How to invest in REITs

Real estate investment trusts (REITs) provide a way to invest in real estate without actually purchasing the property. These are popular among investors because they generate income and help diversify your overall portfolio.

“They have a good position in the portfolio in terms of their risk and return profile,” said Noreen Brown, certified financial analyst (CFA) and co-chief investment officer at Summit Financial. Ta. REITs can be a stabilizer compared to volatile stocks, but still generate superior yields on an after-tax basis compared to taxable bonds, he added.

According to the National Association of Real Estate Investment Trusts (Nareit), REITs collectively own more than $4 trillion in total assets across the United States, with public REITs in particular owning an estimated 575,000 properties and 15 million acres of forested land. ing.

However, before considering REITs, it’s important to understand how to invest in REITs, the details of how REITs work, the different types, and their pros and cons.

What is a REIT and how does it work?

REITs are companies that own and often operate income-producing real estate. Think of your local mall, your apartment, the hotel you visited on your last vacation, or even the office space down the street. Similar to mutual funds, REITs pool funds with other investors’ funds. The REIT then typically rents out the property and pays investors a steady income through the rents the REIT collects.

Some REITs make loans rather than own real estate outright. REITs often specialize in a specific type of real estate, such as retail or office space, but there are also general-purpose REITs that invest in a wide range of properties.

REITs are a way for everyday investors, not just Wall Street professionals and wealthy individuals, to invest in real estate. However, these securities must meet certain criteria to qualify as his REIT.

According to the U.S. Securities and Exchange Commission (SEC), REITs must:

• It pays out at least 90% of its taxable income to investors as dividends.
• Managed by a board of directors.
• Have at least 100 shareholders after the first year.
• Not more than 50% of the shares are held by five or fewer individuals during the second half of the tax year.
• Invest at least 75% of your assets in real estate and cash, and no more than 25% in nonqualified securities or the stock of a taxable REIT subsidiary.
• At least 75% of your gross income, including rent and mortgage interest, is derived from real estate.
• We derive at least 95% of our gross income from these sources, as well as from dividends and interest from all sources.
• Be a corporation that is taxed as a corporation if it does not have REIT status.

Types of REITs

There are several different types of REITs, as they come in a variety of structures and can be traded publicly on an exchange like a stock or privately for a small number of investors.

Stock REIT

Equity REITs own or manage real estate and collect and pay rent to shareholders. According to Nareit, most REITs are publicly traded equity REITs, and equity REITs are often simply referred to as REITs. Like stocks, the value can fluctuate.

Mortgage REIT

Mortgage REITs, also known as mREITs, do not own the real estate themselves. Instead, they provide financing through mortgages or mortgage-backed securities to people who own and operate real estate. The payments they receive are interest payments, making them more sensitive to interest rate risk than equity REITs.

Hybrid REIT

A hybrid REIT owns real estate as well as mortgages and is a combination of an equity REIT and a mortgage REIT.

Listed REIT

Publicly traded REITs trade like stocks and bonds on the public market. They are registered with the SEC and have greater liquidity and transparency than non-traded or private REITs with respect to factors such as market value.

Non-traded and private REITs

Non-traded REITs may be registered with the SEC like publicly traded REITs, but because they are not traded on an exchange like stocks and bonds, they tend to be less liquid and transparent than publicly traded REITs. there is. You can purchase through a brokerage firm that offers unlisted REITs.

Private REITs are not registered with the SEC or sold on an exchange, so the range of investors is even narrower. These are typically available only to accredited and institutional investors and tend to be less volatile than publicly traded REITs.

Advantages of investing in REITs

One of the biggest benefits of REITs is that they can provide investors with strong annual dividends in addition to long-term stock appreciation. Over the past 20 years, REITs have outperformed the S&P 500 index in total return, Narite said. REITs are able to provide such stable dividends in part because of their tax structure. A REIT is structured similarly to a corporation, but typically does not pay the same corporate taxes (as it must pay 90% of its taxable income to its shareholders).

According to the Internal Revenue Service, under the Tax Cuts and Jobs Act of 2017, REIT investors now benefit from the Qualified Business Income (QBI) deduction, which allows them to deduct up to 20% of QBI and 20% of REIT dividends. I can. Service (IRS).

REITs are also considered a stable hedge against inflation, as rents and property values ​​tend to rise with prices.

Finally, it helps diversify your portfolio. This is important to ensure that even if one part of your portfolio declines, other parts remain stable or even increase in value. According to Charles Schwab, REITs typically follow real estate market cycles of 10 years or more, while stock and bond market cycles last an average of about 5.8 years.

Disadvantages of REIT investment

REIT dividends can be a steady source of income, but they are typically taxed as ordinary income, up to 37%, depending on your tax bracket (although they may also be taxed as capital gains or a return of capital) ). ). If you invest in REITs, you need to be prepared to pay taxes on the dividends each year.

Like almost all investments, REITs involve risk. Many of those risks relate to the real estate market, whose value may decline due to changes in real estate demand, asset values, rental prices, occupancy rates and business operations. They may also be concentrated in one geographic area or sector, which may further increase risk.

“You never know what’s going to happen,” Brown said. “No one could have predicted what would happen to office space due to COVID-19.”

REITs are also subject to interest rate risk.

“All else being equal, higher interest rates tend to reduce real estate values ​​and increase borrowing costs for REITs,” S&P Dow Jones Indices researchers said. “Furthermore, rising interest rates make the relatively high dividend yields that REITs generate less attractive when compared to lower-risk bonds, making them less attractive to income-seeking investors.”

Start investing in REITs

Investors can purchase publicly traded REITs through traditional brokerages such as Charles Schwab and Fidelity Investments. For non-traded REITs, investors must go through a broker that specifically trades that type of security.

Most publicly traded REITs have a website where investors can view reports outlining their investments and whether they are concentrated or diversified in one sector or region. A common way to gain exposure to REITs is through REIT mutual funds or exchange-traded funds (ETFs). This includes low-cost funds that mirror REIT indexes.

“You can get exposure to different sectors, different geographic areas, different individual assets,” Brown said of these funds. “There are benefits to diversification.”

The world of REITs is fairly concentrated, so it’s somewhat easy for investors to pick and choose what they want, but there are many different types of real estate that investors may not have been exposed to, so it’s important to diversify. That is important. Brown also said there are significant benefits to investing in higher-quality sectors within real estate, such as multifamily housing, which currently has strong supply and demand characteristics, and areas of population growth in the United States. .

As with any investment, it’s also important to look at costs such as management fees, Brown said.