Investing in REITs: everything you need to know

Did you know that you can add real estate to your investment portfolio without buying a house, apartment complex, or commercial property?

It used to be that investing in real estate required massive amounts of wealth. If you wanted to buy a shopping mall, for example, how would you even begin raising funds?

With REITs, you can get in on the action of commercial and residential real estate investing. You could even realize double-digit returns without having to lift a finger (or a hammer).

In this article, I’ll cover everything you need to know about how to invest in REITs.

What is a REIT?

Short for real estate investment trust, a REIT is a company that owns different types of commercial real estate, including offices, malls, and even hotels. And that’s just the tip of the iceberg. REITs can also hold warehouses, self-storage facilities, apartment buildings, cell towers, data centers, and even timberland.

As I mentioned earlier, REITs are a fantastic way to invest in the booming real estate market without having to come up with a down payment, deal with tenants, or finance upgrades and repairs.

REITs are also a smart way to further diversify your portfolio beyond stocks, bonds, mutual funds, crypto, and precious metals. If one sector of the economy is down, you can hedge your bets by having real estate property in the form of a REIT.

Like dividend stocks, REIT investors can make money from both appreciating stock prices and dividend disbursements. However, I should note that most REITs focus on one type of real estate, so if a particular sector is struggling, the REIT is likely to suffer as well.

How do REITs work?

The 1960s marked an era of economic prosperity, and it was in the first year of the decade that REITs came into existence. REITs presented the average American the opportunity to own income-generating real estate without having to make a large investment.

Thanks to REITs, individual investors could now own pieces of real estate just like they owned shares of stock. Not only could the average person now invest in real estate, but they can also benefit from a diversified portfolio by having stakes in a variety of commercial properties.

How REITs make money

How a REIT makes money depends on what type it is. There are three main categories that a REIT can fall into.

1. Equity. 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.
2. Mortgage. 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). As a reminder, mortgage-backed securities are a collection of mortgages sold as shares to investors.
3. Hybrid. As the name suggests, hybrid REITs are a combination or equity and mortgage REITs.

Types of REITs

There’s a corresponding REIT for any type of commercial property you can think of. For the purpose of this guide, I’ll touch on five of the most common.

Retail REITs

REITs in the retail sector include malls, shopping centers, outlets, and freestanding stores. Famous examples include Simon Property Group, which is the largest shopping mall operator in the U.S. and Realty Income Corp., which owns properties that feature anchor stores like Walgreens and 7-Eleven.

Both are still managing despite having stock prices that have taken a beating. Despite this issue, they’re also paying dividends.

Residential REITs

Everyone needs a place to lay their head, so residential REITs tend to be a fairly stable investment. This type of REIT includes apartments, single-family homes, and even student housing.

In general, residential REITs can fall in value during a recession but bounce back stronger than ever. This pattern was evidenced during the 2008 financial crisis and the corresponding REIT boom that occurred in 2009 and 2010.

Healthcare REITs

Healthcare REITs are a current bright spot in the market, and there are currently 17 of them in the U.S. that could make your portfolio more diversified. As the baby boomer population ages and needs assisted living and more people are looking after their health, every aspect of this sector is booming.

Demand for healthcare is inelastic, which means that even as prices rise, demand remains constant. For most, healthcare is not a choice; it’s a necessity.

So if you’re looking to capitalize on a long-term trend, then you might want to begin your REIT investing career with healthcare REITs. They’re the most likely to offer consistent growth and balanced risk.

Office REITs

I saw an article recently that argued how the coronavirus has killed the corporate culture, and I tend to agree – at least in the short-term. Many businesses have shuttered their doors, and countless others have embraced the remote, work from home environment.

But, this doesn’t mean there aren’t still opportunities to invest in profitable office REITs. As you probably guessed, office REITs invest in office space. Some specialize in a specific type of building, while others focus on a particular location. Look for REITs that boast high tenant occupancy and rent collections.

Mortgage REITs

The hardest-hit REITs in 2020 have been mortgage REITs. As a reminder, mortgage REITs invest in mortgage and mortgage-backed securities, earning income from the interest on those loans.

There is some good news, though. Because the price of mortgage REITs dropped so dramatically, they’re currently considered by many to be undervalued. And, they’re still paying dividends.

On the bearish side of mortgage REITs is the inevitable rise in interest rates that could potentially slow down the housing market, discourage mortgage refinancing, and make it more expensive for these REITs to replace their debt.

With mortgage REITs typically underperforming compared to equity REITs, I recommend doing diligent research before investing here.

How to buy REITs

Below, I am going to outline the different ways you can invest in REITs, starting with opening a good online brokerage.

What’s even better is that all of my preferred brokers offer $0 commission trades, no account minimums, and a convenient mobile trading platform, so you can track your stocks and execute trades on the go.

1. Open an online brokerage account

You can buy REITs directly from your brokerage account, and the process is nearly identical to buying any other type of stock.

I recommend three brokerage accounts that are suitable for all levels of investors, from the very beginner to day trading warriors.

Robinhood

Robinhood’s intuitive interface and mobile trading platform make trading REITs a breeze. At a glance, you can see if your investment has gone up and down since you’ve bought it, and also see your portfolio as a list.

Currently, Robinhood has a vast collection of REITs to choose from with plenty of stats for each and even analyst ratings expressed as a buy percentage. For example, at the time of writing, MFA Financial has a 0% buy rating while Starwood Property Trust has a perfect 100% buy recommendation. 

E*TRADE

As the first internet-based trading platform to be introduced to the public, E*TRADE gets top marks for simplifying the trading process.

You don’t even need much money to get started. You can also set up watch lists for REITs and get notified when their price hits a high or low, or there’s relevant news published about the company. This feature can give you a first-mover advantage. 

TD Ameritrade

TD Ameritrade is another great option for investing in REITs. Not only are they one of the oldest brokerage firms (they’ve been around since the 70s) but their platform is excellent for investors who want a little guidance. TD Ameritrade offers a significant amount of guidance – including relevant articles, newscasts, and analysis.

Those types of things are important when you’re investing in REITs, since it’s a different type of asset class and you’ll want to be sure you’re investing in the right REIT. TD Ameritrade also has access to a massive selection of stocks, mutual funds, and ETFs. You can trade over 300 ETFs and over 4,000 mutual funds for free, too.

2. Publicly traded REIT stocks

Publicly traded REITs are bought and sold just like stocks on public exchanges. Currently, there are more than 225 REITs in the U.S. registered with the SEC (Securities and Exchange Commission). These all trade on the major stock exchanges. Because these REITs are traded on exchanges like the NYSE, they’re transparent and liquid.

By this, I mean that you can get plenty of information about them – what’s in their portfolio, how profitable they are, etc.

Plus, there is plenty of trading volume. High trading volume allows you to get in and out of ownership quickly and easily. This concept is referred to as being liquid. Compare this to traditional real estate where you’ll have to sell a property to cash in, and you can see one of the key advantages of publicly traded REIT stocks.

3. Private REITs

Private REITs are not traded on any exchanges, and they’re not registered with the SEC. Because they’re private and 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. 

4. Non-traded REITs

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.

5. 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, a REIT ETF (exchange-traded fund) is likely to contain a variety of properties.

Still, a REIT fund is not as diversified as owning multiple stocks in multiple industries because the underlying asset class is still real estate. 

6. 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.

How to evaluate a 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:

FFO

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.

Debt-to-EBITDA ratio

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 a 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.

Capitalization rate

Also called the cap rate, this number represents how much a 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.

To get an idea of what appropriate capitalization rates are for different property types in different markets, there’s an annual survey published by CBRE that is very comprehensive and incredibly valuable.  

To sum up this discussion and give you something concrete, my best advice is to compare trends over time to track a 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.

The pros and cons of REITs

Pros:

• 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 a 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.

Cons:

• 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 payout 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.

Summary

At last – 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 (fear of missing out) was real.

With REITs, you can get started for under $10 and start making immediate returns. And, with REITs consistently outperforming the stock market (12% average annual returns from 1998 to 2018, compared to 10% in the overall 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 a REIT in your pension, 401(k), or IRA without realizing it.

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