Investors looking for growth and cash income may want to look to REITs as a long-term solution. REITs – short for real estate investment trusts – have turned in a nearly 12 percent average annual return from 1998 to 2018 while paying out substantial dividends along the way. That compares well to the market’s average return of about 10 percent over time.
Here are five ways to invest in REITs, how they make money and what you should watch out for.
What is a REIT?
A REIT is a fancy name for a tax-advantaged company that invests in real estate. In exchange for not paying tax at the corporate level, they’re required to pay out 90 percent of their taxable income as dividends. Those payouts make them popular, especially with older investors, and REITs usually offer among the highest yields in the market.
By law, REITs must invest at least 75 percent of their assets in real estate and derive at least 75 percent of their gross income from rents or interest charged on mortgages for real estate.
REITs operate in virtual every sector of the real estate industry, including:
- Single-family homes
- Apartment buildings
- Data centers
- Medical buildings
- Cell towers
Those are some of the main categories, and REITs can own almost any type of real property. However, they tend to specialize in certain sectors, preferring to focus on one or two areas, because executives are able to utilize their in-depth knowledge and professional connections. Plus, investors tend to value focused companies more highly than diversified businesses.
How REITs make money
REITs make money in two basic ways: by investing and managing property, and by financing mortgages for real estate. Based on this distinction, REITs are divided into two broad types:
- Equity REITs – where they own a stake in the real asset directly and manage it, collecting the rents regularly and maintaining the property like a traditional landlord.
- Mortgage REITs – where they own mortgages on the real asset and collect interest or other payments on the financing of that property.
REITs usually borrow a lot of money to buy their properties, just as the typical homeowner does. But the consistent cash flows from rents or other payments allow them to borrow substantial amounts relatively safely. This borrowing allows them to make more money than otherwise.
[READ: 15 best investments in 2019]
Five ways to invest in REITs
Below are five different ways that you can get into the REIT game, although for three of them you’re going to need a brokerage account first.
1. Private REITs
While it has the other features of a REIT, private REITs do not trade on an exchange and are not registered with the U.S. Securities and Exchange Commission (SEC). Because they’re not registered, they don’t have to disclose the same high level of information to investors that a public company would. Private REITs are generally sold only to institutional investors, such as large pension funds and accredited investors — those with a net worth of more than $1 million or with annual income exceeding $200,000.
Private REITs may have an investment minimum, and that typically runs from $1,000 to $25,000, according to NAREIT, the National Association of Real Estate Investment Trusts.
Risk: Private REITs are often very illiquid, meaning it can be difficult to access your money when you need it. Second, because they’re not registered, private REITs don’t have to have any corporate governance policies. That means the management team can do things that show a conflict of interest without much, if any, oversight.
Last, many private REITs are externally managed, meaning they have a manager that gets paid to run the REIT. Compensation for external managers is often based on how much money is being managed, and that creates a conflict of interest for the manager. The manager may be incentivized to do things that grow its fees rather than do what’s in your best interest as an investor.
2. Non-traded REITs
Non-traded REITs occupy a middle ground: like publicly traded companies, they’re registered with the SEC, but like private REITs, they do not trade on major exchanges. Because they’re registered, this kind of REIT must make quarterly and year-end financial disclosures, and the filings are available to anyone. Non-traded REITs are also called public non-listed REITs.
Risk: Non-traded REITs can charge hefty management fees, and like private REITs, they’re often externally managed, creating potential conflicts of interest with your investment. In addition, like private REITs, non-traded REITs are usually very illiquid, and it’s tough to get your money back out of them if you suddenly need it. (Here are a few other things you need to watch out for with non-traded REITs.)
3. Publicly traded REIT stocks
This kind of REIT is registered with the SEC and trades publicly on major stock exchanges, and it probably offers the best chance for public investors to profit on individual investments. Publicly traded REITs are considered superior to private and non-traded REITs because public companies usually offer lower management costs and better corporate governance, due to the nature of public companies being subject to disclosure and investor oversight.
Risk: As with any individual stock, the price of REIT stocks can decline, especially if their specific sub-sector goes out of favor, and sometimes for no discernible reason at all. And there are also many of the typical risks of investing in individual stocks – poor management, bad business decisions and high debt loads, the latter of which are especially pronounced in REITs. (Here’s the full deal on how to buy stocks.)
4. Publicly traded REIT funds
A publicly traded REIT fund offers the advantages of publicly traded REITs with some additional safety. REIT funds typically offer exposure to the whole public REIT universe, so you can buy just one fund and get a stake in approximately 200 REITs that trade publicly. These funds comprise all REIT sub-sectors, such as residential, commercial, lodging, towers and more.
By buying a fund, investors get the advantages of the REIT model without the risk of individual stocks. So they benefit from the power of diversification to lower their risk while increasing their returns. Funds are safer for many investors, especially if they have limited investing experience.
Risk: While REIT funds mostly diversify away the risk of any specific company, they don’t eliminate risks that might be typical of REITs as a whole. Rising interest rates, for example, increase the cost of borrowing for REITs. And if investors decide that REITs are risky and won’t pay such high prices for them, many of the stocks in the sector could go down. In other words, a REIT fund is narrowly diversified, not broadly across industries like an S&P 500 index fund.
[READ: How to buy an S&P 500 index fund]
5. REIT preferred stock
Preferred stock is an unusual kind of stock, and it functions much more like a bond than a stock. Like a bond, a preferred stock pays out a regular cash dividend and has a fixed par value at which it can be redeemed. Also like bonds, preferred stock will move in response to interest rates, with higher rates leading to a lower price, and vice versa.
However, beyond its cash dividend, preferred stock doesn’t receive a stake in the company’s ongoing profits, meaning it’s unlikely to appreciate above the price it was issued at. So an investor’s annual return is likely to be the value of the dividend, unless the preferred stock was purchased at a discount to par value. That’s in sharp contrast to a typical REIT, where the stock can continue appreciating over time.
Risk: Preferred stock tends to be less volatile than regular common stock, meaning its value won’t bounce around as much as a common stock’s might. However, if interest rates rise substantially, preferred stock would likely be hurt, much as bonds would be.
Preferred stock sits above common stock (but below bonds) in the capital structure, meaning that it must receive dividends before the common stock receives any dividend, but only after the company’s bonds have received their interest. Because of this structure, preferred stock is generally seen as more risky than bonds, but less risky than common stocks.
What makes a REIT attractive
“Nearly all investors would benefit by exposure to REITs,” says Morris Armstong, financial strategist and founder of Morris Armstrong EA, LLC.
Besides their strong track record of performance, investors have a number of reasons to like REITs:
- High dividend yields, which are derived from the legal mandate to pay out income and are supported by consistent cash flows from rental property.
- Less correlated with the broader market, meaning REITs are driven by different factors from most stocks, so they can offer diversification benefits.
- No management headaches, allowing you to sleep easier knowing that you don’t have to fix a broken air conditioner at 3:00 a.m. or deal with screaming tenants.
- Property diversification, meaning that a REIT is often invested in dozens or even hundreds of properties, so its success is not dependent on just a few assets, unlike the portfolios of many independent landlords.
These benefits are some of the most significant to investing in REITs, relative to both stocks and direct investment in rental property.
What to watch out for
When investing in REITs, pay careful attention to the company’s debt load, to be sure that it’s sustainable. While it’s a common business practice for a REIT to run a significant debt, investors must be sure that the company is able to manage it and still pay out its dividend.
Second, investors need to be careful around non-traded REITs and private REITs. While Armstrong likes publicly traded REITs, he says that other kinds “are sold with high commissions and no liquid secondary market — with the additional burden of no price transparency.”
Salespeople are incentivized to hawk non-traded REITs, and so these REITs often charge a steep commission, which comes right out of your investment before you even begin to make any money. And because they’re non-traded, it’s often very difficult (nearly impossible) for investors to sell them if they have an urgent need for cash. Investors will receive an updated valuation on their investment only periodically, unlike with publicly traded stocks.
Also, investors should be wary of the prices of real estate that comprise the value of the REIT, especially in a red-hot market. Those values can fall, hurting the price of the REIT.
“We’ve all seen this movie before — sky-high real estate prices, sky-high stock market prices,” says Craig Kirsner, president of Stuart Estate Planning Wealth Advisors. “And we know how this movie is going to end, we just don’t know exactly when.”
For this reason, Kirsner advises risk-averse clients may want to steer away from REITs at this time.
Finally, investors may want to keep an eye on rising interest rates. Rates may ding REIT stocks in the short term, as investors sell them based on the popular consensus that rising rates mean falling REITs, says Eric Rothman, portfolio manager at CenterSquare Investment Management.
But often that hasn’t hurt them over this long bull market. “When REITs do sell off due to rate fears,” says Rothman, “it has consistently proved short term and a great buying opportunity.”
Finding lists of REITs
Investors can access a list of REITs at NAREIT’s website. You can sort and track the companies by type – private, non-traded and publicly traded – as well as by industry.
In addition, investors can find information on REITs that are registered with the SEC, including non-traded REITs and publicly traded REITs. Each of these REITs is required to file financial disclosures, so that investors and potential investors can see how the REIT is performing.
All filings can be found at the SEC’s EDGAR database, which is a searchable archive going back many years.
You may already own some REITs and not even know it, especially if you own an index fund based on the Standard & Poor’s 500 index.
“Keep in mind that real estate is about 3 percent of the S&P 500, so just by having that fund, you have exposure, but many people prefer a few percentage points more,” says Armstrong.
For those looking for that extra exposure, there are quite a few ways to invest in REITs, an asset class that has shown strong performance over time. Most prospective REIT investors would be best served sticking to publicly traded REITs and REIT funds, since they offer diversification and the best chance of outperformance due to strong management and the oversight of public markets.