary business comes with some important tax advantages that can be a boon for investors.

The appeal is simple: The most reliable REITs have a track record of paying large and growing dividends for decades. The National Association of Real Estate Investment Trusts notes that from 1979 to March 2016, the FTSE NAREIT All Equity REITs Index outperformed the Russell 3000, a broad stock market index. The REIT index showed returns of 12.9% annually versus the Russell’s 11.6%. That leads to rising stock prices. Plus, REITs tend to be less volatile than traditional stocks, in part because of their larger dividends.

You can buy REITs through a brokerage account, just as you would any normal stock.

» Interested in investing in REITs? Find the best broker for you

Why invest in REITs?

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.

The legislation also created other advantages for REITs and their investors. Congress decided that REITs would not have to pay tax at the corporate level as long as they hewed to a few conditions. They have to keep at least 75% of their assets in real estate, and at least 75% of their gross income has to come from rents and real-estate-related income, along with a few smaller stipulations.

In exchange for this tax advantage, REITs have to pay out 90% of their taxable income to investors — a requirement that regular companies don’t face. This means REITs consistently offer some of the highest dividend yields in the stock market, making them a favorite among investors looking for a steady stream of returns. 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.)

This legal change also created an edge for REITs, allowing them to finance real estate more cheaply than non-REIT companies can. So over time, REITs can grow bigger and pay out even larger dividends.

What to watch out for

The most significant downside to REITs comes as a direct effect of those legal advantages. Because REITs pay out a huge portion of their cash flow to investors, they don’t retain much cash for funding their own growth. Instead, 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 willing to buy new stock and bonds, the REIT can grow again.

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 long-term contractual cash flows — leases and such see to it that money will be coming in — can comfortably support their debt payments and ensure that dividends will still be paid out.

What are the types of REITs?

REITs can be divided into two broad types: equity REITs and mortgage REITs. Equity REITs are the more traditional type, and they operate like a landlord. They own the underlying real estate, provide upkeep on and reinvest in the property and collect rent checks — all the management tasks you associate with owning a property.

In contrast, mortgage REITs 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 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. However, don’t let that higher dividend fool you into thinking they’re safer than equity REITs.

REITs can invest in almost any sort of real estate. The sheer breadth of potential investments is immense: not just homes and apartments, but offices, hospitals, hotels, malls, warehouses, data centers and much more. Still, a REIT tends to concentrate on one or two sectors. This focus helps investors evaluate the company and award it a more accurate stock price.

REITs both public and private

Regardless of what type it is, a REIT can have three different legal classifications:

  • It can be publicly traded in the stock market
  • It can be a public nontraded REIT
  • It can be a private company

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 stock readily. For these reasons, many investors buy and sell only publicly traded REITs.

Public nontraded and private REITs usually offer fewer intervals to trade their stock, may cost more to trade and may have minimum investment amounts. In addition, private REITs have fewer disclosure requirements, potentially making their performance harder to evaluate. These limitations make these classes less attractive to many investors.

How to start investing in REITs

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 an individual retirement account so you don’t have to pay taxes on the distribution.

If you don’t want to trade individual REIT stocks, it can make a lot of sense to simply buy the whole real estate industry as part of an exchange-traded fund or mutual fund. You get immediate diversification and lower risk. Many brokerages offer these funds, and you can start without knowing a lot about REITs while still collecting their juicy dividends.

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