• American Financial Partner

The Basics of Investing in REITs

Updated: Sep 5, 2021

Your Complete Guide To Investing in Real Estate Investment Trusts (REITs)

Real estate investment trusts, or REITs, can be fantastic ways to add both growth and income to your overall portfolio, while adding diversification at the same time. Before you get started, however, it’s important to know that REITs aren’t the same as most other dividend stocks, and it’s important to familiarize yourself with the basics.

What is a REIT?

A REIT (pronounced reet) or Real Estate Investment Trust, is a unique type of company that allows investors to pool their money to invest in real estate assets. Some REITs simply buy properties and rent them to tenants, others develop properties from the ground up, and some don’t even own properties at all, choosing to focus on the mortgage and financial side of real estate.

Although this is an oversimplification, you can think of real estate investment trusts like a mutual fund for real estate. Hundreds or thousands of investors buy shares and contribute money to a pool, and professional managers decide how to invest it.

The purpose of REITs is to allow everyday investors to be able to invest in real estate assets that they otherwise wouldn’t be able to. For example, could you go out and buy a high-rise office tower or shopping mall? Could you buy a portfolio of mortgages, or would you even know how to go about doing this? Probably not. However, a REITs allow you to put your money to work in these ways. You can even gain exposure to billion-dollar commercial property portfolios with just a few hundred dollars to start.

Real estate investment trusts (REITs) are equities often used by those who want to boost the yield of their portfolio. REITs can have high returns, but like most assets with high returns, they carry more risk. It's up to you to figure out if the profits merit the risks taken.

How does a company become a REIT?

It’s important to realize that a company can’t simply buy some real estate and call itself a real estate investment trust. There are some specific requirements that must be met, including:

  • REITs must invest at least three-fourths of their assets in real estate or related assets, and must derive three-fourths of their income (or more) from these assets. In other words, more than 75% of a REIT’s income needs to be from sources like rental income, mortgage payments, third-party management fees, or other real estate-derived sources.

  • REITs must be structured as corporations, and must have at least 100 shareholders. Because of the 100-shareholder requirement, many REITs start out as real estate partnerships, and convert to REIT status later on.

  • No more than 50% of a REIT’s shares can be owned by five or fewer shareholders. In practice, REITs generally limit the ownership of any single investor to 10% in order to ensure compliance with this rule.

  • Most notably, REITs are required to pay out at least 90% of their taxable income. This is why REITs typically pay above-average dividend yields. In fact, most REITs pay out 100% of their taxable income or more -- as we’ll see later, REITs generally earn more than their "net income" indicates.

Why would a company want to be classified as a REIT?

As you can see, there are some pretty strict requirements that must be met in order for a company to be classified as a REIT. So why would any real estate company want to go through the trouble?

There’s a very big motivating factor that encourages companies to pursue REIT status, and it has to do with taxes.

Specifically, REITs are not treated as ordinary corporations for tax purposes. If a company qualifies as a REIT, it will pay no corporate tax whatsoever, no matter how much profit it earns. Even if a REIT’s profits are in the billions, the IRS can’t touch a dime of it.

This is where the 90% payout requirement comes in. Because REITs are required to pay out most of their income, they are treated as pass-through entities and are only taxable at the individual level.

With most dividend-paying companies, profits are effectively taxed twice. When a company earns a profit, it has to pay corporate income tax, which is currently at a flat rate of 21%. Then, when the profits are paid out as dividends to shareholders, they are subject to dividend taxes at the individual level. So, only being taxed once is a huge advantage for REITs.

The caveat is that REIT dividends are typically taxed at a slightly higher rate than that of most stock dividends, and the tax structure can be rather complex, as we’ll see later. However, this is still a major tax benefit for REITs and their investors.

Why REITs can be great long-term investments

Aside from the tax benefit, there are several other good reasons why REITs should be in every long-term investor’s portfolio, including:

  • For starters, REITs can be a source of reliable, growing income. Because most property-owning REITs lease their properties on a long-term basis, REITs can be nicely set up for steady income, quarter after quarter. There’s definitely far less variance in the quarter-to-quarter profits of well-run REITs than there is for most other companies, including those that are generally thought of as "stable."

  • REITs can be a smart way to add diversification to your investment portfolio. They’re technically stocks, but they represent real estate assets, and real estate is generally considered a separate asset class that isn’t closely coordinated with the stock market.

  • If you want to invest in real estate, REITs can be a very easy way to get started. There’s excellent return potential in owning investment properties outright, but there’s a lot of work involved with direct real estate investments, even if you hire a property manager to oversee their day-to-day operations. You can buy shares of any publicly traded REIT with the simple click of a button, and without any ongoing maintenance worries.

The two main types of REITs - Equity & Mortgage REITs

Before we go any further, let’s take a minute to discuss the two different classifications of REITs. As we’ll see later, there are REITs that specialize in a wide variety of asset types, but all REITs can be dropped into one of two buckets.

First, equity REITs are the type of real estate investment trusts that own properties as their primary business. For example, a shopping mall REIT or a senior housing REIT would be considered an equity REIT. Going forward, you can assume the term REIT refers to equity REITs unless specified otherwise.

Second, mortgage REITs invest in mortgages, mortgage-backed securities, and other mortgage-related assets. Generally speaking, these companies borrow large amounts of money at lower, short-term interest rates, and use this money to purchase 15- or 30-year mortgages that pay higher rates. The difference between the borrowing costs and the interest income paid by the mortgages is the profit margin. These are very different investments than equity REITs -- in fact, they aren’t even classified as being in the real estate sector. Mortgage REITs are considered to be financial stocks, just like banks and insurance companies.

There are a few REITs that own both property and mortgage assets, and these are known as hybrid REITs. However, the overwhelming majority of REITs invest in either one type of real estate asset or the other.

Types of REITs to invest in

There are REITs that allow you to invest in just about any type of commercial property you can imagine. Here’s a rundown of the different specializations of REITs you could invest in:

  • Mortgage REITs -- As discussed above, mortgage REITs invest in mortgages, mortgage-backed securities, as well as other mortgage-related assets such as mortgage servicing rights (MSRs).

  • Residential REITs -- Residential REITs generally specialize in apartment properties, but there are some that invest in single-family rental properties. Some choose to specialize even further -- for example, there are residential REITs that exclusively invest in urban apartment buildings, student housing communities, and more.

  • Office REITs -- Some office REITs invest in a wide variety of office properties, while others choose to specialize. There are office REITs that only invest in top-tier urban high-rise offices, for example, while others specialize geographically, concentrating on a specific market.

  • Industrial REITs -- Some industrial REITs also refer to themselves as "logistics" REITs. They own properties such as distribution centers, factories, and warehouses. For example, many of the massive distribution centers used by e-commerce giants like Amazon are owned by industrial REITs.

  • Healthcare REITs -- There is a variety of subspecialties that healthcare REITs can invest in. Healthcare real estate can be broken down into categories such as hospitals, medical offices, senior housing, skilled nursing, life science, wellness centers, and more. Some invest in just one of these, while others invest in several different types.

  • Self-storage REITs -- This category is pretty self-explanatory. Self-storage REITs invest in properties that rent storage units to individuals and corporations.

  • Retail REITs -- There are three main subcategories of retail REITs -- malls, shopping centers, and net lease (also known as freestanding). Most retail REITs choose one of these three types, but there are a few that have a broad retail property portfolio.

  • Infrastructure REITs -- These companies invest in properties like communications towers, fiber optic networks, pipelines, and other infrastructure assets that need real estate (land or buildings) to operate. For example, in order to build a communications tower, you need to own or lease the land it’s going to be installed on. In fact, the largest REIT in the world is an infrastructure REIT with communications towers located all over the world.

  • Timberland REITs -- Timberland REITs own forest land and make their money selling the wood their lands produce, as well as its related products.

  • Hospitality REITs -- Most hospitality REITs primarily own hotels, but some get revenue from additional hospitality-related sources as well. For example, a hospitality REIT might own resort hotels, but may also earn substantial revenue from the restaurants and retail outlets in its properties, in addition to the revenue generated by its hotel rooms.

  • Data-center REITs -- Data centers are facilities designed to provide secure and reliable space for companies to house servers and other computing equipment.

  • Diversified REITs -- Simply put, a diversified REIT is any real estate investment trust that owns a combination of two or more of these types of properties. For example, a diversified REIT might own hotels and shopping centers.

  • Specialty REITs -- Obviously, there are more types of commercial real estate than the 12 discussed here, so any of those other types would belong in this category. Just to name a few examples, a specialty REIT might invest in education properties, entertainment properties, farmland, or prisons.

Two very important metrics for real estate investors to know

To be perfectly clear, there are certainly more than two metrics that REIT investors should use, and you can read our more thorough list of important REIT metrics if you plan to analyze and evaluate individual REITs.

However, the two most important metrics to know are funds from operations (FFO) and company-specific varieties of that same metric.

Funds from operations, or FFO, expresses a company’s profits in a way that makes more sense for REITs than traditional metrics like “net income" or "earnings per share." Without getting too deep into a discussion of how depreciation works, let’s just say that when you invest in real estate, you can write off (deduct) a certain portion of the purchase price each year. Although this decreases taxable income, it also distorts a REIT’s profits -- after all, depreciation doesn’t actually cost the REIT anything. FFO adds back in this depreciation expense, makes a few other adjustments, and creates a real-estate-friendly expression of a company’s profits.

To take it a step further, most REITs report one or more company-specific FFO metrics. These may be called normalized FFO, core FFO, or adjusted FFO. The point of these is to adjust for one-time items or market conditions that distorted earnings for that particular REIT. These metrics are typically very close to FFO. However, the key thing to remember is that despite offering the most accurate picture of a particular REIT’s profits, they don’t necessarily make for good apples-to-apples comparisons between REITs. Unlike FFO, they just aren’t standardized metrics.

Publicly Traded REITs and nontraded REITs

The most popular and largest REITs are generally publicly traded, but it’s important to mention that a REIT doesn’t have to be a publicly-traded company. There are actually three classifications of REITs when it comes to how they accept investments:

  • Publicly traded REITs can be readily bought and sold on major stock exchanges like the NYSE and Nasdaq.

  • Public non-listed REITs are available to all investors, but don’t trade on major exchanges.

  • Private REITs aren’t listed on major stock exchanges, and are generally restricted to accredited investors, which typically means high-income or high-net-worth individuals, or institutional investors.

There are some advantages and disadvantages to each type. One major consideration is that the latter two types generally aren’t liquid investments, meaning that they can be very difficult to sell and cash out of. Private REITs also don’t have to follow most SEC regulations that apply to the other two types, so there’s a lack of transparency.

Tax implications of investing in REITs

Although the lack of corporate taxation is certainly a benefit for REITs and their investors, the caveat is that the tax structure of REITs can be quite complex.

First off, most REIT dividends don’t meet the IRS definition of "qualified dividends," which would entitle them to lower tax rates. For example, someone in the 22% tax bracket typically pays 15% on qualified dividends, but REIT dividends generally don’t qualify for this favorable treatment.

However, because REITs are pass-through businesses, REIT dividends that aren’t considered qualified dividends typically qualify for the 20% qualified business income (QBI) deduction. In other words, if you receive $1,000 in ordinary dividends from an investment in a REIT , as little as $800 of that amount could be taxable.

Plus, REIT dividends often have several different components. The majority of each distribution you receive from a REIT is typically considered to be ordinary income, but some portion might meet the qualified dividend definition. And, some portion of REIT distributions can also be considered a return of capital, which isn’t taxable at all, but reduces your cost basis in the REIT, and can have future tax implications.

Confused yet? The good news is that you don’t have to keep track of any of this. When you receive your year-end tax forms

Risks to be aware of before buying a REIT

No discussion of any investment would be complete without mentioning risks, and there are certainly a few that REIT investors should know about. Just to name some of the most significant:

  • Interest rate risk -- In a nutshell, rising interest rates are bad for REITs. Specifically, when the longer-term interest rates paid by risk-free assets like Treasury securities rise, REIT share prices tend to experience downward pressure.

  • Oversupply risk -- This is a risk factor in all areas of real estate, but especially comes into play with property types expected to grow significantly in the coming years, or with property types that have a relatively low barrier to entry. For example, self-storage properties are generally quick and easy to build, so they are vulnerable to oversupply problems in strong economies.

  • Tenant risk -- Any REIT’s cash flows are only as reliable as its tenants. This can be somewhat mitigated if a REIT’s tenants are mostly of high credit quality, or if there is a diverse tenant base, but it’s still a risk to keep in mind.

  • Economic risk -- In recessions, many REITs see their vacancies spike and their pricing power fall. To be clear, there’s a wide variety of cyclicality (economic sensitivity) among REITs. For example, healthcare is a pretty recession-proof business, so healthcare REITs tend to hold up nicely. On the other hand, hotels are very sensitive to recessions, so hotel REITs often get crushed during tough times, but also tend to do particularly well during prosperous economic times.

In addition to these, there is a variety of company-specific risk factors. For example, most REITs use at least some level of debt to finance their growth, but too much debt can be a big problem.

The bottom line on REITs

REITs can be great additions to your portfolio, as they can produce steady income as well as growth, which can translate into some pretty impressive long-term total returns. Just be sure to have a good understanding of how these companies work -- as well as the risks involved -- before you get started.

How to invest in REITs right now

Real Estate Winners analysts have identified a select group of real estate investments and REITs that are at the heart of some of the biggest demographic and technological trends shaping our society today and have generated returns of 15%, 18%, and even 21% annually! Start earning institutional-quality returns with less than $1,000

Open an account to invest

Open Your Account Today to Invest Your Real Estate Winners Pics and Get Free Stock

3 views0 comments

Recent Posts

See All