A Guide to Investing in REITs

Investing in Real Estate Investment Trusts (REITs) can provide dividend investors with high yields, steadily growing payouts, nice diversification, and an attractive income stream for retirement living.

However, REITs have a number of complexities and risks that should be understood before making any investments.
Before jumping into the essential information investors need to know about REITs to make better informed decisions, it is worth highlighting some of the sector’s appeal.

When it comes to building wealth few industries are more time tested, or successful, than real estate. In fact, real estate is the third biggest creators of the world’s billionaires:

Source: Forbes

This is understandable given that real estate has a several built-in advantages that naturally make it appreciate in value. For example, the growing global population generally leads to both economic growth and higher demand for land and properties involved in housing and industrial development.

In addition, the ability to use leverage (i.e. buying real estate properties with debt, such as a mortgage) means that investors can generate substantial returns on investment.

Furthermore, real estate is usually a predictable and cash-rich business thanks to rental income, which makes this kind of investment highly attractive to long-term investors. And finally, real estate owners enjoy numerous tax advantages, including the ability to deduct depreciation expenses from earnings and mortgage interest from taxable income.

But for most retail investors, the idea of investing in real estate other than their own homes can be intimidating. After all, owning a rental property can be extremely hands on and time intensive. In addition, there are numerous legal implications and risks that becoming a landlord involves. Most people simply don’t have the time or desire to get involved with these matters.

Fortunately, there is a much simpler way for long-term income investors to profit from real estate, one that is no more difficult than buying shares on a stock exchange.

What are Real Estate Investment Trusts?

Real Estate Investment Trusts, or REITs, were created in 1960 as a new, tax efficient means of helping America fund the growth of its rapidly increasing demand for all types of real estate.

Basically, REITs are pass-through equities in which the company pays no federal income tax as long as it pays out at least 90% of its taxable income as unqualified dividends to investors.

The result is a naturally high-yielding class of equities with many REIT stocks sporting dividend yields in excess of 5%. Due to its high payout ratio, which leaves little retained cash flow, the REIT business model is predicated on constantly raising capital from the debt and equity markets in order for management to grow its portfolio of cash-producing properties; thus allowing dividend growth and share price appreciation over time.

REITs: A Proven Long-term, High-yield, Equity Class

Over many decades, REITs have been one of the best long-term asset classes for investors to build income and wealth over time. As you can see below, $100 invested across all REITs at the start of 1972 would have grown to more than $7,000 in 2018, representing compound annual growth of about 10%.

Source: Simply Safe Dividends, REIT.com

A 10% annualized return is on par with the broader stock market’s long-term performance. However, as MarketWatch noted:

“The main reason to own REITs isn’t to improve your portfolio’s return, though sometimes that will happen. The bigger reason is to reduce volatility, increase diversification and provide a source of income.”

And REITs have certainly done just that over the years. In about one out of eveyr four calendar years since 1975, REITs’ returns varied by at least 25 percentage points from those of the S&P 500 Index, according to MarketWatch. In most of those years, REITs earned a higher return.Furthermore, per Andrew Rubin, a portfolio manager at Fidelity, the growth rate of REIT dividends has outpaced inflation in 18 of the last 20 years, demonstrating their inflation-hedging qualities.

The REIT industry’s solid long-term performance and diversification benefits have resulted in it growing over the decades to more than $1 trillion in market capitalization and holding over $2 trillion in total assets. The industry has grown so large, in fact, that in 2016 Standard & Poor’s adjusted its Global Industry Classification Standard system to make REITs their own sector (Real Estate), rather than grouping them into Financials.

This change represents the growing importance of REITs to the overall stock market and is likely to result in far more interest from institutional money, thanks to the need to hold prominent REITs as part of increasingly popular index funds. Which means that, going forward, REITs should represent a potentially even more popular and liquid asset class.

There are Many Different Types of REITs

While all REITs are similar in many ways, investors need to realize that this sector encompasses a vast array of differing real estate assets. There are around 200 publicly listed REITs that operate across various industries:

  • Office
  • Industrial
  • Shopping Center
  • Malls
  • Single Family units (rental homes)
  • Apartments
  • Medical
  • Data Centers
  • Student Housing
  • Hotels
  • Triple Net Lease Retail
  • Manufactured Homes
  • Storage
  • Timber
  • Infrastructure
Note that there is also a separate class of REITs known as mortgage REITs, or mREITs. These are a far more complex, volatile, and challenging class of stocks that are unsuitable for conservative investors seeking steady and growing incomes. That’s because the business model of mREITs is extremely sensitive to interest rate fluctuations (rather than steady contractual rental income).

mREITs are based entirely on buying and selling mortgage-backed securities, and involve little or no owned properties. Therefore, they should be owned only by the most risk-tolerant investors, who are willing to put in the extra effort to find only the strongest mREITs, hold throughout periods of falling dividends, extreme volatility, and buy on the corresponding dips, corrections, and crashes.

Getting back to traditional property-based REITs, as you can see from the above list there is a vast universe to potentially own, each with its own nuances that investors need keep in mind. However, all REITs share common characteristics in that they derive the majority of their cash flow, which is what secures and grows the dividend, from real estate properties and rental income from tenants.

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