Beginner’s Guide To Real Estate Investment Trusts (REITs)
REITs allow anyone to own pieces of commercial real estate portfolios through a liquid, tradeable security similar to stocks. By law, REITs must pay out at least 90% of their taxable income to shareholders as dividends, making them an excellent choice for generating passive income streams.
Here’s a quick overview of what we’ll cover:
Key Takeaways:
| Benefits of REITs | Investing Strategies | Analyzing REITs |
|---|---|---|
| Income generation through dividends | Public markets: stocks/ETFs | Funds from operations (FFO) |
| Portfolio diversification | Public non-traded REITs | Dividend yield |
| Potential for appreciation | Private REITs | Growth prospects |
| Liquidity and affordability | New online platforms | Location and sectors |
Understanding REITs
What is a REIT?
A REIT, or Real Estate Investment Trust, is a company that owns, operates, or finances income-producing real estate. By maintaining compliance with IRS rules, REITs receive special tax considerations and avoid paying corporate income tax.
There are several different types of REITs:
- Equity REITs – Own and manage income-producing properties directly (apartments, malls, offices, etc.)
- Mortgage REITs – Provide financing for real estate by purchasing mortgages and mortgage-backed securities rather than owning properties.
- Public REITs – Trade on major stock exchanges like any publicly traded company.
- Public Non-Traded REITs – Registered with the SEC but do not trade on exchanges.
- Private REITs – Not registered with regulators and can only be purchased by accredited investors.
REITs were established by Congress in 1960 to provide everyday investors with the ability to invest in large-scale, income-producing real estate. They have similarities to mutual funds that invest in stocks.
Recommended: Investing for Success: The Role of REITs and Commodities in Your Portfolio
How Do REITs Work?
The key ways REITs can work to generate returns for investors:
- Income from rent and leases: REITs acquire properties that generate income from tenants paying rent or lease payments. A majority of this income must by law be distributed to shareholders as dividends.
- Appreciation of properties: As the real estate owned by a REIT appreciates in value over time, the market price of the REIT shares tends to also increase.
Benefits of Investing in REITs
1. Income Generation
One of the primary benefits of REITs is their ability to produce consistent income from rent and leases paid by tenants. As mentioned, REITs must pay out at least 90% of taxable income to shareholders as dividends.
This makes REITs among the highest dividend-paying securities:
Average Dividend Yields
- REITs: ~4%
- S&P 500 companies: ~2%
2. Potential for Appreciation
REITs have the ability to invest in a diverse range of real estate assets like malls, office buildings, apartment complexes and more. As these properties increase in value over time, the share prices of the REITs can appreciate as well.
Over the past 20+ years, the FTSE Nareit All Equity REITs Index has achieved over 9% average annual total returns.
3. Portfolio Diversification
Real estate has historically had a low correlation with other asset classes like stocks and bonds. Adding REITs to a portfolio can provide diversification benefits and reduce overall portfolio risk and volatility.
REITs also allow investors to gain exposure to different real estate sectors and locations all through a single investment.
Also See: Understanding Real Estate Investment Trusts (REITs): A Beginner’s Guide
4. Accessibility and Affordability
With share prices similar to traditional stocks and the ability to invest through exchange-traded REIT funds, REITs open the door to real estate investing for those who cannot afford large down payments on rental properties.
An investor can purchase shares of a REIT and gain exposure to a piece of a multimillion-dollar real estate portfolio.
Tax Requirements and Benefits of REITs
1. Distribution Requirements
To qualify as a REIT and receive the associated tax benefits, companies must pay out at least 90% of their taxable income as dividends to shareholders each year. This requirement to distribute a majority of earnings provides a steady stream of dividends for investors.
2. Tax Treatment and Advantages
One of the biggest advantages of REITs is the favorable tax treatment they receive. REITs that comply with all requirements are able to deduct dividends paid to shareholders from their corporate tax obligations.
Tax Advantages of REITs:
- Avoid double taxation at the corporate level
- Dividends taxed as ordinary income for shareholders
- Certain dividends classified as returns of capital are tax-deferred
- 20% qualified business income deduction for REIT dividends
- The ability to depreciate real estate assets can reduce the overall tax burden
This single level of taxation makes REITs more tax efficient compared to if an investor directly owned rental properties, where they would face double taxation on earnings and dividends.
3. REIT Dividends and Taxation
The majority of REIT dividends are classified as ordinary taxable income for shareholders. However, a portion can also be classified as qualified dividends, capital gain dividends, or return of capital.
This breakdown of dividend allocations is provided on the REIT’s annual tax Form 1099-DIV.
- Ordinary dividends are taxed at standard income rates
- Qualified dividends are taxed at capital gains rates (max 20%)
- Capital gain dividends from sales of REIT assets are taxed at capital gains rates
- Return of capital dividends is tax-deferred until the position is sold
So while ordinary REIT dividends don’t qualify for the lower qualified dividend rates, the tax advantages to REITs themselves pass through much of their tax efficiency to shareholders.
How to Invest in REITs
Public Market REITs
The simplest way for investors to gain REIT exposure is to purchase publicly traded REIT shares through a brokerage account, similar to buying stocks. These can be individual REIT companies or REIT-focused exchange-traded funds (ETFs).
Some of the largest public REIT companies include:
- Prologis (PLD) – Industrial properties
- American Tower (AMT) – Communications infrastructure
- Welltower (WELL) – Healthcare Properties
- Realty Income Corporation (O) – Retail Properties
There are also public non-traded REITs that are registered with the SEC but do not trade on public exchanges.
Private REITs
Private REITs are companies exempt from SEC registration requirements and do not trade on public exchanges. They are only open to accredited investors who meet certain net worth and income requirements.
Private REITs can be more illiquid without the ability to easily buy and sell shares. However, they can also provide opportunities to invest in newer real estate assets before they become publicly traded.
New REIT Investment Platforms
Financial technology companies have increasingly opened up new platforms for investing in private real estate deals and REITs. Popular examples include:
- Fundrise: Allows investors to create a personal real estate investment portfolio by investing in a variety of their private eREIT funds and eFunds.
- Streitwise: Provides access to invest in private commercial REIT offerings with low investment minimums.
- DiversyFund: Crowdfunding platform for investing in private real estate projects and REITs.
These new models help democratize access to private market real estate and REITs with lower investment minimums and more liquidity options.
Analyzing and Selecting REITs
Key Metrics for Evaluating REITs
Unlike other stocks, the main metric for evaluating REITs is not earnings per share, but rather Funds from Operations (FFO). FFO is a better indicator of REIT performance as it adds back non-cash deductions like depreciation.
Other important metrics include:
- Dividend yield: Annual dividend amount divided by current share price
- FFO payout ratio: Dividends Here’s the continued section on key metrics for evaluating REITs:
Other important metrics include:
- Dividend yield: Annual dividend amount divided by current share price
- FFO payout ratio: Dividends paid divided by funds from operations. Indicates sustainability of the dividend.
- Growth prospects: Projected growth in FFO and dividends based on acquisitions and rental increases.
- Portfolio occupancy rates: Higher occupied percentages of properties mean more stable income streams.
- Leverage ratios: Amount of debt used to finance the property portfolio.
When analyzing REITs, it’s also crucial to evaluate the management team’s experience in real estate and their strategic focus areas or specialties.
Developing an Investment Strategy
Investors can take different approaches when investing in REITs based on their goals:
Income/Dividend Focus
- Prioritize REITs with higher dividend yields
- May sacrifice some growth for more stable income streams
- Well-suited for investors seeking monthly income
Growth/Appreciation Focus
- Emphasize REITs with more aggressive acquisition strategies
- Potentially higher FFO and dividend growth rates
- This may involve taking on more risk for higher total returns
Diversified/Hybrid Approach
- Balance exposure across various REIT types/sectors
- A mix of income and growth potential
- Provides more diversification benefits
No matter the strategy, maintaining a diversified REIT portfolio across different markets and property types is wise for mitigating risk.
Compared to Direct Real Estate Investing
While both involve investing in income-producing properties, there are some key differences between REITs and direct real estate ownership:
Advantages of REITs
- More liquidity through public trading of shares
- No property management responsibilities
- Portfolio diversification in a single investment
- Preferential tax treatment for dividends
- Generally lower investment minimums required
Advantages of Direct Ownership
- Ability to leverage mortgages to amplify returns
- Greater control over buying, managing, and selling assets
- Potential for higher returns if successfully executed
- Direct tax benefits from deductions like depreciation
Overall, REITs provide an attractive alternative to directly owning rentals by reducing hassles, improving liquidity, and allowing diversification – although potentially at the cost of higher returns.
Risks of REIT Investing
While REITs can be an excellent portfolio component, there are also risks that investors should be aware of:
1. Closely Tied to Real Estate Cycles
- REIT performance is highly correlated to ups and downs in real estate markets
- Economic conditions can significantly impact occupancy rates and growth
- Recessions can lead to higher vacancies and falling property values
2. Interest Rate Risk
- REITs often use substantial debt to acquire properties
- When interest rates rise, borrowing costs increase
- This impacts profit margins and reduces funds available for dividends
- However, rate hikes don’t affect already locked-in mortgage rates
3. Liquidity Risk with Non-Traded/Private REITs
- Lack of liquidity as shares cannot be easily sold
- May face high redemption fees or long holding periods
- Difficult to sell investments during market disruptions
4. General Market Risks
- Like equities, REIT shares can be volatile
- Impacted by fluctuations in stock and bond markets
- Overall economic and geopolitical risks remain
Thoroughly assessing potential risks is essential before investing in REITs. Building a diversified REIT portfolio across sectors and employing risk management strategies can help mitigate downsides.
Examples and REIT Selection
While past performance doesn’t guarantee future results, some of the highest-performing REITs over the past decade include:
- Digital Realty Trust (DLR) – Data center REIT benefiting from cloud computing growth. Around 11% annualized returns.
- Innovative Industrial Properties (IIPR) – Cannabis industry real estate provider. ~60% annualized returns since IPO in 2016.
- Equinix (EQIX) – Global data center and colocation provider REIT. ~18% annualized returns over 10 years.
- Prologis (PLD) – Focused on logistics and industrial real estate. Delivered ~14% annualized returns.
Factors for Selecting REITs
When evaluating potential REIT investments, some key factors to consider include:
- Alignment with investment goals (income vs growth)
- Diversification across property types and geographic markets
- Quality of current real estate portfolio and assets
- Debt levels and capital structure of the REIT
- Historical performance track record of the management team
- Overall economic and demographic trends favoring certain sectors
- Valuation metrics compared to historical averages
It’s generally advisable to build a diversified REIT portfolio across different investment strategies, sectors, regions, and risk profiles based on your individual financial objectives. Regularly rebalancing holdings can also help manage risks over time.
Conclusion
REITs have become an essential part of many investment portfolios by providing exposure to income-producing real estate while offering liquidity, diversification, and favorable tax treatment of dividends.
The income generation and potential appreciation of REITs make them an attractive option for investors of all types – from those seeking consistent income streams to others prioritizing long-term growth.
At the same time, investors must thoroughly analyze REIT opportunities based on factors like funds from operations, payout ratios, portfolio concentrations, and growth prospects.
As with any investment, risks like interest rate fluctuations and real estate cyclicality must also be considered and mitigated through diversification and adequate risk management practices.
It’s advisable for those new to REIT investing to consult with a qualified financial advisor or tax professional to ensure it aligns with their specific financial situation and return objectives.
There are many quality resources available to continue expanding your REIT investment knowledge, such as courses on real estate investing or websites like Nareit which cover REIT news, data, and analysis.
Do you feel ready to explore the opportunities that REIT investing can provide? With proper research and portfolio construction, REITs can be an excellent way to generate income, growth, and diversification for your investments.
Additional Resources
To continue expanding your knowledge of REIT investing, check out these helpful resources:
Books
- The Intelligent REIT Investor by Brad Thomas
- REITs for Dummies by Ralph L. Block and Ralph L. Block
- The REIT Industry Handbook by Michael Giliberto
Websites/Blogs
- Nareit – The National Association of Real Estate Investment Trusts
- The REIT Way – REIT education and analysis
- REIT.com – News, data, and analysis on the REIT industry
- Millionacres by Motley Fool – REIT insights and recommendations
Courses
- Introduction to REIT Investing on Udemy
- Commercial Real Estate & REIT Investing on Coursera
- REIT Investing MasterClass on SkillSuccess
Podcasts
These resources cover REIT fundamentals, analysis techniques, case studies, news, and data to help take your investing to the next level. Many are available for free online as well.
