How To Invest In REITs
Adding real estate to an investment portfolio has, historically, been a wise choice. With the appreciation of property witnessed over the last two decades, it can seem like a no-brainer.
However, while physical properties can give you cash flow, capital appreciation, and the ability to leverage funds, there are some key drawbacks. Physical property investments can take a significant amount of time and effort, high upfront costs, and invested funds become extremely illiquid.
Fortunately, there is another investment product that captures most of the upsides of real estate without the need to buy physical bricks and mortar. These products are known as real estate investment trusts – more commonly referred to as REITs.
What is a REIT?
A real estate investment trust, or REIT (pronounced reet), is a company that owns, finances, and sometimes operates, a collection of real estate properties. These properties can take a variety of forms ranging from apartments to warehouses.
Investors buy shares in a REIT and, therefore, contribute funds to the overall real estate portfolio. Those funds are invested into suitable projects decided upon by professional real estate managers within the company.
The process of combining investor funds can be thought of comparably to ETFs or mutual funds. However, unlike ETFs and mutual funds that collect a basket of stocks, REITs focus solely on real estate investments. Some buy and rent properties. Others focus on financing opportunities.
REITs enable the average investor to gain exposure to properties that they would otherwise not have access to. For example, individuals may struggle to invest directly in the development of a shopping mall. However, by pooling individual funds together, the influence to enter millionaire dollar deals becomes much stronger.
For contributing funds, REITs offer investors significant dividend returns.
How do REITs work?
For a company to gain the classification of a ‘REIT’, and offer high dividend income potential, the company must conform to the following rules:
- A minimum of 90% of all taxable income must be paid to shareholders.
- 75% of the total company assets must be placed into real estate or cash.
- At least 75% of income must be generated from real estate.
- Once a REIT is created, the company has a year to gather over 100 different shareholders. It must have over 100 during the second year of its life.
- 50% of the shares cannot be held by less than 5 individual investors during the second half of a tax year.
Now the above rules are stringent, but there is a good reason for this. If the above rules are followed, REITs do not have to pay any corporate tax. Zero.
By not paying corporate tax it allows REITs to compete far more aggressively in comparison to other real estate investment companies. The ability to capture better deals eventually leads to increased income, which 90% of is returned to investors. The main aim of a REIT is to generate as much dividend income for shareholders, whilst maintaining a reliable increase in share price.
According to data taken from the FTSE NAREIT All Equity REITs Index – which tracks all tax-qualified REITs holding 50% of total assets in qualifying real estate – the average return over the last 5 years has been 9.4%.
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How to value REITs
So, hefty and consistent dividend payments sound like a great long-term deal, right? But you may now be wondering how you go about choosing which REIT to invest in. And you would be REIT to…
Traditional metrics such as price-to-earnings ratios (P/E) and earnings per share (EPS) are not useful when comparing REITs. These metrics use net income, which is a measurement that takes into account the depreciation of assets. However, as most properties generally don’t lose value – in fact, most properties appreciate – these metrics don’t translate well to REITs.
Instead, investors need to look out for some other key metrics. These include:
- Funds from operations, or FFO. FFO helps to define how much money a REIT makes. It is often higher than net income because depreciation costs are added back in. FFO is calculated by adding depreciation costs to net income and then subtracting any gains from interest or from assets that are sold. FFO is usually provided on a REIT’s income statement.
- Price to FFO. This metric is useful for assessing if one REIT looks expensive in relation to the rest of the market. To calculate the price to FFO, you need the FFO per share. Luckily, most income statements also provide FFO as a per-share number. P/FFO is, therefore, calculated by dividing the price of one REIT share by the FFO as a per-share number.
- Adjusted FFO. The adjusted FFO is another measure of the performance of a REIT, however, this metric takes into account company-specific adjustments. Each adjustment is unique. As a result, there is no standard method for calculating it. Like FFO and P/FFO it is also written on most income statements.
- Payout ratio. This is a useful metric for determining how much a REIT paid out in dividends over a year. The payout ratio is calculated by dividing total dividends by the funds from operations (FFO). As 90% of all dividends are paid to investors, this percentage is usually high.
Why invest in REITs?
REITs are excellent investment vehicles for those that do not want to own and manage real estate directly, but that still want to benefit from consistent cash flow. However, while requiring less time and effort to set up, there are some downsides to be aware of. Let’s weigh up both sides by looking at the key pros and cons.
- Consistent income. Dividends are one of the main draws for REITs. 90% of all company income must be paid to investors so dividends are often high and are very reliable.
- High returns. On average, REITs tend to outperform equities thanks to the higher than average dividend payouts.
- Diversification. As REITs are technically a type of stock, they can add diversity to an existing stock portfolio. REITs are in tune with the real estate asset class rather than equities.
- Liquid asset. Publicly traded REITs offer a very liquid option for real estate investors. Shares can be purchased and sold quickly through online brokerages.
- Low volatility. The price of REITs is usually a lot less volatile in comparison to stocks. While not immune to volatility, the large dividends mean that share prices tend to move less.
- Higher dividend tax. While REITs are free from corporate tax, dividends collected by investors incur higher income tax than traditional stocks.
- Low capital appreciation. As REIT share prices tend to increase slowly, the capital appreciation of a REIT tends to be lower than other real estate investments.
- Large debt allocations. Due to the ability to leverage investment funds, REITs can take on significant amounts of debt. However, this is usually readily offset with a high amount of long-term cash flow. However, large debts can be a risk when economic recessions hit and the number of vacancies in rental properties increases.
Public vs Private REITs
REITs can vary considerably, which means there are plenty of options for a new investor. However, this can also make it overwhelming. So, to help break down the options it is useful to look at how REITs can be accessed. And the route of access falls within one of three key categories:
- Publicly traded. The largest and most popular choice for investors is publicly traded REITs. Publicly traded companies are listed on global stock exchanges and can be purchased and sold directly through most online brokers.
- Public non-listed. Although still public and available to any investor, this second category of REITs are not listed on global stock exchanges. As a result, they may take a little more digging to find.
- Private REITs. Finally, REITs that are classified as ‘private’ are usually restricted to accredited investors. Accredited investors usually require a high-income level or high net worth. This means private REITs are not always accessible for every investor.
Types of REITs
After assessing whether a REIT is public or private, it is then necessary to determine what area of real estate the company focuses on. Do they focus on equity, mortgages, or a bit of both?
- Equity. The majority of REITs focus on real estate equity. Equity REITs focus on acquiring equity in a vast range of properties. These may vary from apartment buildings to shopping malls. Income is produced from the rent collected on properties owned. It is the responsibility of the REIT to manage the properties and collect rent.
- Mortgage. The second most popular type of REITs focus on mortgages. These are sometimes referred to as mREITs. mREITs look for opportunities in the financing behind real estate. The trust acquires mortgages or mortgage-backed securities and generates income from the interest and repayments.
- Hybrid. A hybrid REIT, as the name suggests, is a trust that combines both equity and mortgage opportunities. Potentially, the best of both.
You’ve now determined if a REIT is public or private and what sector of the real estate market the company focuses on. The final way REITs are classified is by their industry focus. Ask yourself, what type of property do they acquire or finance?
- Residential. Residential REITs focus on the acquisition and management of residential properties. The residential properties acquired can range from family homes to student accommodation. Any development that deals with multiple dwellings. Residentials may choose to focus on one geographic location or one type of residential property.
- Office. As the name suggests, office REITs focus on office space. They aim to own, manage and rent as many office units as possible. Think skyscrapers.
- Industrial. Industrial REITs own and manage industrial-focused buildings. This often involves spaces such as warehouses or distribution centers. Industrials often deal with large corporate organizations.
- Retail. Retail REITs rent properties to those businesses requiring access to the public. These REITs focus on acquiring large retail developments such as shopping malls and outlet centers.
- Infrastructure. Infrastructure REITs target the services required by property and businesses. This can include fiber cables, power lines, communications towers, and energy services.
- Timberland. Timberland is one of the more unique types of REITs. These trusts focus on the growth, harvest, management, and sale of timber.
- Self-storage. Self-storage REITs focus on acquiring large spaces that can be transformed into storage units. These REITs rent space to both businesses and individuals. Self-storage facilities offer a low-maintenance option.
- Hospitality. Hospitality REITs are those that own and manage primarily hotels. However, hospitality may also include restaurants or retail units if they fall within the boundary of a large hotel.
- Diversified. Diversified REITs is a classification used if a REIT owns a mixture of properties from the previous categories.
- Specialty. If a REIT is classified as a specialty this means that the properties it owns do not fall into any one of the previous nine categories. Examples include movie theatres, bowling alleys, or casinos.
How to invest in reits
All that is required to get started with REITs is a brokerage account. Yep – it can be that simple – especially if you want to invest in publicly traded companies.
Once you have an account set up, you need to choose which type (equity or mortgage) and which industry your REIT should focus on. Take your time to weigh up the options. Is there a sector that you will think will require property over the next few years?
Alternatively, if you prefer not to select individual REITs – it can be an overwhelming process – begin looking for REIT exchange-traded funds (ETFs) or mutual funds. These are a basket of REIT stocks that offer access to a broad range of products. For a near-instant and diversified REIT portfolio, this would be the optimum choice.
Finally, remember the tax implications. REITs avoid all corporate taxes. As a result, you pay standard income tax on all dividends. So while dividends can be high, you may have to pay a little more back than standard stocks. If you can, think about whether you can use a tax-efficient account, such as an IRA or ISA, for your REIT investments. The more dividend returns you can keep, the better.
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