Real Estate Investment Trust (REIT): What Is It, And Should You Invest?
There are endless ways to invest, but what about investing in real estate? You don't have to invest in physical real estate (in other words, you don't only need to become a landlord). You can also invest in real estate through REITs.
Here's what you need to know about REITs, the pros and cons and how to invest in this diversified real estate option.
What Is A REIT?
A company called a real estate investment trust (REIT) owns, operates or finances a portfolio of income-producing real estate properties, like apartments or apartment buildings, office buildings, shopping malls, hotels and storage units. They’re similar to stocks because you don't have to physically own a property. Each portfolio comprises different properties, which offers investors diversification, one of the most important tenets of investing.
As an investor, you buy and sell shares of a REIT just like you would an individual stock or exchange-traded fund (ETF).
How Does A Real Estate Investment Trust Work?
A REIT must meet several requirements or guidelines set by the IRS, which allows investors to diversify their portfolios.
- At least 75% invested in either real estate or cash.
- Minimum of 75% of gross revenue from real estate, such as rent, interest payment on mortgages or from the sale of a property.
- At least 90% of taxable income must be returned to investors yearly in the form of a dividend.
- At least 100 shareholders after the first year.
- No more than 50% of shares held by five or fewer shareholders.
A REIT is not taxed on the corporate level, which allows investors to purchase real estate at a lower cost than investing in physical real estate.
Types Of REITs
There are three main REIT types: publicly traded, non-publicly traded and private – though other types of REITs may be available to you.
A mortgage REIT invests in mortgage debt, including mortgage-backed securities. For example, a developer building a new apartment building might take out a loan to pay for the project. A REIT might purchase the debt on the building from the original lender. In other words, the REIT owns the debt while the building owner still owns the building.
Equity REITs own and manage groups of similar properties, such as commercial real estate properties or apartment buildings. They collect rent and handle all maintenance and improvements to each asset.
Equity REITs may purchase assets that need to develop or have renovations completed before they can tap into their full income potential. Other equity REITs might acquire rehabbed properties ready to earn maximum income.
Hybrid REITs allow investors to invest in both equity and mortgage REITs. Investors can choose a hybrid REIT if they’re still determining whether they want to invest in either a mortgage or equity REIT.
Publicly Traded REIT
You can think of publicly traded REITs as comparable to any other public company because they’re registered with the Securities and Exchange Commission (SEC) and listed on a stock exchange. You have access to liquidity because you can sell a publicly traded REIT whenever you need to. You don't have to wait for a required holding period like you would with other real estate investments.
One of the most popular ways to invest in publicly traded REITs is through the Schwab U.S. REIT ETF or the Vanguard Real Estate Index Fund ETF. These ETFs invest in multiple REITs to make them a more diversified investment.
Publicly Non-Traded REIT
Publicly non-traded REITs lack liquidity due to not being traded publicly, which means you can't necessarily sell your shares whenever you want. Also, note how they’re registered with the SEC but not traded on an exchange like a public REIT.
Some examples of publicly non-traded REITs have become popular over the past few years. Companies like Fundrise, DiversyFund and Streitwise allow investors to start investing in it with as little as $500 – $1,000.
Private REITs are not publicly traded, not listed on the public exchange (similar to a publicly non-traded REIT). However, they are listed on a public exchange.
Private REITs' performance isn't tied to the overall stock market, but they're only available to accredited investors and require a high initial investment.
The Pros And Cons Of REIT Investing
There are both advantages and disadvantages to REIT investing. Take a look at both sides.
First, let's take a list of the pros of REITs first:
- Liquidity: You can make transactions with REITs more quickly than with other real estate investments. For example, selling a rental property involves putting it on the market, hiring a real estate agent and showing the home. On the other hand, you can simply sell a REIT to collect your returns.
- Diversification: Diversification means that you expose your money to many different investments. It means spreading your money among many different assets. This way, if one asset takes a loss, the others may not. REITs offer diversification, more than you could access with a rental property or a single stock.
- High return potential: Since REITs don't pay corporate taxes, they typically offer higher dividends, long-term capital appreciation and a minimum of 90% of taxable income through yearly shareholder dividends.
Next, the downsides of investing in REITs:
- Potentially higher operating costs: Some REITs charge high operating costs, creeping toward 1% or more, compared to some ETF low expense ratios, which can go as low as 0.12%. You can lose a lot of money through high operating costs.
- A long-term investment: You might have to stay invested in the REIT for a long time to make money. For example, private or non-traded REITs have less liquidity, and you may need to stay invested in them for at least 5 years.
- Expensive in many cases: Many REITs charge an upfront fee, sometimes as high as 15%, which can nip into your bottom line. Keep an eye on these fees before you choose REITs as an investment option.
How To Invest In REITs
How do you invest in REITs? Let's look.
First, use a few investment ratios to understand a REIT. Just picking a REIT based on instinct or public sentiment may not offer the largest returns. Many investment tools on financial news sites or investment websites can help you determine basic fundamentals like the ones below:
- Price-to-earnings (P/E) ratio: The P/E ratio looks at a REIT's market value per share against its earnings per share.
- Price/earnings-to-growth (PEG) ratio: The PEG compares an investment P/E ratio by its earnings growth over a certain period and helps evaluate a future earnings potential. Consider investigating those with a low PEG ratio – they could be undervalued and a good investment.
- Capitalization rate: Capitalization rate calculates the potential income against the purchase cost to help you decide whether a REIT is profitable or overpriced. You can find it by dividing the net operating income by the current market value.
- Dividend yield: Dividend yield gauges investment income by comparing a company's yearly dividend against the price of a share. Because REITs pay above-average dividends, the dividend can help you gauge whether it's a worthwhile investment.
Next, understand the fees, because large fees can subtract from your investment returns. For example, publicly traded REITs charge a standard brokerage fee when you buy from a broker. Non-traded REITs, on the other hand, charge rates as high as 10%, which can severely chip away at your bottom line.
Don't forget to consider the tax implications. Your investment income may receive different tax rates depending on regular taxable income or capital gains.
Finally, get ready to purchase your REIT of choice. You can purchase REITs listed on stock exchanges through REITs, mutual funds or ETFs through an online broker. If you prefer to take a hands-off approach to your investment, you can hire a financial professional to help you invest in REITs.
Are REITs A Good Investment?
A REIT might offer a great alternative investment if you're interested in making investments outside of stocks or bonds. Purchasing REITs can help you diversify your portfolio, but you should weigh the pros and cons before investing. It’s also best to speak with a financial advisor before making any investment decision.
The Bottom Line
Adding real estate to your portfolio can do a lot for it. But if you're apprehensive about investing directly in real estate, you may want to consider investing in REITs.
Ready to tackle real estate investing? Learn more about how to invest in real estate.