For many investors, the concept of owning residential or commercial real estate as a means of growing and diversifying their portfolios seems like a solid strategy. However, the cost of outright real estate ownership coupled with the time and attention needed to maintain it can put these investments out of reach for much of the general populace. These barriers to entry can dissuade potential investors from giving real estate a second thought, but for those who see value in the real estate market and are interested in a viable alternative, an option does exist: real estate investment trusts, or REITs. (For related reading, see: What Is the True Cost of Owning a Home?)
REITs are securities invested in real estate, either through physical properties or through mortgages. These securities can be traded on major exchanges just like traditional stocks or ETFs, and a recent change in the Global Industry Classification Standard (GICS) has shaken up the way REITs are classified by those exchanges. More on that later.
An Accessible Choice
Real estate investment trusts make real estate investment more accessible to the average investor, acting similarly to mutual funds in that large and small investors alike have the ability to own stakes in real estate developments and other ventures as shareholders. Specific regulations for REITs dictate that these securities must have a minimum of 100 shareholders, and that five or fewer of a REIT’s shareholders cannot collectively hold more than half of the REIT’s shares.
A minimum of three-quarters of the assets of an REIT must be invested in real estate, U.S. Treasuries, or cash, and an REIT must earn at least three-quarters of its income from real estate. (For related reading, see: REITS–A More Accessible Alternative to Real Estate Investing.)
Additionally, REITs must maintain dividend payout ratios at or above 90% – an attractive attribute for investors whose goals include ongoing income generation. Although investors do pay income taxes on these dividends, REITs themselves can deduct the dividends and avoid as much as 100% of their potential tax liability – and many REITs have dividend reinvestment plans in place to allow for compounding returns.
Three Basic Types
There are three essential types of real estate investment trusts in the United States: equity REITs, mortgage REITs, and hybrids. Equity REITs own and invest directly in physical property. They typically derive their revenue from lease payments on the properties they hold, and the dividends investors receive from these REITs are a percentage of these (and other) profits in proportion to the number of shares the investors hold. Other profit sources can include sales of appreciated properties, also reflected in the dividends investors receive. As of this writing, equity REITs comprise the bulk of the REIT market in the U.S.
Mortgage REITs loan funds for mortgages to property owners, as well as (or instead of) investing in mortgage-backed securities and/or existing mortgages. The amount of money these REITs take in is simply the difference between interest earned and operating costs. Consequently, interest rates have a greater impact on mortgage REITs than on equity REITs. Hybrid REITs invest in a combination of mortgages or mortgage-backed securities and physical properties, paying dividends derived from the earnings of both models.
How to Invest in REITs
Investment in REITs can be accomplished directly, by purchasing shares on an open exchange, or by investing in a fund or funds that focus on real estate. REITs can also be private; public, SEC-registered REITs may or may not be traded on an exchange. That said, as we mentioned earlier, the Global Industry Classification Standard recently divorced certain REITs from their former places alongside financials. A new real estate sector has been designated specifically for equity REITs, making these securities more visible to investors who otherwise may not have understood them fully or known of their existence. Of note, as mortgage REITs are tied directly to financial instruments (mortgages themselves), they remain classified as financials just as before.
REITs present a unique proposition to investors with portfolios of all sizes. Shares of equity REITs can be far less capital-intensive than purchasing property outright, opening up the option to invest in real estate to a broader audience. For smaller investors, this can be an accessible opportunity. Unlike traditional property ownership, holding shares of REITs represents a higher degree of liquidity, meaning that a portfolio containing REITs can be modified as needed or desired by selling or trading securities. This flexibility can be beneficial as financial plans change over time or portfolios require rebalancing.
An Income Opportunity
REITs can provide comparatively high dividend yields that make them appealing to investors who seek ongoing income from their portfolios. As they are correlated with real estate holdings, rather than stocks and bonds, REITs can also play a key role in portfolio diversification, with equity REITs now representing a distinct security class. (For more, see: A Better Way to Think About Diversification.)
While many REITs are diversified in their own right, others focus more narrowly on specific geographies or property types – so even if you don’t have the capital to purchase a downtown high-rise office building, you can, for example, buy shares of an REIT that specializes in high-end urban commercial space.
If you have considered real estate investment but have held off due to concern over a concentrated position, REITs may be an option for your portfolio. They may also be worth considering if cash flow is a concern for your investments, or if you are seeking greater diversification as a risk management measure. Ultimately, no two investors are exactly alike, and the choice to invest in one or more REITs should be made only after careful consideration – and consultation with your financial advisor.