The Ultimate Guide to REITs

A real estate investment trust, or REIT, 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 high dividends.

“REITs are publicly traded companies that exist purely to own real estate or real estate-related assets and allow investors exposure to real estate,” says Jeff Saul, co-CEO and co-founder at Nativ based in New York City. “You can think of a REIT as analogous to an (exchange-traded fund) in the stock world — this is a basket of diversified real estate assets (could be loans or direct equity investments) that is actively managed by qualified real estate investment managers.”

As REIT shareholders, investors get exposure to real estate without the headaches of owning, operating or directly financing properties.

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Types of REITs

There are two broad categories of real estate investment trusts: equity REITs and mortgage REITs, or mREITs. 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 and even student housing. There are other types of equity REITs, too, 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 infrastructures 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. Examples of specialty REITs include Lamar Advertising Co. (ticker: LAMR), an advertising real estate provider, and Gladstone Land Corp. ( LAND), a REIT investing in the agricultural market, leasing land to farmers.

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, nonagency 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 pays dividends for investors.

How REITs Work

REITs were established in 1960 by Congress as a way to allow individual investors the opportunity to invest in scaled, income-producing real estate without the need to physically own underlying properties.

To qualify as a real estate investment trust, companies must meet certain guidelines set by Congress. In short, a 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% of shares.

— Invest at least 75% of assets in real estate, cash or U.S. Treasurys.

— Derive at least 75% of gross income from real estate.

— Pay out at least 90% 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.

Investors still must pay taxes on most of the dividends at their ordinary income tax rates. Currently, investors can deduct 20% of income from pass-through investments, lowering the maximum tax rate on REIT dividends from 39.6% to 29.6%.

Benefits of REIT Investing

Investors buy REITs because they want exposure to the real estate markets, but Ryan Patel, a board member of the Drucker School of Management at Claremont Graduate University in Claremont, California, says investors also turn to REIT investments for their consistency and stability.

REITs provide a reliable investment return you can count on, Patel says, with consistent income cash flow, great dividends and capital appreciation.

Income. Unlike bonds, REITs provide both income and capital appreciation, meaning the value of the asset grows over time. In the long term, REIT values tend to increase by reinvesting capital gains into a property.

Since REITs provide high dividends, this allows a predictable revenue stream for fixed-income investors. But take note, this high yield can come at the cost of increased sensitivity to interest rates.

Diversification. REITs also offer diversification benefits. REITs and stocks have a relatively low correlation and don’t generally move in tandem. 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. When it contracts and falls into recession, most investments begin to wane.

Real estate, however, follows a completely different cycle, appropriately called the real estate cycle. 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.

Liquidity. Another benefit to REIT investments is their liquidity. Unlike actual real estate properties, which cannot be bought and sold at a rapid pace like investments in the stock market, investors can readily purchase and sell REITs through major exchanges.

“The effort involved in buying a REIT stock (a few clicks) is a tiny fraction of the effort involved in researching, acquiring, closing and managing real estate investments privately,” Saul says.

Not only can you easily go in and out of REIT investments, but there is no hassle of managing physical real estate properties.

“Unless you have a significant amount of time or many employees or resources at your disposal, accumulating a diverse portfolio privately typically takes years. REITs can provide exposure to diverse portfolios in seconds,” Saul says

Inflation protection. REIT investments naturally protect against inflation. Inflation in the economy means there is an increase in the price of goods and services. During an inflationary period, real estate tends to do well because of the value of the real estate asset increases along with the rental rate for either commercial or residential real estate investments. Subsequently, income from your real estate investments increases, which helps dividend growth and offers a steady source of income.

Risks to REIT Investing

REITs have similar risks to stocks but also bring other unique investment risks. It’s important to be aware of them to better manage your holdings and know how much REIT exposure to add to your overall investment portfolio.

Interest rate risk. With low interest rates, investors searching for yield may look to REITs as a bond alternative. The relationship between REITs and interest rates tends to be correlated: When rates move higher due to economic growth, a REIT’s value typically grows.

Concentration risk. If you focus your REIT investments in a particular category, you may be prone to concentration risk. This means you are putting too many eggs in one basket. In other words, you could have too much capital in one REIT, sector or geographic location. This concentration increases risk depending on how market movements impact your investments. One way to easily combat this risk is to invest in a REIT ETF, which automatically diversifies among REIT sectors and industries.

REIT Taxation. It can be complicated to understand the tax implications for REITs held in a taxable account. Most REIT dividends tend to be taxed as ordinary income, which is usually taxed at a higher rate. According to Nareit, the majority of REIT dividends are taxed as ordinary income.

Also, consider the maximum long-term capital gains rate, which can vary depending on your income, along with the surtax when it comes time for you to sell your REITs. These tax consequences can take a bite out of your total returns.

Depending on whether your REIT dividends are collected as ordinary income, capital gains or return on capital, there are different tax treatments. Understand REIT taxation to know how to develop your strategy around REIT investing.

[Read: 3 Cheap REITs to Buy for an Economic Recovery.]

How Do You Buy a REIT?

Investors buy REIT securities through mutual funds or ETFs, or on major stock exchanges like the New York Stock Exchange or the Nasdaq. Investing in REITs requires the same due diligence as stocks because REITs function like stocks.

According to Nareit, REITs of all types own more than $3.5 trillion in gross assets throughout the U.S. with stock-exchange listed REITs owning approximately $2.5 trillion in assets.

These REITs are registered with the U.S. 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 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 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.

Investors can also access the REIT market passively through a REIT ETF that tracks a broader index, such as the FTSE NAREIT Global REITs Index.

[See: 7 Infrastructure Stocks to Buy Now]

How to Choose a REIT

On the business side, REITs make money by leasing or collecting rent from the real estate they own — but it can get more complex than that. Investors should take note of certain factors when assessing whether they’re investing in a quality REIT with strong future prospects.

For beginning investors looking to get into this asset class, here are some characteristics you should be looking for in real estate companies.

Assess risk. As you’re assessing investment risks, Patel encourages REIT investors to identify and understand things such as the quality of the REIT’s tenants, length of leases, the REIT’s business strategy, how income is coming in, average occupancy rates and if the REIT is developing new projects.

“Looking out for the REIT’s quality decisions that are ensuring long-term revenue streams is really important,” Patel says.

REITs in certain categories, he says, such as the retail sector, which became victim to the pandemic, may need to be nimble and change their strategy or best practices as they have experienced losses from falling occupancy rates.

Understand different REIT sectors. There are a variety of REIT sectors including retail, residential, industrial, health care, infrastructure and office REITs, among many other property types. When doing your due diligence, research the REIT sector you’re interested in.

“Understanding the risks of some of these different categories within REITs is so important,” Patel says.

While all REITs are income-producing properties, each sector has its own unique risks, and you want to invest in companies that have the proven historical track records in doing business in a particular real estate sector.

“Research the leadership team. What have they done in the category and how long have they done it,” Patel says.

True total return. “REITs are a total return vehicle, where investors benefit from both income produced by required dividend payouts and the capital appreciation of their properties,” says Jeffrey Olin, president, CEO and portfolio manager at Vision Capital.

It can be tempting to get pulled in by a REIT’s attractive dividend yield, which tends to be higher than dividend stocks. Dividend yields are the payments that investors receive from a REIT on a monthly or quarterly basis.

Instead of just looking at the dividend yield, Patel says investors should understand the true total return.

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. REIT dividend yields are higher than average because investors are required to get paid a minimum of 90% of taxable income, making REIT yield averages greater than returns from the S&P 500.

Investors tend to choose REITs with the highest dividend yield because they seem like the best REITs for income, but the highest-yielding REIT may not be the highest-returning investment over time.

Experts say investors should be cautious when they see a very high yield because in more cases than not, a higher yield can point to a struggling company. Like junk bonds, a REIT with an above-average yield may have raised its yield to attract investors because the company was not as strong financially as its competitors.

Dividend yields vary across the REIT sector, so income seekers need to make sure they look for safe dividends that have the potential of outperforming market averages.

More from U.S. News

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The Ultimate Guide to REITs originally appeared on usnews.com

Update 05/18/21: This story was published at an earlier date and has been updated with new information.

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