How to Invest in REITs

Contributor, Benzinga

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Real estate investment trusts, commonly referred to as REITs, offer investors a simple and accessible way to put their money into the real estate market without becoming a landlord or investing hundreds of thousands of dollars at once.

Thankfully, buying REITs is typically just as easy as buying stocks. We’ll go over REIT types, how to buy REITs, the pros and cons you’ll need to consider before you buy and some things to look for when analyzing REIT investments.

Why Invest in REITs

A fundamental truth applies when it comes to investing; regardless where you choose to invest, your end goal is to build wealth for yourself and secure your future. That’s why alternative investments like a real estate investment trust (REITs) are so popular. Unlike traditional investments that may appreciate in value over time, REITS give investors the benefit of generating passive income while they appreciate. 

REITs are funds that use a combination of their own capital, financing and investor contributions to purchase real estate (commercial real estate, industrial property, multi-family residential property, farm-land) or other assets in the real estate sphere such as mortgages and mortgage-backed securities. REITs then pay off investors with passive income generated from the property (rent, crop yield)  or mortgage payments.

This process allows investors who own shares of REITs to have their cake and eat it too. Many REIT shareholders claim depreciation write-offs or annual tax breaks on pass-through income, all without ever having to sell their shares. In the case of traditional investments like stocks and bonds, it’s usually the opposite. The only way to realize the profit your stock has accrued since you purchased it is for you to sell the stock. 

REITs, on the other hand, offer investors the best of both worlds. For these reasons, REIT shares are highly sought after both by institutional funds and retail investors alike. 

According to Nareit, approximately 145 million Americans live in households that currently have some type of REIT investment either directly or through ETFs, mutual funds or their retirement plans. 

If you’d like to learn more about how to invest in REITs, keep reading.

Types of REITs

Although you can find a variety of different REITs to invest in, most REITs fall into one of the following three categories.

Equity REITs

REITs that invest directly in real estate are equity REITs. Generally, equity REITs spread their investments out over a large geographic area to limit their exposure to downward market trends in one particular real estate market. Equity REITs typically pay shareholders on a quarterly or annual basis. The payout will be proportional to the amount of equity each shareholder has. 

Mortgage REITs (mREITs) 

REITs that invest in mortgages or mortgages secured by real estate assets are known as mortgage REITs. Much like equity REITs, a mortgage REIT tends to spread its portfolio out over a large area to insulate itself against market fluctuations. 

As opposed to rental income, mortgage REITs generate passive income for shareholders through mortgage interest. Because of this, assets in mortgage REITs don’t generally appreciate over time but usually pay higher dividends. While, mortgage REITs are secured by the properties they finance, they’re often considered a higher-risk investment.

Hybrid REITs 

Some REITs hold investments invest in a combination of equity and debt. These are known as hybrid REITs and they offer investors the chance to invest in both types of REIT at the same time. 

REIT Sectors

Although equity REITs may be the most common type of REIT, a great variety of equity REIT sectors exist for investors to choose from. A brief summary of the different types of REIT sectors appears below. 

  • Residential REITs own residential real estate properties. Historically, residential REITs targeted multi-family complexes like apartments, but now REITs even own large tracts of single-family homes. 
  • Retail REITs own shares in retail properties such as strip malls, shopping centers or single-tenant buildings. 
  • Office REITs own office property such as commercial high-rises and office parks.
  • Industrial REITs own industrial facilities like warehouses, distribution centers, factories, foundries and industrial parks.
  • Healthcare REITs own healthcare-related facilities such as senior housing, skilled nursing facilities, hospitals, medical office buildings and medical parks where multiple practitioners operate out of shared space.
  • Lodging REITs/Hotel REITs own short-term housing facilities such as hotels, executive stay suites, resorts and other short-term options.
  • Data center REITs own large storage facilities where data-sensitive businesses such as cloud storage companies maintain their hard drives and infrastructure.
  • Infrastructure REITs, a relatively new type of REIT, own and operate facilities that are key to both private and public infrastructure, such as cell-phone towers, fiber-optics networks, natural gas facilities or renewable energy (solar, wind farm).
  • Diversified REITs spread their capital around and make equity investments in a variety of different income-generating real estate assets. 
  • Timberland REITs own shares of forest or rural land that is used for logging or other commercial purposes.
  • Specialized REITs are companies that don’t fall into one of the above categories. These REITs typically invest in a unique real estate asset class, like private prisons or casinos.
number of REITs by sector
Data Source: Nareit

Ways to Invest in REITs

You can choose from a diverse blend of REITs as well as different investment choices. 

  • Publicly Traded REITs offer shares on the open market in the same way a publicly traded company sells stocks. 
  • REIT Exchange-Traded Funds (ETF) hold equity shares in a variety of REITs and derivatives with REIT components.
  • Private REITs sell shares, but only through private placement. These offerings are typically only available to accredited investors.
  • Public Non Traded REITs can be purchased publicly, but the shares are only available through direct purchase from the REIT itself or an authorized broker/dealer.
  • REIT Mutual Funds hold shares of other REITs or other shares offered by real estate companies

Choosing a REIT to Invest In

You’ll want to consider a few factors before investing in a REIT. First, take your risk tolerance into account. One of the advantages of alternative investments like REITs is that they are somewhat insulated from the volatility of the stock market. REITs may not fluctuate in value as wildly as the stock market, but that doesn’t mean REITs are without risk.  

Choosing The Types of REITs to Invest in

If one or more of the real estate markets where your equity REIT holds assets experiences a sharp market downturn, your quarterly dividends will be much lower than expected. Imagine owning shares in a retail REIT that is centered on shopping malls. That would have been humming along fairly well until the pandemic put the squeeze on people going out to do their shopping in public places. 

Mortgage REITs are secured by the properties attached to the loans, but they also have risk. Mortgage REITs profit on the margins between money borrowed at the prime rate by the REIT before they lend it out to builders and developers. If interest rates rise, then the profit margin for the equity REIT can shrink along with your dividend. 

Investment Goals

Another thing to consider when investing in a REIT is that they are meant to be long-term investments. Almost all private and non-traded REITs have a hold period during which your investment capital must remain with the REIT itself. There may or may not be a secondary market for you to liquidate your shares (every REIT has a different policy). 

REIT allocation by investment horizon
Image source: Nareit

Dividends

Aside from your risk tolerance, you have to ask yourself what your investment goals are. If you want passive income, you should target high dividend REITs. Bear in mind, however, that the higher-dividend REITs tend to carry more risk because they have to invest in higher-risk properties to achieve the desired investment yield. High-dividend REITs also have to take on more debt in order to grow since most of the profits are paid out to shareholders. 

Growth

If you’re looking for a REIT that will pay a lower dividend but offer you a higher payoff through share appreciation at the end of the investment period, a growth REIT may be a better choice. The risk is comparably lower here than with a higher dividend REIT, but the risk is not zero. It’s entirely possible that the assets held by your growth REIT won’t appreciate as anticipated, in which case the payoff at the end of the hold period will be smaller than what you were expecting. 

Valuation Metrics

Regardless of what type of REIT you invest in, you can be sure of one thing: all will tell you their particular REIT is the best. Before you take any of those claims at face value, do a deep dive on the numbers in the investment prospectus. The good news is that you don’t have to be an analyst with an MBA from Wharton.

You can use a number of different metrics to assess whether or not a REIT is right for you. For example, a REIT prospectus may indicate that it has a very high dividend payment history, which is a good thing. However, the figure reported in most REIT prospectus or earnings histories represents the average dividend paid out to all the shareholders. 

A preferred shareholder, usually an early investor who made an extremely large contribution, may receive a much higher dividend than a non-preferred shareholder. So, if you’re not a preferred shareholder, the total distributions may not be representative of what kind of dividends you might receive. That’s why you shouldn’t rely on any one claim in an investment prospectus before buying an offering. 

You’re much better served by looking at some hard numbers in the prospectus. What is the total value of all the assets owned by the REIT, or its net asset value (NAV)? How much debt is the REIT carrying? Needless to say, if the REIT is carrying an excessive debt load, that could be indicative of a riskier investment.  

You can also look at funds from operation (FFO), which will give you a concrete idea of how much cash flow the REIT generates after all expenses, depreciation and amortization are calculated. FFO is a popular measuring stick that many real estate investment analysts use when trying to assess the true value of an investment. You can use FFO to compare the apples-to-apples performance of two different REITs. 

Once you have weighed all of these factors, you will have a much better idea of which particular REIT is right for you. The most important thing to remember is that REIT investing is not shooting fish in a barrel. There are a lot of factors to consider, especially the fact that once you’ve made the investment, you may not be able to get your capital back without a lot of additional expense and inconvenience. 

The Bottom Line

The good news is that you can educate yourself as an investor before buying into a REIT. Much of the information you need to analyze the REIT is available in the prospectus or supporting information regarding the offering. Consider what your goals are, how much you have to invest and how long you can afford for your investment to be illiquid. Once you know that, you’ll be well on the road to finding just the perfect REIT for you.

What Are the Pros and Cons of Investing in REITs?

Let’s take a look at a few of the pros and cons that come with investing in REITs. 

ProsCons
Higher dividends: REITs are required by law to pay out at least 90% of their taxable income in dividends. This means more profit for you as the shareholder.

Easy purchase process: Interested in investing in real estate but don’t have the time, down payment or credit score to buy a rental property? REITs give you an easier way to invest. 

Access to more types of property investment: Unless you have a few hundred thousand dollars lying around, you can’t invest in a commercial property or a medical care facility on your own. REITs pool your funds together with other investors, allowing you to invest in more types of properties.
Higher taxes: REITs usually pay out higher dividends than competing stocks. While this can be great for your wallet in the short-term, REIT dividends aren’t taxed at the lower qualified dividend rate that most stock dividends are. This means you’ll need to put away more money for taxes. 

Long-term investments: If you’re looking for a way to mask fast cash, REITs might not be for you. It can take years to recoup your investment through dividends, even if your REIT of choice is relatively affordable. 

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