Real estate investment trusts (REITs) are a key consideration when constructing any equity or fixed-income portfolio. They provide greater diversification, potentially higher total returns, and/or lower overall risk. In short, their ability to generate dividend income along with capital appreciation makes them an excellent counterbalance to stocks, bonds, and cash.
Real estate investment trusts own and/or manage income-producing commercial real estate, whether it's the properties themselves or the mortgages on those properties. You can invest in the companies individually, through an exchange-traded fund, or with a mutual fund. There are many types of REITs available.
Here we look at a few of the main categories of REITS and their historical returns. By the end of this article, you should have a better idea of when and what to buy.
- Using REITs to invest in real estate can diversify your portfolio, but not all REITs are created equal.
- Some REITs invest directly in properties, earning rental income and management fees. Others invest in real estate debt, i.e. mortgages and mortgage-backed securities.
- In addition, REITs tend to focus on a specific sector of properties, for instance, retail or shopping centers, hotels and resorts, or healthcare and hospitals.
- One of the biggest benefits REITs have to offer is their high-yield dividends. REITs are required to pay out 90% of taxable income to shareholders.
- Most REIT dividends don't meet the IRS definition of "qualified dividends".
5 Types of REITs And How To Invest In Them
Historical Returns of REITs
Real estate investment trusts are historically one of the best-performing asset classes available. The FTSE NAREIT Equity REIT Index is what most investors use to gauge the performance of the U.S. real estate market. Between 2010 and 2020, the index's average annual return was 9.5%.
More recently, the three-year average for REITs between November 2017 and November 2020, 11. 25%, was well above both the S&P 500 and the Russell 2000, which clocked in at 9.07% and 6.45%, respectively. Historically, investors looking for yield have done better investing in real estate than fixed income, the traditional asset class for this purpose. A carefully constructed portfolio should consider both.
1. Retail REITs
Approximately 24% of REIT investments are in shopping malls and freestanding retail. This represents the single biggest investment by type in America. Whatever shopping center you frequent, it's likely owned by a REIT. When considering an investment in retail real estate, one first needs to examine the retail industry itself. Is it financially healthy at present and what is the outlook for the future?
It's important to remember that retail REITs make money from the rent they charge tenants. If retailers are experiencing cash flow problems due to poor sales, it's possible they could delay or even default on those monthly payments, eventually being forced into bankruptcy. At that point, a new tenant needs to be found, which is never easy. Therefore, it's crucial that you invest in REITs with the strongest anchor tenants possible. These include grocery and home improvement stores.
Once you've made your industry assessment, your focus should turn to the REITs themselves. Like any investment, it's important that they have good profits, strong balance sheets and as little debt as possible, especially the short-term kind. In a poor economy, retail REITs with significant cash positions will be presented with opportunities to buy good real estate at distressed prices. The best-run companies will take advantage of this.
That said, there are longer-term concerns for the retail REIT space in that shopping is increasingly shifting online as opposed to the mall model. Owners of space have continued to innovate to fill their space with offices and other non-retail oriented tenants, but the subsector is under pressure.
2. Residential REITs
These are REITs that own and operate multi-family rental apartment buildings as well as manufactured housing. When looking to invest in this type of REIT, one should consider several factors before jumping in. For instance, the best apartment markets tend to be where home affordability is low relative to the rest of the country. In places like New York and Los Angeles, the high cost of single homes forces more people to rent, which drives up the price landlords can charge each month. As a result, the biggest residential REITs tend to focus on large urban centers.
Within each specific market, investors should look for population and job growth. Generally, when there is a net inflow of people to a city, it's because jobs are readily available and the economy is growing. A falling vacancy rate coupled with rising rents is a sign that demand is improving. As long as the apartment supply in a particular market remains low and demand continues to rise, residential REITs should do well. As with all companies, those with the strongest balance sheets and the most available capital normally do the best.
3. Healthcare REITs
Healthcare REITs will be an interesting subsector to watch as Americans age and healthcare costs continue to climb. Healthcare REITs invest in the real estate of hospitals, medical centers, nursing facilities, and retirement homes. The success of this real estate is directly tied to the healthcare system. A majority of the operators of these facilities rely on occupancy fees, Medicare and Medicaid reimbursements as well as private pay. As long as the funding of healthcare is a question mark, so are healthcare REITs.
Things you should look for in a healthcare REIT include a diversified group of customers as well as investments in a number of different property types. Focus is good to an extent but so is spreading your risk. Generally, an increase in the demand for healthcare services (which should happen with an aging population) is good for healthcare real estate. Therefore, in addition to customer and property-type diversification, look for companies whose healthcare experience is significant, whose balance sheets are strong and whose access to low-cost capital is high.
4. Office REITs
Office REITs invest in office buildings. They receive rental income from tenants who have usually signed long-term leases. Four questions come to mind for anyone interested in investing in an office REIT
- What is the state of the economy and how high is the unemployment rate?
- What are vacancy rates like?
- How is the area in which the REIT invests doing economically?
- How much capital does it have for acquisitions?
Try to find REITs that invest in economic strongholds. It's better to own a bunch of average buildings in Washington, D.C., than it is to own prime office space in Detroit, for example.
5. Mortgage REITs
Approximately 10% of REIT investments are in mortgages as opposed to the real estate itself. The best known but not necessarily the greatest investments are Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages on the secondary market.
But just because this type of REIT invests in mortgages instead of equity doesn't mean it comes without risks. An increase in interest rates would translate into a decrease in mortgage REIT book values, driving stock prices lower. In addition, mortgage REITs get a considerable amount of their capital through secured and unsecured debt offerings. Should interest rates rise, future financing will be more expensive, reducing the value of a portfolio of loans. In a low-interest-rate environment with the prospect of rising rates, most mortgage REITs trade at a discount to net asset value per share. The trick is finding the right one.
The Keys to Assessing Any REIT
There are a few things to keep in mind when assessing any REIT. They include the following:
- REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
- Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides without being locked in long-term. Liquidity matters.
- Depreciation tends to overstate an investment's decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess a REIT, look at its funds from operations (FFOs) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide it by the FFO per share. The higher the yield the better.
- Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
- Quality counts. Only invest in REITs with great properties and tenants.
- Consider buying a mutual fund or ETF that invests in REITs, and leave the research and buying to the pros.
According to the Securities and Exchange Commission, a REIT must invest at least 75% of its assets in real estate and cash, and obtain at least 75% of gross income from sources such as rent and mortgage interest.
Advantages and Disadvantages of REITs
As with all investments, REITs have their advantages and disadvantages. One of the biggest benefits REITs have to offer is their high-yield dividends. REITs are required to pay out 90% of taxable income to shareholders; thus REIT dividends are often much higher than the average stock on the S&P 500.
Another benefit is portfolio diversification. Not too many people have the ability to go out and purchase a piece of commercial real estate in order to generate passive income, however, REITs offer the general public the capability to do exactly this. Furthermore, buying and selling real estate often takes a while, tying up cash flow in the process, yet REITs are highly liquid—most can be bought or sold with the click of a button.
There are some drawbacks to REITs of which investors should be aware, most notably the potential tax liability REITs can create. Most REIT dividends don't meet the IRS definition of "qualified dividends," meaning the above-average dividends offered by REITs are taxed at a higher rate than most other dividends. REITs do qualify for the 20% pass-through deduction, however, most investors will need to pay a large amount of taxes on REIT dividends if they hold REITs in a standard brokerage account.
Another potential issue with REITs is their sensitivity to interest rates. Generally, when the Federal Reserve raises interest rates in an attempt to tighten up spending, REIT prices fall. Furthermore, there are property specific risks to different types of REITs. Hotel REITs, for example, often do extremely poorly during times of economic downfall.
Dividends are taxed as ordinary income
Sensitivity to interest rates
Risks associated with specific properties
Are REITs Good Investments?
Investing in REITs is a great way to diversify your portfolio outside of traditional stocks and bonds and can be attractive for their strong dividends and long-term capital appreciation.
What REITs Should I Invest In?
Each type of REIT has its own risks and upsides depending on the state of the economy. Investing in REITs through a REIT ETF is a great way for shareholders to engage with this sector without needing to personally contend with its complexities.
How Do You Make Money on a REIT?
Since REITs are required by the IRS to pay out 90% of their taxable income to shareholders, REIT dividends are often much higher than the average stock on the S&P 500. One of the best ways to receive passive income from REITs is through the compounding of these high-yield dividends.
Can You Lose Money on a REIT?
As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.
Are REITs Safe During a Recession?
Investing in certain types of REITs, such as those that invest in hotel properties, is not a great choice during an economic downturn. Investing in other types of real estate such as health care or retail, however, which have longer lease structures and thus are much less cyclical, is a great way to hedge against a recession.
The Bottom Line
The federal government made it possible for investors to buy into large-scale commercial real estate projects as far back as 1960. However, only in the last decade have individual investors embraced REITs.
Reasons for this include low-interest rates, which forced investors to look beyond bonds for income-producing investments, the advent of exchange-traded and mutual funds focusing on real estate and, until the 2007-08 real estate meltdown, an insatiable appetite on the part of Americans to own real estate and other tangible assets. REITs, like every other investment in 2008, suffered greatly. But despite this, they continue to be an excellent addition to any diversified portfolio.