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Are you looking to diversify your portfolio with real estate, but the costs and risks are holding you back? Real estate investment trusts (REITs) can offer you most of the pros and a few cons of real estate investing. Find out how.
Real estate is a popular alternative asset class for many investors looking to diversify their portfolios.
Including asset appreciation, real estate provides recurring income from tenant leases. However, becoming a landlord is not possible for everyone.
If you want to participate in the industry, invest in REITs. REITs own over 530,000 properties across the United States, with their assets adding up to $4.5 trillion.
Using REITs to invest in real estate can diversify your investment portfolio while generating dividend income.
Keep reading for more benefits of having a REIT share and how to purchase into plans that align with your investment philosophies.
How to Invest in REITs
- Understand how REITs work
- Learn about the 5 types of REITs
- Assess your risks
- Choose a REIT to invest in
- Open a brokerage account
What is a REIT?
A REIT is a company that owns, finances or operates income-producing real estate across multiple sectors. The law requires the company to pay most of its income from rent and mortgage payments to investors.
A REIT avoids taxation on earnings at the corporate level to pay out most of its taxable income. The legal structure makes it cheaper and easier for REITs to acquire real estate.
Many REITs follow a simple business model. The REIT leases space and collects rent from tenants before distributing the income as dividends to individual investors.
Most REITs specialize in a specific property type, while others maintain diverse portfolios. You can sell and buy publicly traded REIT shares on major exchanges.
5 Steps to Investing in a Real Estate Investment Trust
No investment strategy offers as much ease and accessibility as REITs when investing in real estate.
If you’re looking to expand your portfolio by investing in REITs, here are five easy steps to help you get started.
1. Understand How REITs Work
REITs came into existence in 1960 after an amendment to the Cigar Excise Tax Extension. The provision allows you to purchase shares in commercial real estate portfolios.
Before this, such properties were only available to the wealthy and large financial intermediaries.
Properties in a REIT portfolio include data centers, hotels, apartment complexes and healthcare facilities. A REIT can also invest in infrastructures, such as energy pipelines, cell towers and fiber cables.
Most REITs lease commercial space, collect rent and then distribute the income as dividends to shareholders. However, mortgage REITs don’t own property but finance the real estate industry.
The REITs earn an income from investment interest. Many REITs are publicly traded securities, so you can access them by picking stocks.
Public non-listed REITs are available to all investors, but their shares are not on a major exchange. REITs from real estate crowdfunding platforms, such as RealtyMogul, fall into this category.
Only brokers sell private REIT shares, which are available to institutional and accredited investors.
2. Learn About The 5 Types of REITs
REITs are diverse, offering a simple way to gain exposure to multiple industries. The investment vehicle makes it possible for you to invest in movie theaters, single-family homes, shopping malls and many other commercial properties.
You can choose a preferred REIT type among five popular options.
A retail REIT owns, operates, manages, acquires and develops retail-related real estate. Such properties include freestanding retail properties, strip malls, outlet centers, power centers, and shopping centers and malls.
Many retail REITs focus on a specific tenant base and property type. They make money by renting space in their properties to service providers, retailers and others.
Most retail REITs earn via gross leases, where a tenant pays a fixed rental rate each month depending on square feet and a section of the common area.
Freestanding retail property REITs use triple net leases, where the tenant pays for rent, real estate taxes, and building insurance and maintenance.
A triple net lease helps a REIT earn a stable cash flow.
A residential REIT allows you to purchase real estate without taking out a large mortgage loan. The REIT only buys residential properties, including manufactured housing, student housing, condo buildings, apartment buildings, single-family homes and townhomes.
Residential REITs are recession-resistant investment vehicles. People still require homes to live in, even in a recession economy.
Because of this, the value of your residential REIT share often stays solid and may even increase during economic slowdowns.
Years of inventory shortages are driving home prices high, making it hard for people to purchase homes. More people opt to rent for longer periods because of larger down payments and tougher loan qualification processes.
Healthcare REITs own, manage and collect rent from real estate in the healthcare industry. Some properties they own include hospitals, senior living facilities, medical office buildings, skilled nursing facilities and life sciences research facilities.
Demand for healthcare-related real estate continues growing, and REITs are likely to benefit from the rising rental rates.
Further, they also develop new properties to meet the growing demand.
An office REIT builds, manages and maintains office buildings. It leases the offices to companies that require space to accommodate employees.
While some firms own the buildings they work from, most turn to office REITs that specialize in office spaces in central business districts and suburban areas.
The buildings range from office parks to skyscrapers. Potential customers include government agencies, banks and law firms.
Mortgage REITs (mREITs) invest in residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and residential and commercial mortgages.
Most mREITs focus on commercial or residential mortgage markets, but some invest in CMBS and RMBS. The REITs earn income from the interest paid on the assets.
mREITs are critical in providing real estate market liquidity. They provide an essential function in the economy by facilitating the housing market.
Without mREITs, the industry would have less liquidity, which makes it difficult for borrowers to find financing opportunities.
3. Assess Your Risks
REITs are not a risk, especially when they invest in diversified holdings and are part of a diversified portfolio.
However, REITs are sensitive to a few risk factors, and it’s important you know the various risks before investing.
Taxes on dividends
Investing in REITs means you must declare dividend distributions received when filing ordinary income taxes.
Note that the ordinary income tax rate is the same as the investor’s income tax rate, which might be higher than dividend tax rates and stock capital gains taxes.
Sensitivity to interest rates
Unfortunately, REITs do not perform well when interest rates are high. A rise reduces demand for REITs, as many people opt for safer income avenues, such as U.S. Treasuries.
Risk of profitability
The dividends you earn are not safe, either. The REIT can eliminate or reduce payouts if the properties it manages don’t produce enough income.
Bad property management
Bad property management increases the risk of reduced rental income, increased repair costs and disgruntled tenants.
The high REIT dividend is quickly cut to lower levels during dilution because of poor property management decisions.
The pass-through structure of REITs means they do not experience much value growth. The entities pay out 90 percent of their earnings to investors as dividends, which leaves 10 percent for administration and emergency purposes.
4. Choose a REIT To Invest In
Knowing the basics of how to value stocks is a critical component of your investor’s toolkit. While REITs are technically stocks, determining the right ones is different from other stocks, and effective evaluation can be a challenge.
Here’s a rundown of some essential metrics for choosing a REIT to invest in.
Funds From Operations (FFO)
A good starting point is checking out the financials of a company. Look at the usual profits, expenses and gross revenue. However, FFO are more important than profits when evaluating REITs.
A REIT is a company that derives most profit from real estate, so depreciation and amortization play a role in their earnings, which means a lower balance sheet profit.
What you want to look at is the FFO, which is the cash flow a company gets by adding amortization and depreciation to earnings.
Use this metric when choosing a REIT by comparing the figures of different companies.
A critical component to focus on is the REIT’s debt-to-earnings before interest, taxes, depreciation and amortization (EBITDA) ratio.
This ratio is a measure of the number of years it would take the REIT to pay off its leverage using the last quarter’s EBITDA.
For instance, a debt-to-EBITDA ratio of five means it will take the REIT five years to repay debt, assuming the recent EBITDA is recurring.
The debt-to-EBITDA ratio formula is the net debt divided by EBITDA. A low ratio shows that the REIT is not excessively indebted and can repay the debt.
However, a high debt-to-EBITDA ratio shows the company is dealing with a lot of debt.
Strong management team
When purchasing into a managed pool of assets or trust, it’s essential to understand the management team’s track record.
Asset appreciation and profitability have a close relationship with the team’s ability to choose the right investment and employ the best strategies.
Make sure you know the managers and the team in a REIT. Check to see their compensation structure.
Teams compensated based on performance are more likely to look out for your best interest.
The capitalization (cap) rate helps you better estimate the cash flow of a REIT from its real estate investments. You are trying to figure out the historical return on investment from each property the REIT earns from.
Calculating the cap rate involves dividing net operating income (NOI) by the current market value. NOI is the cash flow from the property after adjusting for expenses.
The current market value is the property’s value. The higher the cap rate of a REIT, the better, as it means the REIT receives more returns from its investments from rent.
An abundance of liquid assets ensures you can access cash quickly if your financial position shifts.
Many publicly traded REITs offer you liquidity. You can buy and sell the shares the same way you acquire others in the stock market.
However, the transactions are through brokers and are subject to the usual brokerage fees.
Non-traded REITs lack liquidity because once you place capital, there may be no way of selling the shares.
Some non-traded REITs offer buyback provisions, which are programs available at the discretion of the management — and they can rescind the offer at any time.
History of high dividend yields
Remember to look into the dividend yield and history of a REIT. The dividend yield represents the current yield of the investment.
This yield figure is usually higher than other dividend-paying stocks because REITs distribute most of their profits as dividends.
The REIT dividend history means looking into the company’s capability to pay dividends. You must check whether the REIT has growing dividends over time, which shows that it cares about its shareholders, and the dividend payouts keep pace with inflation.
Long-term capital appreciation
The real estate industry appreciates over time, and the best REITs exhibit a capacity to achieve long-term capital appreciation.
A REIT’s capital appreciation value depends on the contracted rental streams the underlying properties generate.
Most properties offer essential services to the broader economy, including living accommodations, infrastructure and office space.
The rental rates of these properties experience an increase tied to the inflation rate.
The result is that real estate properties in strategic, high-demand areas with good tenants are likely to experience long-term capital appreciation at the economy’s inflation rate.
Property capital appreciation also depends on other factors, including:
- Infrastructure — properties with superior infrastructure have a greater chance of attracting high-quality tenants and buyers, which boosts their value.
- Employment-centric location — a new office space or headquarters for a mass recruitment agency and commercial office space encourages people to relocate for employment.
The best REIT management teams have strategies to add value, such as property redevelopment, capital redeployment and renovations.
Such strategies make these REITs an excellent total return investment with a hedge against inflation.
Great properties and tenants
The best REIT managers strive to include prime properties with high rental yields and weed out low rental yields or high-maintenance properties in their portfolios.
Look at the asset quality of a REIT each quarter because this affects your capital value.
Evaluate REITs based on the rental yield they earn — so a company’s ability to acquire assets in prime locations at discount prices is a significant benefit.
Look for the portfolio occupancy rate, which shows the ratio of a REIT’s rented area to the amount of space available.
It’s advisable to choose REITs with full occupancy or at least near the maximum space available.
If 100-percent occupancy is impossible, choose a REIT with an above-market average occupancy rate. Also watch out for positive rental reversions.
The REIT rental reversion shows the number of new lease properties signed over a period against the previous one.
Leases that are better in this quarter than the last one show a positive rental reversion. Watch out for properties with a history of positive rental reversions or growing at the same pace at the minimum.
5. Open a Brokerage Account
You can buy shares in a REIT listed on major stock exchanges. You can also purchase shares in a REIT ETF or mutual fund.
You must open a brokerage account before you can buy REIT shares. Alternatively, you can purchase through your workplace retirement plan if it offers the option.
Opening a brokerage account is straightforward:
- Provide basic contact and personal details, such as a valid ID and Social Security number.
- The broker will ask for more information about your occupation, income and investing experience.
- Some brokers allow signing up online or via a mobile app, while others expect you to visit a branch.
- Use the various research and education tools available to review plausible REIT investments. Some brokers offer screening tools that will help fine-tune research and selection.
After choosing a REIT investment that fits your financial requirements and investment goals, you can proceed to buy it online.
However, make sure you understand the fee structure of the broker. Like any other investment, always monitor your REIT investment regularly.
Real estate ownership is among the oldest investing methods, but the associated risks and costs can be a poor fit for your current portfolio.
REITs provide most benefits of real estate investing and only a few cons. This step-by-step guide can help you get started with investing in real estate through REITs.
However, consult with a financial advisor, who will help develop a cohesive strategy for your investment portfolio.
Here are answers to common questions about REITs.
Who should invest in REITs?
Purchasing shares of a publicly traded REIT is sensible if you want to add real estate exposure to your portfolio.
However, REITs are better suited for dividend investing instead of growth investing because the share prices might not change over the long term.
REITs experience much value growth via a highly taxed dividend income, which makes them an excellent option for tax-advantage investment accounts that don’t experience capital gains taxes.
Do REITs pay dividends?
Yes, the IRS requires REITs to return at least 90 percent of their taxable income to shareholders each year.
This makes REITs an attractive pick because you can expect a high dividend yield, especially if you’re looking for a long-term income stream.
What returns can I expect with REITs?
The returns can be high, depending on the REIT company and type you invest in. For example, REIT Extra Space Storage was the top-performing stock between 2010 and 2019, with a return of 1.179 percent.
Are REITs a good investments?
Investing in REITs is an excellent way to diversify your portfolio beyond traditional bonds and stocks.
REITs are also attractive because they offer strong dividends and long-term capital appreciation.