Roughly one year ago, the Standard & Poor’s 500 index made a big change to its structure, giving real estate-related investments their own category.
This move increased the number of core sectors in the popular stock index from 10 to 11, and gave real estate a prominent place in the list of investments that should make up a well-balanced portfolio. According to current sector weightings right now, the real estate sector represents a 2.9 percent share of the S&P 500 — larger than both the materials and telecommunications sector.
But despite this increased attention, many investors don’t really understand what makes the real estate investment different from conventional blue-chip stocks.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
And one particularly sticky subject is a unique kind of publicly traded business known as a real estate investment trust.
REITs are publicly traded companies that own or finance real estate almost solely for the income. The government allows these companies to forgo taxes at the corporate level — similar to the way partnerships are taxed — and instead investors pay individual taxes on the dividends they receive.
That’s a pretty good deal for a real estate investment company. But it’s also a pretty good deal for investors, too, because a REIT must pay nearly all of its income back to its shareholders in order to get that favorable tax treatment.
“Congress originally permitted real estate companies to form as REITs as an incentive to allow individual investors the ability to participate in the growth of the commercial real estate market,” says Evan Serton, senior vice president and REIT portfolio specialist at Cohen & Steers. “It is much more practical, obviously, for most individual investors to seek access to commercial real estate via purchasing shares of a REIT than through the direct purchase of commercial properties.”
But this easy access to real estate investing is not without its challenges. With more than 30 REITs in the S&P 500 index and scores of smaller real estate investments floating around the New York Stock Exchange and Nasdaq, how do you choose the one that’s right for you?
The business model of most REITs is pretty simple to understand — own property, collect regular rent checks and pass on a portion of that income to shareholders via dividends.
But while many REITs simply lease space in an office building or a mall, the real estate universe covers many other interesting and quirky properties. A few worth noting include:
Storage facilities. Companies like Public Storage (NYSE: PSA) and Extra Space Storage ( EXR) generate rent from nationwide networks of storage lockers full of furniture, boxes and other stuff people don’t have space for in their homes anymore.
Health care buildings. REITs like HCP ( HCP) and Ventas ( VTR) operate everything from hospitals to medical office space to senior housing facilities.
[See: The 10 Best REIT ETFs on the Market.]
Wireless communication infrastructure. Believe it or not, many of the cell phone towers that allow you to text and surf the web on the go aren’t owned by the big telecom companies. They are instead owned by companies like Crown Castle International ( CCI) and American Tower Corp. ( AMT) that lease their infrastructure to other communications companies.
Mortgage paper. Some REITs don’t even invest in physical real estate at all and simply invest in the underlying finances. Mortgage REITs like AGNC Investment Corp. ( AGNC) and Two Harbors Investment Corp. ( TWO) generate their regular income from the interest on real estate loans rather than from tenants writing them rent checks.
All these companies generate regular income and distribute at least 90 percent of their net income to shareholders. But clearly they all do it in very different ways.
What makes a good REIT? Part of the reason real estate investment trusts have soared in popularity is because of the big yields paid out across the sector. Take HCP, a popular health care REIT that yields about 4.7 percent annually to deliver more than two times the 2.3 percent yield of 10-year Treasury bonds right now or the 2 percent average yield in the S&P 500.
But as is so often true with dividend investments, you can’t simply bank on a high yield alone.
“It is often the case that REIT returns diverge significantly across property sectors,” says Evan Serton, senior vice president and REIT portfolio specialist at Cohen & Steers. “We are seeing this sort of effect in 2017 as well.”
That means taking into account the same kind of big-picture analysis that’s applied to the stock market and applying it in a similar way to the real estate sector.
For instance, the tech sector is having a great run in 2017 — and right now Serton likes technology-focused REITs as a result. Those include companies that lease space on cellular towers similar to Crown Castle and AMT, but also REITs that run data centers.
“As cloud computing becomes an increasing necessity for corporate and personal use, and given the proliferation of online commerce, there has been substantial growth in demand for networking, data storage, and communications equipment,” Serton says. “Data centers are places that house such equipment, the use of which is rented to corporate tenants.”
This subset of REITs isn’t just generating reliable income, he adds, but seeing brisk growth in both cash flow and dividend payments to shareholders.
But whatever subsector of real estate appeals to you, Serton believes that REITs have an important place in just about every investor’s portfolio as a way to diversify beyond traditional stocks and bonds.
[Read: What Is a Mortgage REIT?]
“A long-term holding in REITs may be able to deliver to an investor returns similar to what private real estate investors realize, which can be an effective diversifier away from traditional equities and fixed income,” he says.
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Are REITs Good Dividend Investments? originally appeared on usnews.com
