This is a guest post from the personal finance app, Hardbacon.
As an investor, the idea of buying REITs through your brokerage account has probably crossed your mind. However, what exactly are REITs? And how will you know which one is the best choice for you?
This guide will cover everything you need to know about REITs and how they work.
What are REITs?
Real Estate Investment Trusts, or REITs for short, are companies that own and operate or finance real estate that generates income, including apartments complexes, shopping centers, storage facilities, hotels, and more. As REIT shareholders, investors get the experience of being involved in real estate without the complications that come with owning, operating, or directly financing properties.
Types of REITs
REITs can be divided into three main categories: mortgage, equity, and hybrid REITs.
These three categories can then be divided into a further 3 groups according to their trading status: private, publicly-traded, and public non-traded REITs.
REIT types according to investment holdings
1. Equity REITs
These typically invest in a particular type of property. Equity REITs own a particular real estate property. This means they provide the required upkeep of the property in addition to reinvesting in it and collecting rent. Examples of equity REITs include:
- Retail REITs - these invest in shopping centers
- Residential REITs - these invest in apartment complexes, student housing, single-family homes, etc.
- Self-storage REITs - these invest in storage facilities
- Lodging or resort REITs - these invest in hotels, lodges, or resorts
2. Mortgage REITs
Mortgage REITs do not own the property itself; instead, they own the debts that are backed by the property. They are considered to be significantly riskier than equity REITS but they pay out higher dividends, making them worth the risk.
3. Hybrid REITs
Sometimes known as diversified REITs, Hybrid REITs are a combination of equity and mortgage REITs. They own properties as well as commercial property mortgages.
REIT types based on trading status
1. Publicly traded REITs
These REITS can be readily sold and bought like stocks and ETFs. They can be bought using a standard brokerage account. They are more transparent and have better governance standards than other REITs. They also offer liquid stocks, which means you can buy and sell them faster than it would take you to do the same for a retail property. This is why a lot of investors exclusively go for publicly-traded REITs.
2. Public non-traded REITs
Although public non-traded REITs are registered with the SEC, they are not on exchanges. They can be bought from brokers that take part in public non-traded offerings, such as online brokers. Because these types of REITs are not traded publicly, it makes them very illiquid (for up to eight years or more in some cases).
It can also be difficult to put a value on non-traded REITs. In fact, according to the SEC, the estimated value is usually given about 18 months after their offering closes, which can be years after you first invested.
3. Private REITs
These are unlisted REITs that are difficult to value and trade. They are generally exempt from SEC registration. This means they have fewer disclosure requirements, which may make their performance difficult to track and evaluate.
How do REITs work?
REITs were created in 1960 by Congress in a bid to allow individual investors to own equity stakes in large-scale income-generating real estate, just as they could own stakes in other types of businesses.
To qualify as a real estate investment trust, companies are required to meet certain standards set by Congress. They include
- A company must be categorized as a corporation under the IRS revenue code.
- A company must have a minimum of 100 shareholders after the first year of investment, with no fewer than five individuals holding no more than 50% of shares.
- The company has to be managed by a board of directors
- The company must invest 75% minimum of its assets in cash or real estate
- A minimum of 75% of the company’s income must come from real estate, such as sales of real estate, property rents, or mortgage interest
- The company must return a minimum of 90% of its income as annual shareholder dividends
As long as REITs meet these requirements, they are exempt from paying tax at the corporate level. As a result, REIT companies can finance real estate more cheaply than non-REIT companies can, which means that they can grow bigger and pay out even larger dividends to shareholders over time. That said, investors are still required to pay taxes on most of the dividends at their ordinary income tax rates.
Pros of investing in REITs
Steady dividends
REITs must pay out most of their taxable income (at least 90%) to shareholders as dividends. This makes them offer a predictable revenue stream for fixed-income investors. They offer some of the most lucrative dividend yields in the stock market.
Liquidity
It’s easier to buy and sell publicly-traded REITs than to buy, manage, and sell actual real estate properties.
High returns
REITs often do better than equity indexes; yet another reason why they are an attractive investment option for investors who want to diversify their portfolios.
Lower volatility
REITs are less volatile than traditional stocks, mainly due to their larger dividends. They can serve as a hedge against the instability of other asset classes.
Cons of investing in REITs
Tax burden
While REITs typically don’t pay taxes, their investors tend to be taxed on dividends at their ordinary income tax rates, unless the dividends are collected in a tax-sheltered account.
Heavy debt
REITs are some of the most indebted companies. However, most investors are still happy to invest because of their long-term contracts and steady cash flow that ensure dividends are still paid out.
Non-traded and private REITs are illiquid
Non-traded and private REITs are illiquid, which means they have to be held for years for potential gains to be realized.
Interest rate risk
Because of low-interest rates, investors looking for yield may consider REITs as a bond alternative. There’s usually a correlation between REITs and interest rates - as rates increase due to economic growth, so does the value of a REIT.
How to choose REITs
Here are factors to keep in mind when looking to invest in a REIT:
1. Assess risk
It’s important to consider the risks that come with investing in REITs, such as the length of leases, how the income is generated, the quality of the tenants under the REIT, average occupancy rates, the REIT’s business strategy, and whether new projects are on the horizon. It’s especially important to monitor the decisions that a REIT makes to ensure long-term revenue streams are maintained.
2. Understand the different REIT sectors
As mentioned earlier, there are different REIT sectors, including residential, retail, infrastructure, and industrial REITs, among other property types. When researching what to invest in, make a point of looking into the REIT sector you may potentially invest in. It's paramount to understand the risks that come with investing in a particular category. All in all, you want to invest in a company within a sector that has a proven historical track record of profit generation.
3. What’s the true total return?
REITs allow investors to benefit from both the income generated by required dividend payouts as well as the capital appreciations of their properties. You can easily be lured in by a REIT’s appealing dividend yield (the payments that investors receive from a REIT on a quarterly or monthly basis), which in most cases is usually higher than dividend stocks. However, instead of simply focusing on the dividend yield, investors should also understand the true total return.
Final Thoughts
REITs are an important consideration to keep in mind when putting together any equity or fixed-income portfolio. Now that you know what they are and how they work, choosing the best one for your portfolio shouldn’t be difficult.
