How to Invest in Real Estate Investment Trusts (REITs)
REITs are investment companies that own income-producing real estate. These can include:
Apartments
Hotels
Malls
Self-storage facilities
Warehouses
Medical facilities
Congress created REITs in 1960 so individual investors could invest in commercial real estate without having to buy and manage it themselves.
The most reliable REITs pay large and growing dividends.
However, they must meet specific IRS standards. They should:
Pay a minimum of 90% per year of their taxable income as shareholder dividends
Invest at least 75% of their total assets in real estate or keep them as cash
Receive a minimum of 75% of their gross income from real estate
Have a minimum of 100 shareholders after their first year of operating
Have no more than 50% of their shares held by five or fewer individuals during the final half of the taxable year
By keeping to these standards, REITs do not have to pay tax at a corporate level. This allows them to finance real estate cheaper, allowing them to grow and pay more significant dividends.
Key Types of REIT
REIT Trading Status
REITs can be both traded publicly and privately and non-traded.
REITs can be traded publicly. Their shares are traded on an exchange the same as stocks and exchange-traded funds (ETFs) and are available using traditional brokerage accounts.
The National Association of Real Estate Investment Trusts (NAREIT) states there are over 200 publicly-traded REITs on the stock exchange so you have plenty of options.
REITs can also be privately traded. These are unlisted, hard to value and hard to trade.
They are less attractive as they are exempt from SEC regulations, so there are fewer disclosure agreements. However, with higher risk comes greater reward.
REITs can also be non-traded. These REITs are registered with the US Securities and Exchange Commission (SEC) but are not available on an exchange.
Instead, they are purchased from a broker.
Publicly non-traded REITs are highly illiquid (not readily converted into cash for eight years or more) and are hard to value.
The SEC warns that REITs do not estimate their value to investors until 18 months after the offer closes; in some cases, this could take years.
Public non-traded and private traded REITs come with steeper fees and a higher account minimum – usually around $25,000.
They are only open to accredited investors with a net worth of at least $1 million, or a two-year annual income of $200,000 (single) or $300,000 (married).
Five Types of REITs
1. Retail
Retail REITs account for approximately 24% of REIT investments.
Money is generated from the rents charged to store owners.
Before investing, research the property and assess footfall, turnover and store owner reliability.
You do not want to invest in a mall with low footfall and empty shop units.
Retail may seem like a sure investment, but it is highly dependent on the economy. As more people embrace online shopping, the value of a mall falls.
2. Residential
Residential REITs are concerned with rental apartment buildings and manufactured housing.
If you are thinking of investing in residential REITs, look for areas with high job growth and population. You want to invest in an area with young professionals, usually a mobile population, who prefer to rent or have no other option.
You might also want to consider the development and gentrification of the surrounding areas and the impact it will have on your rent.
Areas that are soon to be developed or that are being gentrified will likely see a rent increase.
3. Healthcare
Healthcare REITs are an exciting subsector to watch as healthcare costs are climbing. We live longer, and we are paying more attention to our health.
Healthcare REITs include:
Hospitals
Medical centers
Nursing facilities
Retirement homes
When investing in healthcare, diversification is key. You want a variation of locations with a variety of customers.
You should also consider companies with healthcare experience and low-cost capital.
4. Office
These are long-term investments, as tenants usually expect to stay in their office for the foreseeable future.
Invest in REITs located in steady economic areas such as Washington DC, rather than new hotspots without a proven track record.
As more employees look to improve their work-life balance, the concept of co-working spaces is increasing.
Consider buildings that offer this service, as well as traditional office spaces.
Do also consider the effect the rising remote working trend could have on your office investments.
5. Mortgage
With mortgage REITs, you do not invest in the property itself, but the mortgage someone needs to buy the property.
Mortgage REITs depend heavily on interest prices. The higher the interest rate, the lower your dividend.
Finding a mortgage REIT that operates in a low-interest-rate environment is possible but very difficult.
Before committing to any mortgage REIT, do extensive research on the company and the deal involved.
Pros
There are guaranteed dividends
Easy way to own real estate
Passive with low minimums
Liquidity
Less volatile
Cons
Limited growth
Property values
Ordinary tax status
Fees
Advantages of REITs
As with any investment, there are pros and cons.
For REITs, the advantages are:
There are guaranteed dividends – The law requires investment companies to pay out at least 90% of their income in dividends, meaning you will always receive a financial payout.
Easy way to own real estate – They are packaged into shares and easily purchased or sold. Mutual funds and ETFs allow you to diversify by purchasing many individual REITs without doing the work to find them yourself.
Passive with low minimums – You do not need a large sum of money to start investing. As the investment means you do not actually own the property, you are not tasked with any maintenance or landlord duties. You can continue with your typical working day and wait for the dividends to come through.
Liquidity – As you do not own the physical building, it is easier for you to sell your investment as there is no hassle of assessments or viewings.
Less volatile – REITs are less volatile than other stocks. This allows for a more diverse portfolio. Historically, REITs have outperformed other investment types in high-interest-rate environments and slow economies.
Disadvantages of REITs
Limited growth – The 90% law means that companies do not have the funds to grow as much, or be as diverse, as they would like.
Property values – Property is known for its changing habits. Some years see periods of steady growth and others, massive slumps. Carefully consider the location and type of investment. You want your investments to withstand recessions.
Ordinary tax status – Aim to invest in tax-deferred accounts such as an IRA to keep tax at a minimum. REITs are taxed according to standard income rates rather than trading rates.
Fees – Most REIT fees are taken upfront but can set you back around 30% of the REIT value. This could take a considerable chunk out of your investment fund, and it may be a while before you break even.
How Do You Start Investing in REITs?
Investing in REITs follows the same process as any other stock or investment. You simply open an online brokerage account and trade as you would any other stock.
To get started, consider looking at one of the following:
As of September 2024, the top-performing REIT stocks and their one-year average returns are as follows:
Power REIT: 112%
Safehold Inc.: 104%
Equinix Inc.: 51%
Innovative Industrial Properties Inc.: 43%
Goodman Group: 35%
Key Points to Consider When Investing in REITs
Do Your Research
An investment of any kind should always be carefully considered, but as REITs are usually part of your long-term strategy, take the time to assess the market.
Ask yourself the following questions:
What are the trends of the location?
What type of REIT do you want to invest in?
What are the consumer habits and demographics in that location?
How is the economy looking?
How did that location/REIT company/REIT type manage the last recession?
Consider everything before making your investment.
Start With Mutual-Funds or ETFS
While you familiarize yourself with trading and investments, let a professional do all the research and buying for you. As you gain confidence, you can begin trading on your own.
Use the Right Companies
You want reliable, well-known companies that provide high dividends and moderate long-term capital.
Look up reviews of companies you are interested in to see other people’s experiences with them.
Use the Correct Assessment Tools
When it comes to assessing a REIT, it is better to assess its funds from operations (FFO) rather than its payout ratio. The higher the number, the better.
Invest in Quality
This includes the type of company you invest with, but also the kind of people/businesses that will rent your real estate. It is better to have a few quality investments that pay well than many lower-quality ones that give nothing back.
Final Thoughts
REITs can be a great addition to your investment portfolio. Use them as part of your investment strategy to diversify your portfolio with long and short-term investments.
Real estate is a proven long-term investment. Opting for a REIT instead of buying the physical property removes the stress and hassle involved with being a property owner.
It also makes being a property owner a reality for those who may not be able to otherwise afford it.
Before investing any money, take the time to do your research and assess all the risks involved.
REITs are no better and no worse than any other investment type. All come with their good days and their bad.
Always remember, if any deal seems too good to be true, it probably is.