If you’re not quite ready to jump into a real estate investment as an owner or landlord, there is another option that allows you to reap the benefits of real estate investing without all of the negatives of property ownership. A real estate investment trust (or REIT, pronounced “reet”) offers investors a way to invest in commercial real estate in much the same way they would invest in the stock market.
In short, a REIT lets you invest in real estate without having to actually buy property or land. There are more than 200 REITs to choose from, and shares of REITs are traded much like shares of stock. In fact, you can find REITs listed on the stock exchanges. Less popular than stocks, funds, and even bonds, REITs are not new. They were established more than fifty years ago as a safe way to get into the real estate market. They are more liquid, and therefore more attractive than direct investments in real estate; selling shares of a REIT is as easy as selling a mutual fund or stock.
Since you don’t actually own real estate, you don’t suffer the hassles that come with property ownership. On the other hand, a REIT gives you none of the rights that come with property ownership, either. REITs share the characteristics of both stocks and mutual funds. A REIT is a publicly-traded company, so owning shares is similar to owning shares of stocks. On the other hand, REITs were created to follow the paradigm of the investment companies or mutual funds. Since most small investors cannot invest directly in income-producing real estate, a REIT allows them to pool their investment resources and is, therefore, like a mutual fund. This investment type is called pass-through security, passing through the income from the property to the shareholders. The income is not taxed at the corporate level but at the investor level.
What’s in the Real Estate Investment Trust (REIT)?
Unlike mutual funds, which purchase stock in companies, REITs focus on all types of real estate investments. These investments usually take one of two forms. An equity REIT buys actual property (with the property’s equity representing the investment). A mortgage REIT invests in mortgages that provide financing for the purchase of properties. In the latter, the income comes from the interest on those mortgages. Of course, like everything else, there’s always one option that fits in the gray area in between. In this case, that’s known as a hybrid REIT, which does a little of each. When comparing REITs and deciding which is best for you, you need to consider several factors. Here are some important areas to look at when you start comparing different REITs:
- Dividend yield. Review how much the REIT offers when paying dividends and how that compares to the price of the stock. The dividend yield is the dividend paid per share divided by the price of the stock. So if the price goes down, the dividend yield goes up. Dividends in 2014 averaged 6.9 percent for REITs—compared with 1.9 percent for S&P 500 companies.
- Earnings growth. With REITs, the magic earnings number is called funds
- from operations, or FFO. The FFO indicates the true performance of the REIT, which can’t really be seen with the same kind of net income calculation used by standard corporations. A REIT’s FFO equals its regular net income (for accounting purposes) excluding gains or losses from property sales and debt restructuring, and adding back real estate depreciation.
- Types of investments held. Identify what properties the REIT invests in. REITs can invest in office buildings, shopping malls, and retail locations; residential property, including apartment complexes, hotels, and resorts; healthcare facilities; and various other forms of real estate.
- Geographic locations. Check out where the REIT invests. Some REITs invest on a national level and others specialize in regions of the country.
- There’s that word again. Whether you choose a REIT that diversifies across state borders or buy several REITs with the idea of investing in everything from small motels to massive office complexes, you should always favor diversification when investing, and that includes investing in REITs.
- Much like buying shares in a mutual fund, you are purchasing an investment run by professional management. You should look at the background of the manager. In this case, you’ll be looking for someone with a real estate background. REIT managers often have extensive experience that may have begun in a private company that later went public as the person continued on with the company.
Just as you investigate a company issuing shares of stock, you have to investigate the company behind your REIT. You must also look at the real estate market and the economic conditions in the area or areas where your REIT is doing business.
REITs Compared with S&P 500
Over the thirty-year span ending December 31, 2013, the compound annual total return for equity REITs was approximately 11.7 percent. Compare that with the S&P 500 return during the same stretch of time, which came in lower at 10.8 percent (data from www.nareit.com).
Tracking Your REITs
You’ll see share prices for your REIT quoted daily, so you can follow your investment pretty much the same way you would track a mutual fund. The best measure of your REIT’s performance is its FFO, which is often referred to simply as earnings. The FFO differs from corporate earnings mainly in the area of depreciation. For corporations that have assets like computers and tractors, all physical assets (except land) depreciate, meaning they record a decline in value. That makes sense because they really do lose value over time.
However, real estate typically maintains or increases its value. A company whose main holding is real estate calculates its earnings, or FFO, by starting with the standard net income number, adding back depreciation on real estate and other non-cash items, and removing the effect of some capital transactions. This way, you can see a clearer picture of what kind of cash the REIT is really generating.
All in all, if you are a beginning investor who believes the time is right to invest in real estate, the best choice is a REIT. This form of investment provides a cost-effective way to invest in income-producing properties that you otherwise would not have the opportunity (or the capital) to become involved in. Regardless of how you get into real estate, whether through a REIT or as a property owner, it can be a lucrative and worthwhile investment strategy.
What Qualifies as a REIT?
Most REITs lease space and collect rents, and then distribute that income as dividends to shareholders. Mortgage REITs (also called mREITs) don’t own real estate and instead finance real estate. These REITs earn income from the interest on their investments, which include mortgages, mortgage-backed securities, and other related assets.
To qualify as a REIT, a company must comply with certain Internal Revenue Code (IRC) provisions. Specifically, a company must meet the following requirements to qualify as a REIT:1
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
- Earn at least 75% of gross income from rents, interest on mortgages that finance the real property, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Be an entity that’s taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit, then decides how to allocate its after-tax profits between dividends and reinvestment. A REIT simply distributes all or almost all of its profits and gets to skip the taxation.
Types of REITs
There are a number of different types of REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging/resort facilities. Some are diversified and some defy classification—for example, a REIT that invests only in golf courses.
The other main type of REIT is a mortgage REIT. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure.
While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs are the equity-type—the REITs that focus on the “hard asset” business of real estate operations. When you read about REITs, you are usually reading about equity REITs. As such, we’ll focus our analysis on equity REITs.
How to Analyze REITs
REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend-paying stocks. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some big differences due to the accounting treatment of the property.
Let’s illustrate with a simplified example. Suppose that a REIT buys a building for $1 million. Accounting rules require our REIT to charge depreciation against the asset. Let’s assume that we spread the depreciation over 20 years in a straight line. Each year we deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).
Let’s look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (i.e. the book value), which is the original cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the expense is a depreciation charge.
However, our REIT doesn’t actually spend this money in year 10—depreciation is a non-cash charge. Therefore, we add back the depreciation charge to the net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net income because our building probably didn’t lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge. FFO includes a few other adjustments, too.
We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures gives a figure known as adjusted FFO (AFFO).
Net Asset Value
Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost was depreciated. So, book value and related ratios like price-to-book—often dubious in regard to general equities analysis—are pretty much useless for REITs. NAV attempts to replace the book value of a property with a better estimate of market value.
Calculating NAV requires a somewhat subjective appraisal of the REIT’s holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize on the operating income based on a market rate. If we think the market’s present cap rate for this type of building is 8%, then our estimate of the building’s value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000).
This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equal equity, where the ‘net’ in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate of intrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.
Top-Down vs. Bottom-Up Analysis
When picking stocks, you sometimes hear of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on the fundamentals of specific companies. REIT stocks clearly require both top-down and bottom-up analysis.
From a top-down perspective, REITs can be affected by anything that impacts the supply of, and demand for, property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag.
A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain renters, rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.
Important Note: Since REITs buy real estate, you may see higher levels of debt than for other types of companies. Be sure to compare a REIT’s debt level to industry averages or debt ratios for competitors.
Capital market conditions are also important, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entire asset class.
At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents.
Economies of Scale
REITs typically seek growth through acquisitions and further aim to realize economies of scale by assimilating inefficiently run properties. Economies of scale would be realized by a reduction in operating expenses as a percentage of revenue. But acquisitions are a double-edged sword. If a REIT cannot improve occupancy rates and/or raise rents, it may be forced into ill-considered acquisitions in order to fuel growth.
As mortgage debt plays a big role in equity value, it is worth looking at the balance sheet. Some recommend looking at leverage, such as the debt-to-equity ratio. But in practice, it is difficult to tell when leverage has become excessive. It is more important to weigh the proportion of fixed versus floating-rate debt. In the current low-interest-rate environment, a REIT that uses only floating-rate debt will be hurt if interest rates rise.
Most REIT dividends aren’t what the IRS considers qualified dividends, so they are generally taxed at a higher rate. Depending on your tax bracket, qualified dividends are taxed at 0%, 15%, or 20%. However, with REITs, most dividends are taxed as ordinary income—up to 37% for 2020. 2
Tips: In general, REIT dividends are taxed as ordinary income. As such, it’s recommended that you hold REITs in a tax-advantaged account such as an IRA or a 401(k).
However, there may be some good news here. Since REITs are pass-through businesses, any dividends that don’t count as qualified dividends may be eligible for the 20% qualified business income (QBI) deduction. For example, if you have $1,000 in ordinary REIT dividends, you might owe taxes on only $800 of that.
Advantages and Disadvantages of REITs
As with all investments, REITs have their advantages and disadvantages. One of the biggest benefits REITs have to offer is their high-yield dividends. REITs are required to pay out 90% of taxable income to shareholders; thus REIT dividends are often much higher than the average stock on the S&P 500.5
Another benefit is portfolio diversification. Not too many people have the ability to go out and purchase a piece of commercial real estate in order to generate passive income, however, REITs offer the general public the capability to do exactly this. Furthermore, buying and selling real estate often takes a while, tying up cash flow in the process, yet REITs are highly liquid—most can be bought or sold with the click of a button.
There are some drawbacks to REITs of which investors should be aware, most notably the potential tax liability REITs can create. Most REIT dividends don’t meet the IRS definition of “qualified dividends,” meaning the above-average dividends offered by REITs are taxed at a higher rate than most other dividends. REITs do qualify for the 20% pass-through deduction, however, most investors will need to pay a large amount of taxes on REIT dividends if they hold REITs in a standard brokerage account.
Another potential issue with REITs is their sensitivity to interest rates. Generally, when the Federal Reserve raises interest rates in an attempt to tighten up spending, REIT prices fall. Furthermore, there are property-specific risks to different types of REITs. Hotel REITs, for example, often do extremely poorly during times of economic downfall.
- High-yield dividends
- Portfolio diversification
- Highly liquid
- Dividends are taxed as ordinary income
- Sensitivity to interest rates
- Risks associated with specific properties
Are REITs Good Investments?
Investing in REITs is a great way to diversify your portfolio outside of traditional stocks and bonds and can be attractive for their strong dividends and long-term capital appreciation.
What REITs Should I Invest In?
Each type of REIT has its own risks and upsides depending on the state of the economy. Investing in REITs through a REIT ETF is a great way for shareholders to engage with this sector without needing to personally contend with its complexities.
How Do You Make Money on REITs?
Since REITs are required by the IRS to payout 90% of their taxable income to shareholders, REIT dividends are often much higher than the average stock on the S&P 500. One of the best ways to receive passive income from REITs is through the compounding of these high-yield dividends.
Can You Lose Money on REITs?
As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.
Are REITs Safe During a Recession?
Investing in certain types of REITs, such as those that invest in hotel properties, is not a great choice during an economic downturn. Investing in other types of real estate such as health care or retail, however, which have longer lease structures and thus are much less cyclical, is a great way to hedge against a recession.
The Bottom Line
The federal government made it possible for investors to buy into large-scale commercial real estate projects as far back as 1960. However, only in the last decade have individual investors embraced REITs.
Reasons for this include low-interest rates, which forced investors to look beyond bonds for income-producing investments, the advent of exchange-traded and mutual funds focusing on real estate, and, until the 2007-08 real estate meltdown, an insatiable appetite on the part of Americans to own real estate and other tangible assets. REITs, like every other investment in 2008, suffered greatly. But despite this, they continue to be an excellent addition to any diversified portfolio.