If you’ve ever thought about buying property and becoming a real estate investor but didn’t really want to deal with all of the hassle of managing the property or dealing with tenants, then don’t! There’s a way to invest in real estate where you can reap all of the benefits of owning property without actually having to physically acquire it. What you want is something called a REIT, and here is how you can invest in one.
What Is A REIT?
A real estate investment trust (REIT) is a company that owns and operates income-producing real estate and related property. These are typically larger-scale properties such as apartment buildings, medical facilities, gym facilities, offices, hotels, etc. A REIT could also own other forms of infrastructure property that have little human interaction such as cell towers, data centers, and warehouses.
REITs function similar to mutual funds. The collection of properties contained in a REIT are broken up into shares. Thousands of investors will buy shares of these REITs and their value fluctuates based on their performance of the properties.
Because the average person rarely has the resources to own commercial property, a REIT provides a convenient way to own these types of property without the trouble of actually acquiring it.
Similar to the goal of someone who owns a rental property, the goal of the REIT is not to sell the property to new owners for a profit but rather to groom it into an asset that produces income every month.
Types Of REITs
There are at least four types of REITs:
Equity REITs
These are REITs that are traded publicly, just like stocks. Usually, when someone generically talks about REITs, they are referring to equity REITs.
mREITs (Mortgage REITs)
This is a special type of REIT that purchases mortgages or mortgage-backed securities that can be used to finance income-producing real estate.
Public, Non-Listed REITs (PNLRs)
REITs that are not publicly traded but still registered with the SEC.
Private REITs
REITs which are neither public-traded or registered with the SEC.
Why Should You Invest In A REIT?
Like we already mentioned, the biggest draw to investing in a REIT is that it allows you to own commercial real estate.
Just like a stock can outperform the market average for several years at a time, so to can a REIT. This can be useful when you consider also that real estate is a completely different type of asset from stocks and bonds. While these assets may go down in value, your REIT might hold or even go up in value. Therefore, it can be a useful component in your portfolio diversification.
The other big attraction of investing in a REIT is that they produce relatively high dividend yields. This is because REITs are required to payout at least 90 percent of their taxable income to shareholders. Most go so far as to payout 100 percent!
The average REIT dividend pays approximately 5 percent whereas the average stock pays 1.9 percent. Higher than average dividend payments are great for income investors who are looking to receive the biggest return on investment that they can get, such as retirees.
REITs And Taxes
Because of the way REITs pay out their income, the IRS treats their dividend payments like ordinary income (similar to the money you would earn from your job). This is different from the traditional, corporate dividends you earn on stocks. Because ordinary dividends aren’t “qualified”, they don’t receive the same type of tax reduction that corporate dividends receive. This can sometimes be seen as a drawback to REIT investing.
Before you do your taxes, the REIT will send you an IRS Form 1099-DIV that will report your dividends and capital gains. You can find out more the way a REIT is taxed here.
How To Choose A REIT
There are several ways you can find good REITs to invest in.
Recommendations
You can start by looking up which ones come highly recommended, such as these suggestions from Nerd Wallet which are updated regularly. Compare them against other lists from respected financial sites like The Motley Fool, Seeking Alpha, and Kiplinger.
Industry Type
Next, you’ll want to choose which type of REIT industry you feel comfortable investing in. Retail, residential, healthcare, etc? Each one will have specific pros and cons.
For example, healthcare has been a rising industry for several years now. However, operators often rely on Medicare and Medicaid reimbursements for the funding. Therefore, any changes to these systems could impact the occupants’ ability to pay their lease.
You’ll want to spend some time considering the advantages and disadvantages of each type.
Metrics
Just like stocks, REITs have various metrics that can indicate the overall health of the asset. Here are a few key ones you’ll want to become familiar with:
- Price Range – Where is the share price currently compared to the past 52 weeks? How much has it fluctuated?
- Funds from operations (FFO) – Net income (similar to a stock’s “earnings per share”).
- Price-to-FFO (P/FFO) ratio – Tells you how expensive the REIT is relative to its peers (similar to a stock’s “P/E ratio”).
- Payout ratio – Dividend payment as a percentage of its earnings.
- Debt-to-EBITDA ratio – How much debt the REIT carries.
- Dividend Yield – 12-month distributions divided by the REIT current share price. Note that price fluctuations could make the
Mutual Funds And ETFs
If you’d prefer not to buy a REIT directly, or you’d like to diversify across several industries at once, then there’s an easy way to do this.
Just like mutual funds let you buy several different types of stocks and bonds all at once, you can do the same thing with REITs also if you buy them indirectly through a mutual fund or exchange-traded fund (ETF). For example, Vanguard offers the Vanguard Real Estate ETF (VNQ) which has the bulk of its holdings in specialized REITs, residential REITs, industrial REITs, and many others.
Where To Purchase A REIT
REITs can be purchased on the open market just like stocks. If you’ve already got an account with a broker, then you can log in, do your research, and buy them whenever the market is open. If you don’t, discount brokers such as E-Trade or TD Ameritrade would make a great place to open an account and get started.
Again, if you’d prefer not to buy a REIT directly, you could also buy them indirectly through a mutual fund or exchange-traded fund (ETF). Try a full-service brokers such as Vanguard and Fidelity.
If you’d like some help picking out the right REIT ETF, then you might want to try a robo-advisor. A robo-advisor is a relatively new financial service where investors fill in some profile information about their goals and risk tolerance. The robo-advisor will then pair up the right ETF with the investor. Try services like Betterment, Wealthfront, and M1 Finance.
You could also invest in public non-listed REITs and private REITs. However, you would need to purchase them directly from the REIT company.
REIT Risks
Just like stocks or any financial assets carry risk, REITs are no different. Real estate is an asset class where demand can fluctuate for a variety of reasons.
For example, suppose the REIT you invest in specializes in hotels, and a recession occurs. If the hotels are not producing any income, then the REIT will go down in value. This actually happened during the real estate bubble in 2008. During that time, the iShares Dow Jones US Real Estate ETF (IYR) returned -40.03% including dividend income.
The other thing that can affect your REIT investment is interest rates. When rates are low, it’s a good thing for REITs because investors will gravitate to these types of higher dividend producing assets. But when interest rates are high, investors will move their money into assets they perceive as “safer” such as bonds or other fixed-income securities.
As with all investments, always be on the lookout for red flags. Be cautious of any company that advertises unusually high dividend yields, has limited access to capital, or carries way too much debt (relative to its peers). Check the metrics and do your research before you make your purchase.
