A REIT, or a real estate investment trust, is a company that owns, operates or finances income-producing real estate. This is often done by pooling investors’ money to buy and possibly manage commercial or residential buildings. The company then collects rent from its tenants and passes that income onto investors in the form of strong dividends.
REITs are essentially just big landlords, says John LaForge, head of real asset strategy for Wells Fargo Investment Institute in Sarasota, Florida. “They’re a company that has professional money managers who understand real estate,” buying and managing it for investors.
As REIT shareholders, investors get exposure to real estate without the headaches of owning, operating or directly financing properties.
Types of REITs. There are two broad categories of real estate investment trusts: equity REITs and mortgage REITs. Most REITs are equity REITs, which own or operate income-producing real estate, such as apartment buildings, offices or shopping centers.
Equity REITs typically invest in a particular type of property. For example, retail REITs invest in shopping centers while residential REITs invest in apartment complexes, single-family homes, even student housing. There are also more obscure equity REITs such as:
— Lodging and resort REITs, which invest in hotels and resorts
— Self-storage REITs, which invest in storage facilities
— Data center REITs, which invest in data storage centers
— Infrastructure REITs, which invest in infrastructure, such as pipelines and cellular towers
— Industrial REITs, which invest in facilities such as distribution centers and warehouses
— Timberland REITs, which specialize in harvesting and selling timber
If a REIT invests in a mix of property types, it’s called a diversified REIT. If the properties it owns and manages don’t fit into any other category, it’s called a specialty REIT.
Mortgage REITs finance commercial and residential properties by investing in mortgages and mortgage-backed securities. These can be agency mortgages (secured by Fannie Mae, Freddie Mac or Ginnie Mae), non-agency mortgages, or commercial mortgages. Mortgage REITs typically specialize in either commercial or residential mortgages, but some invest in both.
These REITs borrow money to buy mortgages paying a higher interest rate. The difference between the rate the REIT pays lenders and the one it receives from investments, called the interest rate spread, is how it generates income and ultimately dividends for investors.
[Read: 3 Reasons to Revisit REITs in 2018.]
How REITs work. To qualify as a real estate investment trust, companies must meet certain guidelines set by Congress. In short, the company must:
— Be considered a corporation under the IRS revenue code
— Be managed by a board of directors
— Be held by at least 100 shareholders, with no fewer than five holding 50 percent of shares
— Invest at least 75 percent of assets in real estate, cash or U.S. Treasurys
— Derive at least 75 percent of income from real estate
— Have 95 percent of income be passive, which is income that doesn’t require direct action from the corporation, such as rental payments
— Pay out at least 90 percent of its taxable income to shareholders through dividends
As long as it satisfies these requirements, a REIT is exempt from corporate taxes. So unlike a typical corporation, which has to pay taxes on earnings, a REIT’s income is not taxed, leaving more money to pass on to shareholders. That’s why you’ll sometimes hear REITs referred to as pass-through investments, LaForge says. Investors still must pay taxes on most of the dividends at their ordinary income tax rates. However, as a result of tax reform, investors can deduct 20 percent of income from pass-through investments, lowering the maximum tax rate on REIT dividends from 39.6 percent to 29.6 percent.
It’s a common misconception that REITs require investors to file a Schedule K-1, says Brad Case, senior vice president of research and industry information at Nareit, the REIT industry association. “REITs are companies like every other company in the stock market” and issue only 1099, he says.
How REITs work inside your portfolio. “Don’t let anyone tell you that REITs are somehow separate and distinct from a stock portfolio,” says Steve Violin, senior vice president and portfolio manager, F.L.Putnam Investment Management Co. in Wellesley, Massachusetts. They’re not an alternative investment, nor are they a substitute for bonds, “but [are] an important part of a well-diversified portfolio.”
Every portfolio needs four types of holdings: cash or short-term investments so you can pay your bills, stocks for their strong returns, bonds to provide a floor for your portfolio when stocks fall and real estate because it reduces portfolio volatility while boosting potential returns, Case says.
Benefits of REIT Investing. Unlike bonds, REITs provide both income and capital appreciation. REITs offer “diversification benefits over time relative to other asset classes and higher average yield compared to the broader equity markets,” says Colby Feane, a portfolio strategist at Manning & Napier in Rochester, New York, who works closely with the firm’s real estate funds. For example, REITs and stocks have a relatively low correlation and don’t generally move in tandem.
The correlation between REITs and the broader stock market historically has averaged about 55 percent, Case says. “Any correlation less than 100 percent means if you hold those two assets together, it smooths out the changes in the value of your whole portfolio.”
One reason for this low correlation is that REITs march to a different beat than the rest of the stock market. Most stocks are driven by the business cycle, which is the rise and fall of economic production. When the business cycle is expanding, market returns are good. But when it contracts and falls into recession, most investments begin to wane.
Not so for real estate, however. It follows a completely different cycle, appropriately called the real estate cycle. While the business cycle lasts four years on average, the real estate cycle often lasts closer to 18 years, Case says. So when stocks go down because the business cycle is in a recession, your real estate investments can continue to march happily along. This makes real estate a good diversifier for your portfolio.
Because REITs own real assets, they also provide some inflation protection. When inflation rises, the rents on apartments and the prices of hotel rooms also increase, and with them the income you receive from your REIT, Case says.
High dividend payouts are another way REITs shine. The FTSE Nareit All REITs Index, which includes all publicly listed, tax-qualified real estate investment trusts, has a dividend yield of 4.3 percent compared to 1.9 percent for the Standard & Poor’s 500 index, as of February 2018, according to Nareit research. But this high yield can come at the cost of increased sensitivity to interest rates.
[Read: Dividend Stocks: Is Yield Better Than Growth?]
Risks to REIT investing. In general, REITs have the same risks as stocks, with an added emphasis on interest rate risk, LaForge says. “I wouldn’t look at REITs as having any more risk than a traditional stock, but since they do have a higher dividend yield, they can be more sensitive to interest rate movements.”
When long-term yields (for example, those on 10-year and 30-year U.S. Treasurys) rise, government bonds “compete against REITs for investors’ money,” he says. This is called the “crowding out effect” in investing.
For instance, when the 10-year Treasury note rose from 2.3 percent to 3 percent in the first two months of 2018, the REIT market fell 6 percent. A 4 percent yield on a REIT looks less appealing if you can get a 3 percent risk-free return on a 10-year Treasury note.
REITs are also subject to the risks all real estate investments face, such as falling property values or occupancy rates, Feane says. But different subsectors of the REIT market can behave differently to market conditions. “When investing in REITs, it’s important to identify the risk factors specific to each company based on their property characteristics, geographic location and the market they operate in,” he says.
How do you buy a REIT? Investing in REITs requires the same due diligence as stocks because REITs function like stocks. REITs “offer investors the benefits of real estate exposure along with the liquidity of publicly traded stock,” says Iman Brivanlou, head of high income equities at TCW in Los Angeles.
According to Nareit, $1 trillion worth of publicly listed REITs trade on U.S. stock exchanges every day. These REITs are registered with the Securities and Exchange Commission and listed on a public stock exchange. Individual investors can buy publicly listed REITs the same way as any stock.
There are also public, non-traded REITs, which are registered with the SEC and subject to the disclosure requirements of any exchange-listed stock, though they don’t trade on public exchanges. These REITs are less liquid than those trading on exchanges and may have a minimum holding period for investors.
Likewise, private REITs, which are not registered with the SEC or listed on national stock exchanges, aren’t liquid and have redemption programs that can vary and change. Private REITs are generally sold only to institutional investors, such as pension funds or accredited investors (individuals with a net worth of at least $1 million, excluding a primary residence, or with more than $200,000 of income per year).
Investors can also access REITs through a REIT ETF or mutual fund, which pools investors’ money to purchase a basket of REIT stocks. Bear in mind that not all real estate funds invest exclusively in REITs. Some funds may hold other real estate assets for broader exposure. Generally, a REIT-exclusive fund will say REIT in the name, LaForge says, but always research the fund’s holdings and investment strategy before buying.
Investors should also “be thoughtful and selective in choosing a manager,” Brivanlou adds. “Because the real estate market is perceived as a very stable industry, most REIT managers rarely focus on long-term secular trends.”
This matters more when selecting an actively managed fund. “Choose a manager with an investment platform that has demonstrated substantial breadth of expertise across asset classes beyond just real estate, as that will be a tremendous advantage in evaluating long-term outcomes for many REIT subsectors,” Brivanlou says.
Investors can also access the REIT market passively through a REIT exchange-traded fund that tracks a broader index, like the FTSE NAREIT Global REITs Index.
How do you make money on a REIT? However you invest, your total return for REITs combines two things: dividends and share price appreciation. Both are how investors make money on REITs.
Total return trips up some REIT investors, LaForge says. Investor tend to choose REITs with the highest dividend yield because they seem like the best REITs for income, but he cautions investors “not to reach for yield.” The highest yielding REIT may not be the highest returning investment over time.
“Usually the higher the yield, the worse the financial situation of the company,” he says. Like junk bonds, a REIT with above-average yield probably raised its yield to attract investors because the company was not as strong financially as its competitors. Often, the best REITs to invest in are those with average yields because they have stronger underlying fundamentals. This means they’re more likely to appreciate in price and outperform with higher long-term total returns.
For the new REIT investor, LaForge recommends choosing quality over yield, which usually means large-cap funds with lower dividend yields.
How to choose a REIT. One goal should be to identify REITs with a strong and growing cash flow profile and an attractive price, Feane says. To determine how attractively priced a REIT is, look at its price minus its net asset value, or the per-share value of each of its holdings, called the P-NAV.
A positive P-NAV means you could purchase all of the REIT’s properties more cheaply outside of the REIT itself, suggesting it’s overvalued. If the P-NAV is negative, however, the properties are worth more outside the REIT, making it undervalued by the market.
Case prefers a simpler method of valuing REITs, that of comparing their dividend yields to those of other asset classes, such as corporate bonds. By comparing them, you can gauge how the market values the yields for each, he says. A higher yield means “you’re getting that dividend stream for a [lower] price.”
Other factors to consider when evaluating a REIT include “supply and demand, geographic location and other trends such as demographics that may impact rent and occupancy levels,” Feane adds.
[Read: Are REITs Right for Your Retirement Portfolio?]
How much of your portfolio should be REITs? There is no hard and fast rule about how much of a portfolio should be invested in REITs. LaForge says generally 5 to 10 percent is a good place to start. Meanwhile, studies have shown the optimal exposure ranges between 5 and 15 percent, according to Nareit, and Case has seen research suggesting 20 percent is optimal.
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