Investing in real estate is a great way to diversify an investment portfolio. Unfortunately, for many people, real estate can be intimidating. Buying a house or an apartment building and becoming a landlord isn’t for everyone, especially if you’d prefer to keep a more hands-off investment approach.
That’s where a real estate investment trust (REIT) comes into play. REITs allow you to invest in realty without physically owning a property. Instead, you buy and sell shares of a REIT just like you would an individual stock or an exchange-traded fund (ETF).
What Is A REIT?
A REIT is a company that owns a portfolio of income-generating real estate properties. They could be apartment buildings, office buildings, shopping malls, hotels, self-storage units and more. Because each portfolio is made up of many different properties, it offers investors a greater amount of diversification.
REITs were first established by Congress in 1960 to give investors the ability to have a diversified equity stake in real estate companies the same way they could own shares of companies in other industries. When investing in a REIT you can either purchase shares of the company’s stock or shares of a mutual fund or ETF.
The IRS has set certain requirements for how a REIT needs to operate. By following these guidelines, a REIT isn’t taxed on the corporate level, which allows them to purchase real estate at a lower cost. In the end, it means a higher return for investors.
Some of the requirements set by the IRS include:
- At least 75% invested in either real estate or cash.
- Receive a minimum of 75% of its gross revenue from real estate. This could be rent received, interest payments on mortgages, or from the sale of a property.
- At least 90% of taxable income must be returned to investors each year in the form of a dividend.
- At least 100 shareholders after the first year.
- No more than 50% of its shares can be held by five or fewer individuals.
A REIT is a real estate investment trust that owns, operates or finances properties that produce income in a particular sector of the real estate market. Investors can buy shares in a REIT or a REIT fund to diversify their portfolio and generate income.
How To Start REIT Investing
Just like other investment vehicles, REITs require careful consideration from investors to avoid poor-performing companies and maximize total returns. If you’re new to the world of investing, there are a few important steps you should keep in mind. Let’s review them.
1. Calculate Potential Value
Investors have several tools at their disposal to help them figure out the value of REITs. That’s because the value of a REIT isn’t always outwardly apparent – and basing your decision on instinct, public sentiment or an isolated metric likely won’t net you the largest returns.
Instead, use these widely adopted investment ratios to gather a holistic picture of a REIT’s standings:
- The price-to-earnings (P/E) ratio evaluates a REIT’s market value per share against its earnings per share. This helps investors gauge whether the stock price reflects the company’s earning potential. The higher the P/E ratio, the more likely it is that the REIT is overvalued.
- The price/earnings-to-growth (PEG) ratio compares an investment’s P/E ratio by its rate of earnings growth over a designated period. This ratio helps investors calculate a company’s future earnings potential. That means that REITs with low PEG ratios could be undervalued and worth further investigation.
- Cap rate, or capitalization rate, is a rate-of-return metric that calculates the potential first-year income of a property against the cost to purchase. An investment opportunity’s cap rate is determined by dividing the net operating income by the current market value. Understanding cap rate can help you decide whether a REIT is profitable or overpriced.
- Dividend yield gauges investment income by comparing a company’s yearly dividend against the price of a share. Although a REIT’s dividend yield fluctuates with changes to the REIT’s dividend amount, dividend yield gives you an idea of how much you can expect to receive from your REIT investments – especially because REITs pay above-average dividends.
2. Have A Clear Idea Of Fees
Fees are a part of most investment opportunities, and REITs are no exception. However, the amount and number of fees you pay can depend on the specific REIT you purchase.
Publicly traded REITs, for example, charge a standard brokerage fee when you buy through a broker. Non-traded REITs, on the other hand, often charge rates as high as 10% of your investment, which can severely bite into your bottom line.
Beyond upfront fees, investors should understand the tax implications of REIT investing. Depending on how your dividends are categorized, your investment income may receive different tax rates. Generally speaking, your dividends will be distributed into regular taxable income, return of capital or capital gains. Make sure you don’t spend all your profits before April 15th.
3. Set Up A Brokerage Account Or Meet With An Expert
Once you’ve completed your research, you’re ready to purchase your REIT of choice. Similar to buying other public stocks, you can purchase REITs that are listed on the stock exchange through shares, mutual funds or ETFs. Just make sure you have a brokerage account beforehand.
For investors who prefer a hands-off approach or are seeking professional insight, hiring an industry expert is the way to go. Some financial professionals may even have access to REIT investments outside of those that are publicly held.
Types of REITs
There are three main types of REITs: equity REIT, mortgage REIT (mREIT) and a hybrid REIT. Then each of these types can be broken down even further into publicly traded REITs, public non-traded REITs and private REITs.
Equity REITs own and manage groups of similar properties. They could be commercial real estate, apartment buildings, etc. They collect rent and manage all maintenance and improvements to each asset. Typically, the more work involved to make a property profitable, the greater the risk, and the profit potential. This might sound a little familiar. It’s like being a landlord without the work.
Equity REITs tend to come in different shapes and sizes. Some look to purchase assets that need to have a lot of development or renovations completed before the true value and income potential of the property is realized. Other equity REITs focus on acquiring properties that are completely rehabbed and ready to earn maximum income through rents. These types of properties tend to require significantly less upfront work and require less capital in the short term.
Mortgage REIT (mREIT)
While equity REITs focus on owning and managing property, mortgage REITs invest in mortgage debt. As an example, let’s assume that a developer is building a new apartment building. They would take out a loan to pay for the project and then a REIT might purchase the debt on the building from the original lender. The building owner would still own the building, but the REIT would own the debt. Mortgage REITs don’t tend to be as profitable as equity REITs and earnings are directly correlated to interest rates.
Hybrid REITs offer investors the best of both worlds. Not only do they own properties like an equity REIT, but they also own mortgage debt on other properties.
While REITs are frequently grouped by their investment style, they’re also grouped by the way they’re traded.
Publicly Traded REIT
Publicly traded REITs are registered with the Securities and Exchange Commission (SEC) and listed on a public stock exchange. Publicly traded REITs are traded just like any other public company would be. The biggest advantage of investing in a publicly traded REIT is liquidity. It’s much easier to sell when needed and eliminates a required holding period that comes with most real estate investments. Unfortunately, liquidity comes at a cost. Publicly traded REITs tend to trade at higher prices, which reduces potential profits for the investor.
A popular way to invest in publicly traded REITs is through an ETF like the Schwab U.S. REIT ETF or the Vanguard Real Estate Index Fund ETF. Each of these ETFs invests in multiple REITs, helping to make them a more diversified investment. Unfortunately, the biggest downside to a REIT ETF is that they tend to move in similar directions as the overall stock market.
Private REITs are not registered with the SEC and are not listed on a public exchange. This means they have lower liquidity compared to a publicly traded REIT. On the bright side, their performance isn’t correlated to the overall stock market. Unfortunately, because private REITs are not listed on an exchange, they’re only available to accredited investors and require a high initial investment.
Public Non-Traded REIT
Public non-traded REITs are registered with the SEC but do not trade on an exchange as a public REIT does. They also have similar transparency requirements to a public REIT. The biggest difference is that because they aren’t publicly traded, they lack liquidity. It’s not as easy to sell your shares whenever you want.
Public non-traded REITs have become extremely popular over the past several years. Companies like Fundrise, DiversyFund and Streitwise give investors the chance to start REIT investing with as little as $500 – $1,000 while producing annual returns that have been over 10% in recent years.
The Pros Of REITs
Investing in a REIT is similar to any other investment in that it has pros and cons depending on your investment style and goals. Here are a few of the advantages of investing in REITs:
- High dividend yield. The federal government requires all REITs to pay out at least 90% of their taxable income to shareholders as a dividend. Because of this, the average dividend yield for an equity REIT is around 5%. This is compared to 1.87% for the S&P 500.
- Large return potential. Equity REITs operate by purchasing real estate assets. The goal is to both collect rent from tenants but also realize capital appreciation over time. Combine this appreciation with high dividend yields and this can lead to a large return for investors.
- Diversification. REITs can be a great way to add real estate to an investment portfolio, helping to diversify away from stock or mutual fund only portfolios.
- REITs outperform the S&P 500. Over the past 20 years, REITs have outperformed the S&P 500 by nearly 300%.
- Easy transactions. When you purchase an investment property, it requires a lot of work. A lot of time is spent finding a property that makes sense financially. Then once you’ve bought the property, you spend time marketing it to prospective tenants and managing the ongoing maintenance. With a REIT, you make an investment, and everything is done for you. On average, you’re still earning a high return, but in exchange for a fee, everything is taken care of by the company that owns the REIT.
- Investments can be liquid. If you purchase an investment property, the only way you can get cash out is to either do a cash-out refinance or sell the property. With a public REIT, you can sell your shares when you need the funds. Even public non-traded REITs give you the ability to sell your shares, though it usually has a fee when done within the first few years.
- Suitable for different investment account types. REITs are thought to be options for taxable investment accounts, but they can also be a great addition to a retirement account like an IRA.
The Cons Of REITs
Just like there are several advantages to investing in REITs, there are also some negatives:
- Dividends taxed as normal income. When you earn dividends on most investments, they’re taxed at a lower rate. It can be anywhere from 0% for low income earners up to 20% for high income earners. Unfortunately, dividends from REITs aren’t allowed to take advantage. Instead, REIT dividends are taxed at ordinary income tax rates.
- Long-term investments. Public REITs are very liquid, which means you can buy and sell much more freely. However, private or non-traded REITs are much more illiquid. When investing in either of these, you should plan on staying invested for at least 5 years.
- Appreciation can be restricted. Because 90% of all taxable income must be returned to investors, this can limit the cash available for the REIT to perform improvements and purchase new properties. Instead of relying on profits, they must issue additional shares of stock and bonds. Unfortunately, buyers aren’t always available at the optimal time.
- Lots of debt. REITs tend to be some of the most debt-heavy investments. However, this is generally overlooked by many because REITs are producing regular cash flow.
- Some REITs are expensive. Public REITs tend to have very low minimum investments. You can get started with some public non-traded REITs with just $500. However, there are many nontraded REITs that have minimum investments of $25,000 or more and require you to be an accredited investor.
- High operating costs. Many private and public non-traded REITs charge high operating costs that can end up totaling 1% or more. This is in comparison to something like the Vanguard Real Estate ETF, which has an expense ratio of just 0.12%.
The Bottom Line: Invest In Real Estate Without Owning It
Real estate is a great way to diversify an investment portfolio. However, many people don’t want to put forth the time or effort it takes to become a landlord. REITs give average investors the chance to add real estate to their portfolios without all the added work.
If you’re just getting started, look into the different types of REITs. Understand the pros and cons of each and how they might fit into your portfolio. If you might need the funds in a couple of years, you’ll want to look toward equity REITs because of their liquidity. However, if you don’t think you’ll need the money, then a hybrid REIT might be the route to go. They are much more illiquid, but the earnings potential can be much greater. To learn more about REITs and other ways you can help grow your wealth, check out our Learning Center.