REIT is short for real estate investment trust. They’re what you call alternative investments. REITs allow big and small investors to play landlord, minus all the hassles and headaches.
Most REITs own and manage all sorts of commercial and residential properties while enjoying a steady stream of rental income. Most profits are returned to investors in the form of dividends. And those profits for the trust and dividends for investors enjoy some unique tax advantages.
REITs are a great way to virtually own real estate without having to go out and buy, manage, or finance property (as well as deal with problem tenants). Investing in a REIT is easy for people seeking real-estate exposure in their stock portfolios. Some 80 million Americans are invested in them, mainly through their workplace 401(k)s.
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I’ve been in REITs for more than 10 years, and they have been one of my most reliable investments, consistently producing double-digit returns.
How Do REITs Work?
REITs are simply companies with a special tax status that lets investors pool their cash to invest in properties or other real estate assets.
To qualify as a REIT, they must meet several regulatory guidelines. Namely, 75 percent of assets must be invested in real estate, there must be at least 100 shareholders, and no five shareholders can own more than 50 percent of shares. REITs must also return 90 percent of their income as dividends, which allows them to avoid paying corporate taxes.
But REITs offer more to investors. As property values rise over time, so does the REIT's income stream.
That means more profits for investors — the double whammy that comes with higher dividends and share prices. REITs trade on the major exchanges, such as the New York Stock Exchange.
Are all REITs the Same?
Hardly. The majority are what you call equity REITs, which invest in the gamut of properties: apartments, shopping malls and individual retail businesses, hospitals, hotels, office buildings, self-storage facilities and warehouses, and even single-family homes and timberlands.
Another type of REIT is available to investors, as well, but I suggest you avoid this one. It’s a bit complicated and downright risky. Called a mortgage REIT, it plays the mortgage-backed securities game — the same game that helped crash the economy in 2008. Yup.
These REITs borrow money at very low interest rates and buy mortgages that pay higher interest rates. The difference, or spread, between the two rates represents the REIT's profit.
Again, this is really risky investment, and today these kinds of REITs are becoming less attractive as interest rates rise and the profit spread shrinks. They can also receive another clobbering when folks carrying those high-interest-rate mortgages, who tend to have poor credit and iffy finances, default on their mortgages.
The Drawbacks of REITs
Like any investment, REITs are not perfect. You can lose money with them if you’re not careful, although I think most REIT investors see their picks as long-term winners. Probably the biggest negative is that REITs, both equity and mortgage, are very sensitive to rising interest rates, which inversely lowers share prices.
For example, when rates started to increase at the start of 2018, most REITs got slammed.
However, share prices have ticked up a bit since then as investors realize REITs will continue to make money despite rising interest rates.
Property taxes also can depress share prices. When state or local politicians raise property taxes, that increases REITs’ operating expenses. That in turn cuts into profits and thus reduces REITs’ share price.
How to Invest in a REIT
Investors can purchase shares directly from the REIT, mutual funds, or exchange-traded funds (ETFs). My REIT investment is a mutual fund — the Vanguard Real Estate Index Fund.
If you're fortunate enough to have a retirement savings account like a 401(k), I bet you have access to an REIT investment. If you have an individual retirement account (IRA) or plan to open one, investing in a REIT is simple.
REITs work well in retirement accounts, given how Uncle Sam taxes them. For instance, the REIT dividends you receive are taxed as ordinary income instead of as “qualified” dividends, which can carry a tax between zero and 20 percent. Your ordinary income — your annual take-home pay — is typically taxed at much higher rates.
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Keeping your investments in a 401(k) or IRA allows your money to grow and compound tax-free until it's time to start cashing out when you retire.
That said, you can also buy shares of REITs in nonretirement accounts. Online discount brokerages are a dime-a-dozen, so you’ve got a lot to pick from. Once you set up an account, you’re ready to buy.
Keep in mind that each REIT is designed to focus on only one property type, such as hospitals or shopping malls. Investors have 165 REITs from which to choose, the largest being American Tower. It is worth $61 billion, and owns and operates communication towers.
Before you start buying a REIT’s shares directly, take a quick look at its funds from operations (FFO). That metric reflects its cash flow. A rising FFO means the REIT has a stable tenant base and no problem hiking rents. That also means higher dividends for investors.
Want to own shares in every REIT? Buy a mutual fund or ETF. They carry inexpensive fees and simply track indexes. Some indexes gauge the collective average performance of all those 165 REITs. Meanwhile, others are niche-focused and only track REITs of specific regions, states, countries, or property types.
Final Thoughts
REITs offer advantages that you can't find with other investments, like not having to pay corporate taxes on profits. This in turn frees the REIT up to return 90 percent of profits back to investors to give them a steady income stream of growing dividends.
But for anyone looking to start investing on a small or grand scale, whether through an employer or on their own, REITs should never be a first choice for a new portfolio.
Start with low-cost mutual funds or ETFs that give you broad exposure to U.S. and foreign corporations (stocks), as well the debt these companies issue (bonds). Then consider adding a REIT mutual fund or ETF as one way to add diversity, income, and stability to your portfolio.
