Investing in real estate isn’t just for the wealthy anymore. In fact, you don’t even need to hire an agent to become a sophisticated real estate portfolio owner.
REITs have opened the world of residential and commercial real estate to regular investors without the headache of down payments, tenants, and maintenance.
In this article, we’ll cover every. square. inch. of investing in real estate using REITs, including the types of REITS, the costs associated, potential returns, pros and cons, and how it compares with traditional real estate investing.
What is an REIT?
A real estate investment trust (REIT) is a company that owns, manages, or finances real estate for investment purposes.
REITs can own a wide range of real estate investments, including offices, malls, hotels, warehouses, self-storage facilities, apartment buildings, cell towers, data centers, and even timberland. REITs can also own the financing for real estate properties, such as mortgages or other debt notes, collecting interest payments to generate income.
REITs are designed to function like a mutual fund, as the funds are used to purchase real estate investments, sharing the income generated from these activities with investors. You can invest in an REIT by simply purchasing shares of it through an online brokerage or through a private REIT company.
REITs operate under strict guidelines set by the IRS. All REITs must:
- Pay out (at least) 90% of the income generated in the form of dividends to REIT investors.
- Spread the equity, meaning no more than 50% of the shares in an REIT can be held by five individuals or fewer (during the second half of the year).
- Invest at least 75% of the total assets in real estate.
- Acquire at least 100 investors within the first year.
These rules give REITs favorable tax treatment, as they are not taxed as a corporation, and can distribute more profit to investors than non-REITs are able to.
Pros and cons of REITs
- Source of income. REITs provide a reliable source of income to investors. Because REITs are invested in properties for the long-term, it’s easier to predict and plan revenue and profits.
- Diversification. If you’re looking to diversify your stock portfolio, REITs are a great option. Even though most of them are traded like stocks, they’re technically a different asset class and don’t always move with stock market trends.
- Lots of options. With REITs, you can invest in any type of property imaginable. Have a passion for malls or data centers? There’s an REIT for that.
- High dividends. 90% of annual income must be earmarked for shareholders. This makes them a highly desirable way to earn dividends.
- Solid performance. Historically, equity REITs have outperformed the stock market.
- Liquid compared to traditional real estate. Unlike buying real estate, REITs are liquid. You’re not stuck with a property. Instead, you can buy and sell REIT stocks at your convenience when you have extra cash on hand or need to collect cash for something else.
- Low volatility. Compared to traditional stocks, REITs have relatively low volatility. The high dividend disbursements, long-term holding strategies, and transparency keep the value of REITs more stable than other types of stocks.
Read more: How to diversify your portfolio
- Interest rate risk. REITs are subject to interest rate risk. When rates rise, REITs are vulnerable to eroding earnings.
- Risk of profitability. Risk of default and vacancies can put REITs in a position that makes it difficult to maintain profitability. In the current economic climate, this is a very real risk.
- Limited growth. Because REITs pay out 90% of their profits as dividends, it limits how quickly they can grow. While other dividend-paying stocks tend to pay out 30% to 50% of their earnings and execute growth strategies, REITs don’t have this flexibility.
- Higher taxes. REITs are also taxed at higher rates than qualified dividends. Expect to pay taxes at your marginal rate for dividend income.
How do REITs work?
REITs came about in the 1960s due to an amendment to the Cigar Excise Tax Extension (I know, weird, right?). Legal history aside, REITs allowed retail investors to purchase shares in commercial real estate portfolios. This gave average investors access to an asset class previously reserved for wealthy individuals with private financing.
REITs are companies that purchase real estate for investment purposes, typically generating income for shareholders in the form of monthly, quarterly, or annual dividends.
A majority of REITs focus on commercial real estate, though some also include residential real estate investments, such as apartment buildings or single-family homes.
Income is generated through collection of rent or lease payments, as well as capital appreciation when a property is sold.
REITs can also consist of real estate debt, such as mortgages, short- or long-term notes, or mortgage-backed securities (MBSs). These REITs invest capital through real estate loans and collect income via interest payments, which are dispersed through dividends.
REITs vs. real estate
While REITs make it easy to invest in real estate, how does it compare to investing directly? Here are a few of the advantages in investing for both direct real estate investing and REITs:
Direct real estate investing
- Potential high monthly cash flow. If you find a great deal, investing in a single family home or multi-family real estate has the potential for high monthly cash flow.
- More tax advantages. Owning real estate gives individuals the ability to write off a ton of expenses directly, deduct depreciation of the property, as well as access 1031 exchanges to avoid taxes on the sale of the home.
- More control. As the sole investor on a property, you can choose the tenants, set the price for rent, and make the property improvement choices.
- Price appreciation. While REITs can benefit from price appreciation, directly owning real estate gives you 100% of the proceeds when a home is sold.
- HELOC. Want to access some of that price appreciation? As a direct owner, you can open up a home equity line-of-credit (HELOC) to access capital for improvements or more investment properties.
- Refinance. Rates drop? You can instantly lower your payments by refinancing the property. You can also do a cash-out refinance and gain access to any equity appreciation on the home.
- Small up-front investment. Some REITs can be purchased for as little as $100, which is accessible for most investors. Much smaller than the tens of thousands needed to buy a rental property.
- Almost no effort involved. REITs are truly passive. You can purchase shares of an REIT and forget about it. Many REITs can even be purchased on a recurring basis, making it an automated real estate investment.
- Less monthly expenses. REITs handle all of the expenses for the investment, and you, as the investor, don’t have to pay out of pocket for them.
- Liquidity. Publicly traded REITs offer instant liquidity, allowing you to sell them on the open market and access cash if needed.
Directly investing in real estate is ideal for hands-on investors who want more control over their deals and access to multiple tax advantages, while REITs are ideal for passive investors who want to diversify their portfolio into the real estate asset class.
How REITs make money
How an REIT makes money depends on what type it is. There are three main categories that an REIT can fall into. Here’s how they each make money:
Most REITs are equity REITs, and they’re what most people are familiar with when they think of this asset class. An equity REIT owns and operates the real estate in its portfolio. This REIT operates like a traditional landlord and makes money by collecting rent checks from tenants or selling off properties.
Mortgage REITs don’t own the property. Instead, they earn money by making loans and collecting interest in mortgages and other lending vehicles. They can also profit by acquiring mortgage-backed securities (MBS), which are a collection of mortgages sold as shares to investors.
As the name suggests, hybrid REITs are a combination of equity and mortgage REITs.
Types of REITs
There are several types of REITs, depending on how shares are bought and sold, or what types of investments they hold:
Publicly traded REIT stocks
Publicly traded REITs are bought and sold just like stocks on public exchanges. Because these REITs are traded on exchanges like the NYSE, they’re transparent and liquid.
Publicly traded REITs are required to disclose their financial statements, making it easy for investors to learn about what’s in their portfolio, how profitable they are, and details of the operating expenses. They’re also easy to buy and sell through your favorite broker. This liquidity gives it an advantage over traditional real estate investing, which you can’t easily sell and cash in.
Private REITs are not traded on any exchanges, and they’re not registered with the SEC. Because they’re not publicly traded, private REITs are under no legal obligation to disclose the financial details. This can be problematic if you are trying to do your own analysis, or you don’t have “trust fall” level confidence in the fund managers.
Private REITs are also illiquid. Since they’re not publicly traded, it can be difficult or impossible to sell your shares and cash out. Plus, there’s no corporate governance, which can easily lead to conflicts of interest and unethical compensation practices.
Most individual investors steer clear of private REITs. They’re typically restricted to institutional and accredited investors with a high net worth who are well-versed in this asset class or have intimate knowledge of the fund managers.
Non-traded REITs are registered with the SEC, but they’re not publicly traded. They’re kind of like a balance between public and private REITs, but they’re not meant for a short-term, casual investor.
This type of REIT is typically sold through a broker that charges an upfront fee. Depending on the size of the fee compared to your investment, this could potentially wipe out your principal and returns, so proceed with caution.
The advantage of a non-traded REIT is that it tends to move independently of the stock market since it’s not associated with any exchanges. Several crowdfunded real estate companies also offer non-traded REITs and have proven great performance over the past decade.
Publicly traded REIT funds
Not surprisingly, investing in a publicly traded REIT fund follows the same process as investing in a publicly traded REIT. The only difference is that you get multiple REITs in one fund. Think of it like enhancing diversification because instead of a single type of real estate, an REIT ETF (exchange-traded fund) is likely to contain a variety of properties.
Still, an REIT fund is not as diversified as owning multiple stocks in multiple industries because the underlying asset class is still real estate.
REIT preferred stock
REIT preferred stock is similar to a bond but also has some properties of a stock. It pays a cash dividend, but it also has a set redemption price. The price moves are based on interest rates. The higher the interest rate, the lower the value of the REIT preferred stock.
Investing in REIT preferred stock does give you an extra layer of protection. This is because the dividends for preferred stockholders are cumulative, meaning that they get any deferred dividends before common stockholders get paid.
Where to buy REITs
There are two main ways to purchase REITs. The first (and simplest) approach is to purchase REIT stocks and funds through a brokerage account. The second is purchasing directly from an REIT company or broker.
How to evaluate an REIT
Just like you’d evaluate a company’s performance before buying a stock, you should also take a look at a variety of metrics before investing in a particular REIT.
Though there are some similarities in how you compare performance, this unique asset class requires a slightly different lens. Here’s what to evaluate and how to interpret your findings:
Short for “funds from operations,” this figure represents the REIT equivalent of “earnings.” It’s essentially the same thing as the P/E ratio for stocks, which measures the ratio of price to earnings and helps you determine if the stock is over or undervalued.
The calculation looks like this:
FFO = GAAP Net Income + Depreciation and Amortization – Gains from Property Sales
The reason this calculation is different for REITs than it is for traditional stocks is that it adds back in the deductions taken for depreciation and amortization. Unlike a regular company, these capital assets generally appreciate over time, so it would be an inaccurate portrayal of performance to deduct these items as expenses.
Once you have FFO, you can calculate P/FFO (price-to-FFO) to come up with a ratio for comparison. Look at several P/FFO ratios side-by-side to see if a particular REIT is higher or lower priced than similar funds.
REITs are notorious for having high amounts of debt. They’re buying real estate, after all.
However, it’s smart to look at how much debt an REIT has relative to earnings. As a rule of thumb, many investors look for a debt-to-EBITDA of less than 6:1, but you can be flexible given your investing goals and risk tolerance.
Also called the cap rate, this number represents how much an REIT has paid for property relative to its income. Individual investors might look at this as how much cash flow or profit a property generates each year based on occupancy rates, repairs, advertising, property management, etc. In the REIT world, this is essentially the same thing.
Best REITs to invest in
REITs have been around long enough to have a decent track record, so we can find the ones that have performed the best.
Here are a few of the best REITs to invest in based on recent performance (one-year total return), according to NAREIT:
- Bluerock Residential Growth REIT, Inc. (BRG): 160.91%
- InvenTrust Properties (IVT): 104.83%
- Cedar Realty Trust (CDR): 72.63%
- American Campus Communities (ACC): 41.82%
- Whitestone REIT (WSR): 36.05%
My best advice when deciding which REITs to invest in is to compare trends over time, to track an REIT’s performance and compare it to peer REITs investing in similar properties. This will give you plenty of context to make a logical decision about what’s a good buy and what you should avoid.
You don’t have to be a millionaire to become a real estate mogul. For many people without wealthy families and silver spoons in their mouths, the FOMO was real.
With REITs, you can get started for under $10 and start making immediate returns. And, with REITs consistently outperforming the stock market, you can build wealth even faster.
If this is the first time you’ve dug deep into REITs, you might be wondering where they’ve been all your life. Almost half of all publicly traded REIT shares are held in retirement accounts, so you might have an REIT in your pension, 401(k), or IRA without realizing it.