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Real estate investment trusts, also known as REITs, have been around for more than 60 years now. They came into existence after President Dwight D. Eisenhower signed an act known as the Public Law 86-779, which allowed investors to participate in income-producing real estate projects that were marketed in the form of investable securities.
This was the first step of an industry that has grown to become a $3.5 trillion behemoth and that has also diversified to a wide range of niche vehicles that invest in different kinds of properties, like residential single and multi-family units and/ large-scale health care facilities.
REITs are a go-to investment vehicle for investors who love hard assets and they can add an extra layer of diversification to the typical stock/bond portfolio that financial advisors tend to recommend.
If you would like to know more about REITs, how they work, how they have performed over time, and how you can invest in them, the following article goes into those and many more other details.
What Are REITs?
A real estate investment trust (REIT) is a vehicle through which investors can participate in large projects that involve the development, acquisition, or administration of a group of real estate properties.
Most REITs are publicly traded companies, which means that investors can easily purchase a fraction of the entity that holds the properties via a traditional stock exchange. That said, there are other types of REITs, including non-listed and private REITs.
To be considered a REIT, the holding company must have a long-term investment horizon, at least 90% of its taxable income must be distributed to investors, and a minimum of 75% of its assets must be invested into real estate.
However, there are certain specific types of REITs, such as mortgage REITs, which provide financing for real estate projects in the form of loans or by originating or transacting with mortgage-backed securities — these being the primary assets they would hold in their balance sheet instead of real estate properties.
Pro Tip: Not all REITs are created equal, some invest directly in properties allowing them to earn rental income and management fees, while others invest in real estate debt (i.e. mortgages and mortgage-backed securities).
How Do REITs Work?
Investors can get exposure to REITs by buying shares of any of the hundreds of different vehicles currently available on the public market. Each share represents a portion of the REIT’s equity and they give the common shareholder the right to cast a vote on the different affairs that are relevant to the company.
REITs generate gains for investors in two ways. They deliver cash gains in the form of dividend distributions and they also produce capital gains through increases in the price of their stock.
In terms of taxation, REITs do not pay corporate taxes, which avoids the double-taxation issue that investors tend to suffer when they receive distributions from the corporations they own.
Ways to Invest in REITs
Most REITs are publicly traded companies whose shares can be bought and sold through traditional stock exchanges. However, not all REITs are created equal and therefore, in the following section, we will explain the different types of REITs you will usually encounter so you can pick the ones that fit your investment methodology best.
An equity REIT is perhaps the most common form of REIT you’ll find in the market. These companies invest in a wide range of income-generating properties but they tend to specialize in a certain industry or market niche based on the expertise of the management team and the opportunities that emerge.
Some industries for REITs include lodging and resorts, healthcare, services, retail, industrial, residential, office, data centers, and more. See table below.
Beyond individual industries, certain REITs, known as diversified REITs, hold an ample range of properties across multiple industries. These REITs are designed to withstand sector-specific downturns due to their broadly diversified nature but their returns might also be lower than those produced by specialized REITs as losses from one underperforming sector can drag the trust’s overall performance down.
The description of the strategies, performance, and portfolio of each REIT can usually be found in the Investors section of the trust’s official website and a more extensive discussion of these and other matters can also be found on the REIT’s annual reports — also known as 10-K filings.
|Industrial||Factories, warehouses, cold storage, and distribution centers|
|Data Centers||Data centers either leasing rack space or kilowatts|
|Residential||Multifamily properties, single-family homes, and mobile home parks|
|Retail||Shopping malls, grocery-anchored shopping centers, and single-tenant retail properties|
|Office||Office parks, office towers, and other office properties|
|Healthcare||Senior housing, skilled nursing, hospitals, medical office buildings, and life sciences|
|Lodging||Hotels and resorts|
|Infrastructure||Cell towers, fiber optics routes, and other data networks|
|Specialty||Property types that don’t fall into the typical categories, such as private prisons, casinos, etc.|
|Timber||Income generated from trees being cut on the property for lumber|
|Diversified||Portfolios that include multiple property types|
Mortgage REITs, also referred to as mREITs, offer different types of services to real estate developers, buyers, and other REITs. They can extend financing to any of these parties, originate and transact with mortgage-backed securities (MBS), or provide fee-based services.
To be considered a mortgage REIT, the company must invest at least three-quarters of its assets into real estate-related instruments, have 100 or more shareholders, and distribute at least 90% of its taxable income to investors in the form of dividends.
Like other REITs, mortgage REITs are not taxed at the corporate level.
A hybrid REIT is, in essence, a mix of the two types of REITs mentioned above, an equity REIT and a mortgage REIT. The goal of a hybrid REIT is to increase returns for investors by combining these two activities into a single entity while reducing the risk typically carried by pure-play mREITs.
In a hybrid REIT, the balance sheet’s top accounts will be spread between fixed assets, composed of the properties owned and operated by the REIT, and investable securities, which in this case are mortgage-backed securities and other similar real estate-related financial instruments.
Since mortgage REITs are typically considered risky ventures due to their sensitivity to interest rate changes, hybrid REITs aim to reduce that risk by investing a portion of the portfolio into income-producing properties that are typically deemed as more stable.
Publicly Traded REITs
Most REITs are publicly traded entities whose shares can be bought and sold through a traditional stock exchange. These trusts are regulated by the US Securities and Exchange Commission (SEC), similarly to corporations.
Buying and selling shares of a publicly-traded REIT is the same as transacting with shares of Coca-Cola (KO) or PepsiCo (PEP) and most brokerage firms nowadays have slashed their commissions for buying and selling these securities to zero.
Publicly traded REITs must publish their financial statements periodically in the form of 10-Q and 10-K reports and they must also inform investors about material events that affect the business via 8-K reports.
Public Non-Listed REITs
Public non-listed REITs are vehicles that are also accessible to retail investors but shares of these trusts are not traded on traditional exchanges. Instead, they are offered by regulated brokers or networks to increase their liquidity.
Some of these platforms include Fundrise, DiversyFund, and CrowdStreet. These REITs must also be registered with the SEC and publish their financial reports periodically and disclose relevant events that affect the business. Moreover, non-listed REITs must disclose their net asset value (NAV) periodically to inform investors about the value of their investments.
The main difference between publicly traded and public non-listed REITs is liquidity. However, higher brokerage fees tend to apply when transacting with these instruments while the minimum investment required tends to be higher as well.
|Fees||0.50% to 2.5% (Funds); Project fees vary||1.0% per year||No management fees; other fees may apply|
|Promotion||None||Advisory fee waived (*12 months)||None|
|Highlight||Access to commercial real estate investment opportunities||Access to private real estate deals||Access to commercial real estate deals and no management fees|
|Best For||High-net-worth individuals||Long term investors||Non accredited investors|
Private REITs are vehicles through which sophisticated investors, typically institutional ones, can gain access to opportunities in the real estate market offered by well-reputed players in the industry.
The instruments offered by these REITs don’t have to be registered with the SEC and only accredited investors are allowed to purchase shares of these trusts. An accredited investor is an individual who meets specific criteria, including having a net worth of at least $1 million or income exceeding $200,000 for individuals and $300,000 for married couples.
Shares of private REITs are not traded on public exchanges and brokerage fees tend to be higher compared to the other two types of REITs mentioned above. They are also less liquid compared to their regulated peers due to the smaller number of prospective investors that might be available and willing to buy the holdings at any given point in time.
Private REITs are not required to disclose their results periodically and corporate governance policies will usually be determined by the Board of Directors of the trust.
How to Analyze a REIT
Even though REITs function similarly to a regular corporation, certain financial metrics and ratios help in better portraying the underlying performance, financial health, and profitability of this type of company.
Here’s an overview of the top metrics to keep an eye on when analyzing a REIT’s financials:
Funds from Operations (FFO): The FFO metric aims to adjust a REIT’s net profits by adding back all non-relevant non-cash charges such as the depreciation of the properties held by the trust. Since these properties do not necessarily lose value to the extent indicated by depreciation charges during the time that the REIT holds them, the FFO is generally a more accurate measure of a REIT’s profitability.
FFO Payout Ratio: The payout ratio of a REIT should be determined based on its FFO and not its GAAP net earnings due to the distortion caused by overly large depreciation charges. The higher the payout ratio, the higher the portion of the REIT’s profitability that shareholders will receive in the form of cash distributions.
Additionally, there is an alternative metric known as Alternative FFO (AFFO), which includes adjustments for charges that the management might deem as non-recurring or extraordinary to the extent that they might also be distorting the underlying earnings produced by the trust.
Debt-to-EBITDA: The Debt/EBITDA ratio is used to assess how indebted a REIT is compared to its operating profits. The lower the ratio, the better, in most cases. However, a healthy amount of leverage is usually beneficial for REITs as long as the firm’s operating profits significantly exceed the amount paid in interest and the debt-to-asset ratio remains conservative based on the mark-to-market value of the properties held by the trust.
Interest Coverage: The interest coverage ratio of a REIT is estimated by dividing its annual FFO by the amount paid in interest every year. The higher the ratio, the better, as it indicates that the trust has more than enough money to cover the interest portion of its financial obligations.
Net Asset Value: The net asset value (NAV) of a REIT is calculated by subtracting the value of its total asset minus all its liabilities. The result is interpreted as the shareholder’s equity of the REIT.
In theory, the NAV is calculated by using the book value of both components of the formula. However, a more accurate estimate of the NAV would use the mark-to-market price of the assets held by the trust rather than their book value as the result could be quite different if market conditions have changed or the price of the properties has suffered a significant modification over time.
Dividend Yield: The dividend yield of a REIT shows the percentage that an investor would receive per every $100 in stock owned. For example, a 3% dividend yield would result in a $3 annual dividend paid to the investor in cash. Although a high dividend yield tends to be interpreted as favorable, an elevated percentage tends to reflect that the market is doubting that the trust will be able to maintain the dividend at its current level in the future.
Credit Rating: A credit rating is awarded to a REIT based on its financial health, past performance, and future prospects. These ratings are commonly estimated and assigned by companies like Fitch Ratings and Moody’s and the best REITs hold A+ ratings that reflect their ability to meet their financial commitments as expected.
Understanding Taxes on REITs
Even though REITs are structured similarly to a corporation, they are taxed differently due to the special status they have been given. They are a vehicle through which retail investors can benefit from the advance of the real estate market.
The earnings produced by REITs are not taxed at the corporate level, which means that regardless of how much the trust earns, only the investor will pay for the taxes these gains generate.
Dividend distributions will be taxed as ordinary income while capital gains will be taxed at that rate as well if they are liquidated less than a year after the shares were purchased. On the other hand, they could be taxed at a lower rate — the long-term capital gains rate — if they are held for longer than a year.
Benefits of Investing in REITs
- Increased portfolio diversification by incorporating an asset class that is directly exposed to a unique market
- Tax savings are passed to shareholders by avoiding the double-taxation scheme applicable to traditional corporate dividends
- There is a wide range of REITs to choose from based on the investor’s preferences and field of expertise
- REITs invest in tangible assets and valuing them is often easier compared to companies that rely heavily on intangibles to generate profits
- REITs have delivered attractive historical returns while their performance has been less volatile compared to the stock market
- These investment vehicles provide a combination of fixed and variable income in the form of dividends and price appreciation in the properties held by the trust
- Publicly traded REITs offer a high level of liquidity for investors as shares can be easily traded through traditional stock exchanges
Pro Tip: REITs are required to pay out 90% of taxable income to shareholders.
Downsides of Investing in REITs
- Certain types of REITs are very sensitive to the economic cycle and their value can suffer during recessions
- Assessing the value of a REIT’s portfolio demands in-depth knowledge of the local real estate market in which the properties are situated
FAQs About How to Invest in REITs
These are answers to some of the questions we frequently get about REITs from our readers.
Why Should I Invest in REITs?
REITs are a great addition to a traditional stock and bond portfolio as they add an extra layer of diversification along with another source of fixed income for investors. Moreover, a higher portion of the profits generated by REITs ends in the hands of investors since dividends are not taxed at the corporate level.
How Are REITs Dividends Taxed?
Dividends distributed by REITs are only taxed at the individual level. This means that the trust itself will not pay any taxes on these earnings, only the shareholder will. These dividends are treated as ordinary income and taxed accordingly.
How Much Money Do You Need to Invest in REITs?
For publicly-traded REITs, the minimum amount to be invested is the price of a share of the trust. That said, some brokers nowadays offer the possibility of buying fractional shares and this would allow investors to buy a fraction of a REIT’s stock instead of an entire unit.
Meanwhile, for non-traded REITs, the minimum investment required typically starts at $1,000 and can go much higher depending on the scope and size of the project. Finally, for private REITs, the minimum investment can start at $10,000 or higher due to the sophisticated nature of these vehicles.
Are REITs a Good Investment?
According to data from Nareit going from January 1990 to October 2020, REITs have outperformed US stocks by around 3% while their standard deviation — a measure of their volatility — was also lower during that period, at 6% compared to 13.8% exhibited by US equities.
Although historical comparisons can often be distorted depending on the exact date at which the analysis starts and ends, it is fairly clear that REITs would contribute positively to a portfolio’s returns while they are typically less volatile compared to equities.
How Do You Make Money on a REIT?
You can make money in REITs through the periodical dividends distributed by the trust to its shareholders, which are paid in cash. You can also gain from the price appreciation of the REIT’s shares.
On the other hand, for non-listed and private REITs, this price appreciation is typically reflected by the NAV of the REIT.
Are REITs A Good Hedge Against Inflation?
Empirically speaking, the price of real estate assets tends to rise when inflation goes up as investors commonly buy hard assets to hedge their net worth against inflationary pressures. Moreover, the income-producing side of real estate assets is also beneficial from an inflation standpoint as rent payments can be adjusted based on market conditions.
Therefore, dividends from REITs will usually go up during times of higher inflation although the exact extent to which their increase will outpace that of the market’s overall prices will probably vary from one REIT to the other.
REITs are a fascinating financial vehicle that can help investors further diversify their portfolios by incorporating a well-reputed asset class — real estate.
Moreover, the vast universe of available REITs makes this industry an appealing one for those who have in-depth knowledge about the dynamics that dominate the real estate ecosystem. Investors can benefit from determining the intrinsic value of REITs if they can identify potentially undervalued REITs.
We hope this guide was helpful enough to prepare you to start investing in these attractive vehicles.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.