The Ultimate Guide to Investing in REITs
By: Olivia Faucher,
The Ultimate Guide to Investing in REITs outlines valuable information for prospective investors.
Real Estate Investment Trusts (REITs) can provide investors with a source of income, increased diversification and reduced portfolio volatility. REITs have a number of complexities that investors should understand before buying them, so continue reading to learn what to be aware of when considering such investments.
The Ultimate Guide to Investing in REITs: What are REITs?
A REIT is a company that owns, operates, or finances real estate that produces income. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers and farmland. Typically, REITs focus on an individual property type, but some REITs do have diversified property portfolios. Investors can buy shares in a REIT, just like any other equity stock.
REITs can be classified into four categories. The categories are: equity, mortgage, public non-traded and private.
- Equity REITs: The majority of REITs are equity REITs. Equity REITs own or operate income-producing real estate, and they are publicly traded on major stock exchanges. Equity REITs are often simply referred to as REITs.
- Mortgage REITs: Also known as mREITs, mortgage REITs provide financing for real estate by buying or originating mortgages and mortgage-backed securities. mREITs earn income from interest received from their investments.
- Public Non-Traded REITs: Public, non-traded REITs are registered with the Securities and Exchange Commission (SEC) but do not trade on national stock exchanges.
- Private REITs: Private REITs are exempt from SEC registration and the shares do not trade on national stock exchanges.
The Ultimate Guide to Investing in REITs: What Constitutes a REIT?
To be classified as a REIT, a company must meet the following criteria:
- Invest at least 75% of total assets in real estate.
- Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from real estate sales.
- Have a minimum of 100 shareholders.
- Be an entity that is taxable as a corporation.
- Be managed by a board of directors or trustees.
- Have no more than 50% of its shares held by five or fewer individuals.
- Pay at least 90% of taxable income as shareholder dividends each year
The Ultimate Guide to Investing in REITs: How Do REITs Work?
Generally, REITs follow a simple business model: the company buys or develops properties and then leases them to collect rent as its primary source of income. The income generated by the company is paid out to shareholders in the form of dividends. REITs are required to pay at least 90% of the company’s taxable income to shareholders, and the shareholders pay the income taxes on those dividends.
However, some REITs do not own any property, choosing instead the alternate route of financing real estate transactions. These REITs generate income from the interest on the financing. Mortgage REITs are an example of REITs that do not actually own properties.
The Ultimate Guide to Investing in REITs: Sub Sectors
Similar to the stock market, there are subsectors of REITs that investors should be aware of. The sectors are differentiated based on the varying types of real estate that a REIT may own. Each sector comes with its own host of potential risks and advantages. Each REIT sector has its own degree of economic sensitivity, and each sector’s performance is impacted by different factors. It is crucial for investors to understand the differences among the varying types of REITs when deciding where to invest.
The National Association of REITs recognizes 13 major REIT sectors. The 13 sectors are listed below:
- Self Storage
- Health Care
- Data Centers
To read a detailed analysis of each of the 13 REIT sectors, click here.
The Ultimate Guide to Investing in REITs: Ways to Invest in REITs
If a REIT is listed on a major stock exchange, investors can easily buy shares the same way any other public stock is purchased. The majority of REITs are equity REITs, which are all listed on public stock exchanges.
Investors also can invest in a REIT mutual fund or a REIT ETF (exchange-traded fund), through which the investor would be buying a portfolio of shares in an entire index of REITs.
Private REITs and public non-traded REITs can also be purchased; however it is more complicated. Those investments are generally limited to individuals and institutions who meet certain financial criteria.
There are also a number of ways for investors to invest in overseas REIT markets. International REITs add diversification to portfolios that already hold a lot of U.S. real estate. One popular global ETF is Vanguard’s Global ex-US Real Estate Index Fund ETF.
The Ultimate Guide to Investing in REITs: What Factors Impact REIT Performance?
REITs face different risk factors depending on what kinds of properties the REIT owns. Certain REITs are very cyclical and highly sensitive to economic changes. For example, hotel REITs do not perform well during recessions because leisure travel is an easy expense for consumers to cut. On the other hand, health care REITs typically perform well throughout all phases of the economic cycle. This is because people cannot live without health care, so consumers do not stop using health care services during recessions. While the risk of economic fluctuations exists for every REIT, it can be expected that different REITs will respond differently to those changes.
Although different REITs have largely different risk factors, there are some circumstances that impact all REITs in the same way. For example, all REITs are sensitive to changes in interest rates. High interest rates are bad for REITs in more ways than one. Given the REIT business model, and the fact that REIT growth generally stems from raising debt or issuing stock, higher interest rates imply that REITs will face increased borrowing costs. Additionally, rising interest rates can affect property values.
Another risk that exists for all REITs is that of oversupply. If there is an overabundance of certain types of properties that thereby incur diminished demand, the REIT will suffer.
The Ultimate Guide to Investing in REITs: Taxation
It is very important for potential investors to understand the way REITs are taxed before making investment decisions. REIT taxes are unique, and the concept can be difficult to understand.
As previously mentioned, REITs are legally required to pay out at least 90% of taxable income as dividends. Given that the dividends are the taxable portion of a REIT’s income, the REIT is able to pass its tax burden to the shareholders as opposed to paying the taxes itself. Therefore, the REIT itself pays no federal income taxes, and the tax obligation instead falls on the shareholders.
Each dividend payout from the REIT to its shareholders is composed of a mix of funds that are acquired by the REIT from an array of sources. Profits earned by the REIT from different sources have individual tax rules. Therefore, investors do not always pay the same tax rate on the distributions received from the REIT. Rather, the payout must be dissected and categorized to determine the tax treatment.
Dividend distributions may be allocated to three categories: operating profit, capital gains and return of capital.
Oftentimes, the dividend payouts are only made up of operating profit. When the company passes along operating profit to investors, it is received as ordinary income, and therefore the investor must pay his or her ordinary income tax rate on the dividend.
When the distributions consist partially of capital gains or return of capital, the tax rate that the investor must pay is different. To read about the taxation rules in these scenarios, click here.
However, it is most common that the payout consists only of operating profit, in which case the investor must pay his or her ordinary income tax.
REIT dividends are considered ordinary, or nonqualified dividends. Ordinary dividends are taxed at standard federal income tax rates. On the other hand, qualified dividends are taxed at the capital gains rate. Dividends are distinguished as qualified if they meet certain requirements from the IRS. Generally speaking, most dividends from U.S. corporations are qualified. REITs are one of only a few scenarios where dividends are considered ordinary.
The Ultimate Guide to Investing in REITs: Important Financial Metrics for Determining Smart REIT Investments
Since REITs are regarded as high-yield investments that pay a reliable dividend, it is important to look at the payout profile of a REIT before investing. It may be the instinct of a potential investor to look at the earnings per share (EPS) of the stock to understand if the dividend is reliable. However, given the way REITs are structured for tax purposes, the traditional EPS ratio is not a good indicator of a safe dividend.
Instead, it is crucial for investors to look at a REIT’s funds from operations (FFO), which is the REIT equivalent of operating cash flow, Additionally, adjusted funds from operations (AFFO) is a very important metric, too. AFFO is equivalent to free cash flow for a REIT. AFFO indicates how much cash the company is generating after running its operations and investing enough capital to preserve what it already owns. AFFO is even sometimes referred to as “funds available for distribution.” AFFO is an investor’s best indication of whether or not the dividend is reliable.
The Ultimate Guide to Investing in REITs: The Bottom Line
While REITs have multiple attractive upsides, it is still crucial for investors to do research and be aware of the potential risks. Economic sensitivity, oversupply and interest rates are all important factors to consider.
Investors seeking diversification, decreased volatility and a stream of income can benefit from adding REITs to their portfolio. However, it is important to invest in moderation, and to be patient with REITs, as they usually are best held as a long-term investment.
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Olivia Faucher is an editorial intern with Eagle Financial Publications.