What are REITs
You’ve probably heard the term REIT but may not know what it is. A real estate investment trust (REIT, pronounced “reet”) is an entity that receives revenue through owning or financing an income-producing property. Similar to other industries, REITs can be private organizations or they can be publicly traded on a stock exchange. This can be a fantastic way to add growth and income to your overall portfolio while adding diversification at the same time.
A Reit allows investors to pool their money to invest in real estate assets. Think of it like a mutual fund for a real estate. Hundreds of thousands of investors buy shares and contribute money to a pool, and professional managers decide how to invest it. The purpose of REITs is to allow everyday investors to be able to invest in real estate assets that they otherwise wouldn’t be able to.
There are some specific requirements that must be met. REITs must invest at least three-fourths of their assets in real estate or related assets and must derive three-fourths of their income or more from these assets. In other words, more than 75% of a REIT’s income needs to be from sources like rental income, mortgage payments, third-party management fees, or other real-estate-derived sources. REITs also must be structured as corporations, and they must have at least 100 shareholders. Because of the 100-shareholder requirement, many REITs start out as real estate partnerships, and then they become REITs later on.
No more than 50% of a REIT’s shares can be owned by five or fewer shareholders. In general, REITs limit the ownership of any single investor to 10% in order to ensure compliance with this rule. Most importantly to you as an investor, REITs are required to pay out at least 90% of their taxable income. This is why REITs typically pay above-average dividend yields.
Types of REITs
There are three basic types of REITs.
1. Equity REITs
Equity REITs derive the majority of their revenue from rents paid by tenants according to the terms of leases that exist between the REIT (the landlord or lessor) and its tenants (the lessees). These REITs usually have fee simple interest in their properties and use debt to finance a percentage of the purchase price. This investment approach is similar to how individuals purchase homes in that the REIT generally uses some amount of debt and pays the remainder in cash.
Sometimes, equity REITs own properties according to a leasehold interest, which is also called a ground lease. In this case, the REIT does not own the land on which the building sits. The REIT pays the landowner (or lessor) a monthly fee for an agreed-upon time period—usually several decades—in exchange for the right to use the land as needed to support the building’s operations.
2. Mortgage REITs
Mortgage REITs lend money to real estate owners directly, by issuing mortgages, or indirectly, by acquiring existing loans or mortgage-backed securities. Mortgage REITs, which are also referred to as mREITs, derive the majority of their revenues from interest received on commercial mortgage loans or from investments in residential- or commercial-based real estate instruments.
Mortgage REITs are analogous to banks that lend almost exclusively to commercial real estate developers and landlords, except mREITs do not have customer deposits from which to lend. Instead, they raise capital by issuing debt and equity in private or public capital markets. Their revenue comprises the principal and interest payments received from their investments.
3. Hybrid REITs
Prior to 2011, there was a third category of REITs called the hybrid. These companies combined the ownership strategies of equity and mortgage REITs, depending on the investment opportunities. Historically, hybrid REITs represented the smallest class of REITs industry and it was reclassified as mortgage REITs.
Why invest in real estate
Many investors buy REITs solely for the attractive dividend yields they offer relative to government bonds and other investments. However, there are many more, equally compelling reasons to include REITs as part of a well-balanced portfolio.
REITs have delivered total returns that exceed those of the S&P 500 Index
Investor total returns on any stock investment are calculated as the sum of dividends received plus any appreciation (or less any declined) in stock price during the time the stock is owned. Due in part to their attractive current yields, REITs have tended to deliver annualized total returns to investors of 10 to 12 percent over time.
Their dividends generally increase faster than inflation
Dividend income is one of the primary reasons to invest in REITs, in large part because their yields represent an attractive premium to yields offered by other investments. REITs are an attractive investment for people seeking current income, provided that the REIT has a conservatively leveraged balance sheet and well-located assets that are competitively managed. When a REIT possesses these qualities, it generally can sustain and preferably grow the dividend it pays to shareholders.
Publicly traded REITs offer investors the ability to add real estate returns to their portfolios without incurring the liquidity risk that accompanies direct real estate investment. This is because REITs that are publicly traded on stock exchanges can be bought or sold in an instant, like other stocks, through a financial advisor or online trading services. In contrast, direct investments in real estate can take several months or even years to sell.
REITs are a diversification tool
Diversification means that adding a particular investment to a portfolio increases the overall expected returns of that pool of investments while also reducing risk. The reason for this diversification benefit is because real estate and, by extension, REITs represent one of the three fundamental investment asset classes, the other two being stocks (also called equities) and bonds.
REITs are a proven diversification tool for portfolio management, a fact that has been demonstrated in multiple studies by various prominent investment advisory firms using different techniques, data sources, and time periods.
Acts as a hedge against inflation
Most leases provide that landlords will bill tenants for various costs (utilities, taxes, insurance, landscaping, etc.) after they have been incurred. In the case of triple-net leases, the landlord does not pay any of these operational costs; instead, tenants pay the costs directly. The ability to pass along increases in operating costs enables. REIT revenues to keep pace albeit with some lag with rising prices in times of inflation. The result is that REITs generate inflation-adjusted earnings, which makes their stocks attractive investments during times of inflation.
Reit risks to look out for
No investment would be complete without mentioning the risks. There are certainly a few that any REIT investor should know about: Interest rate riskRising interest rates are bad for REITs. Specifically, when long-term interest rates are paid by risk-free assets like Treasury. Securities rise, and REIT share prices tend to experience downward pressure.
This comes into play with property types expected to grow significantly in the coming years, or with property types that have a relatively low barrier to entry. For example, self-storage properties are generally quick and easy to build, so they’re vulnerable to oversupply problems in strong economies.
Any REIT’s cash flows are only as reliable as its tenants. This can be somewhat mitigated if a REIT’s tenants are mostly of a high credit quality, or if there’s a diverse tenant base.
In recessions, many REITs see their vacancies spike and their pricing power fall. To be clear, there’s a wide variety of cyclicality and economic sensitivity among REITs. For example, healthcare is a pretty recession-proof business, so healthcare REITs tend to hold up nicely. On the other hand, hotels are very sensitive to recessions, so hotel REITs often get crushed during tough times, but tend to do particularly well during prosperous economic times.
Many investors make the mistake of investing in a REIT because they “like the buildings” or know someone who works there. Although these two stock picking strategies can work out, they usually do not. If a REIT has a superior portfolio of properties, a conservatively leveraged balance sheet, and a management team with a proven track record of allocating capital prudently, it is likely to be a good investment, even if the price at which you buy it is not “cheap” or deeply discounted at the time.
Most investors do not have the opportunity to assess management’s character directly. One thing every investor can do is understand the risks and rewards inherent in each of the different property types. Predicting REIT returns is more complicated than for other industries. The difficulty arises from the fact that commercial property is a defensive, lagging indicator for the economy. However, stock prices represent investors’ present value of future expected earnings. As a result, REIT stock prices often do not reflect what investors physically see as they go to work, shop, or enjoy recreational activities. Each economic cycle is different with regard to how long and how strong a recovery phase will last.