Proper diversification is key to a successful long-term investing strategy. Many experts believe that real estate should have a place in most portfolios, in addition to equities and bonds. However, as real estate values soar, more and more people are getting priced-out of traditional real estate investment. Luckily, there’s an alternative to buying physical real estate: REITs, or real estate investment trusts. But what are REITs, and how do they work?
What Are REITs?
REIT is an acronym for real estate investment trust.
A REIT is a type of company that derives its income from owning and renting out real estate. Many are publicly traded, available for the average person to invest in on public stock exchanges.
To qualify as a REIT, a company must meet certain standards, including:
- Have at least 75% of total assets in real estate, U.S. treasuries or cash
- Earn at least 75% of gross income from rents, real estate sales or interest on mortgage financing
- Pay out at least 90% of taxable income in shareholder dividends
- Have at least 100 shareholders
- Other requirements; see here for full list
In short, a REIT is a company that owns and rents out property, whether commercial or residential. They are owned by a minimum of 100 shareholders (while publicly traded REITs often have thousands of shareholders), and they pay out at least 90% of their income in dividends.
What Are REITs Good For?
Real estate investment trusts can serve as an accessible way to invest in real estate. While buying a traditional real estate investment costs hundreds of thousands of dollars, one can invest in a REIT with just a few hundred dollars.
Publicly traded REITs function as normal stocks do, so you can buy and sell them with the click of a button. Thus, they are highly liquid investments, unlike traditional real estate.
Also, they are a good option for income-focused investors. REITs pay significant dividends, often of 4-8% or more. This compares to a yield of around 2% for the S&P 500.
In short, REITs are good for:
- Providing real estate exposure to your investment portfolio
- Providing significant dividend income on a quarterly basis
- Diversifying an investment portfolio
- Offering a liquid, accessible form of real estate investment
Are There Different Types of REITs?
There are typically three different categories of real estate investment trusts:
- Equity REITs, which own and rent out income-producing real estate
- Mortgage REITs, which own property mortgages, or mortgage-backed securities, and earn income off interest rate spreads
- Hybrid REITs, which own a combination of real estate and mortgage notes
The bulk of real estate investment trusts fall into the first category, equity REITs. They’re also typically the most-recommended category. Mortgage REITs may be useful for some, however, they are highly sensitive to interest rate fluctuations. In a rising rate environment, mortgage real estate investment trusts may not be the best investment opportunity.
In addition to these broad categories, many REITs also operate in specific industries or specialties. For example, there are residential REITs which invest primarily in residential properties, commercial REITs which rent out commercial property, healthcare REITs which own hospitals and medical facilities, etc. This allows the average investor to gain targeted exposure to specific real estate categories, if desired.
How to Invest in REITs
REITs are either publicly traded or private. Publicly traded REITs are obviously more accessible to the average investor.
To invest in a publicly traded REIT, there are two ways to go: buy a specific REIT, which trades like any other stock – or buy a REIT-focused ETF/mutual fund.
For many investors, a REIT ETF or mutual find may be a good option, because it provides diversified exposure to real estate. For instance, Vanguard’s VNQ REIT ETF holds a basket of ~180+ different REIT companies, which in turn own thousands of investment properties. VNQ currently yields more than 4% in dividends, and also offers the potential for equity appreciation and capital gains.
The other option is to buy a specific REIT company. Popular options include Realty Income (O), which invests in single-unit commercial properties, Simon Property Group (SPG), which invests primarily in shopping malls, and Equity Residential (EQR), which invests in urban residential units. Note that these REITs are used solely as examples, and are not endorsed or recommended by Capitalist Review.
There are pros and cons to each approach.
A ETF or mutual fund provides broad diversification, but also exposes you to certain sectors that may not perform well in the future. For example, many believe that shopping malls will continue to die out as online shopping grows, so companies like SPG that own primarily shopping malls might suffer. Broad ETFs also generally have lower yields than many individual REITs, although yields are still significantly more than most stocks.
Investing in a specific REIT gives the investor more control over their investment, and allows for exposure to specific industries. On the other hand, they also concentrate your risk a bit more than broad ETFs. However, consider that even a single REIT stock is much more diversified than an investment in a physical property, simply because most REITs own many different properties in geographically diverse areas.
Depending on your investment style, risk tolerance and goals, each option could be a good choice. Speak with your financial adviser if you have questions or concerns.
Are REITs a Good Investment?
It’s impossible to say what the future holds. This is true of any investment.
What we can do, however, is to look at the past performance of REITs to speculate on their future performance.
Looking at VNQ, the 10-year average annual return was 7.75% (as of 07/31/2018). This compares to a 10-year average annual return of 10.67% for the S&P500, a popular choice for equity exposure. This is just an example, looking specifically at VNQ.
Looking back even further and more broadly, REITs have actually outperformed the S&P500 index. Between 1975 and 2014, REITs returned an average of 14.1%, while the S&P 500 returned 12.2% (source).
So, if history is any guide, REITs can be a solid investment. There are a variety of benefits, as discussed below.
Pros & Cons of REITs as an Investment
Real estate investment trusts may have a place in a balanced portfolio. Like any other investment, it’s important to weigh the pros and cons. You should do your own due diligence, but to get you started…
- Low investment minimum (as little as a few hundred dollars)
- Highly liquid, unlike traditional real estate
- High yield, with dividends of 4%+
- Historical evidence of great performance and total returns
- Low correlation with stocks, offering better diversification
- Can be volatile
- Many REITs may be sensitive to changing interest rate environments
- Fairly risky
- Future performance may not match past performance (but this is true of any investment)
Should I Invest in REITs?
Nobody can answer that question except yourself or your licensed financial adviser.
The decision of whether or not to invest in REITs is highly specific to your risk tolerance, financial goals, and the rest of your portfolio.
If you do choose to invest in real estate investment trusts, the next decision is to determine what percentage of your portfolio to dedicate to the sector.
Again, this is a question with an answer that greatly depends on your situation. Many experts recommend holding 5-10% of your portfolio in REITs. Others say 20%, and still others say you shouldn’t hold them at all!
Bottom line – you should do your own research and speak with a financial adviser if you have any questions. Hopefully this article has answered the basic question of what are REITs, and given you some tools to help you further explore this investment opportunity.