Guide to REITs: A New Way to Invest in Real Estate
A real estate investment trust (REIT) gives regular people the ability to own real estate holdings. They open up possibilities beyond traditional stock and bond investments, but along with those possibilities come risks.
As is generally the case with investment vehicles, knowledge is power. The more you know about REITs, the better able you’ll be to manage the risks and take advantage of the possibilities.
What Are Real Estate Investment Trusts (REITs)?
REITs are investment funds specializing in the real estate sector. They can invest across a range of different properties or other holdings and typically focus more on generating income from those investments than gains from buying and selling. With the boom of investment apps, including REIT investments apps like DiversyFund, investing in REITs has become easy to do.
According to Nareit, a REIT trade organization, REITs are required to invest at least 75% of their assets in real estate and must derive 75% of their income from rents, mortgage interest, or property sales.
Ordinary REITs invest directly in real estate properties and derive income from the leases on those properties. Another category called mREITs invest in mortgages or mortgage-backed securities; they derive income from the spread between the interest charged on mortgages and the cost of financing mortgages.
In either case, the REIT’s management team chooses which properties or mortgage investments to own and is responsible for overseeing the management of those assets.
Find the Best REIT
The best REITs make it possible to invest in real estate without being a millionaire. Shop and compare REITs to find the lowest fees and opening balances.
How Do REITs Work?
Typically, REITs own and/or operate properties that generate income, such as any of the following:
- Office buildings
- Shopping malls
- Self-storage facilities
- Mortgages or loans
REITs do not develop properties with the goal of reselling them, which separates them from other types of real estate firms.
If you want to invest in commercial real estate without having to go out and buy and manage an actual building, REITs are an alternative option. As an investor in a REIT, you get to share in a portion of the income generated from a REIT’s commercial properties.
REITs are registered with the SEC and made up of pooled investments from 100 or more shareholders. By law, a REIT must pay out at least 90% of its taxable income to shareholders each year in the form of dividends. REITs usually pay out more — typically at least 100% — because a REIT is allowed to deduct these dividends from its corporate taxable income. Thus, paying out such dividends helps a REIT to avoid paying corporate income taxes.
It is important to remember that as a shareholder, you are responsible for paying taxes on the dividends and any capital gains you receive from the REIT. These dividends generally are treated as ordinary income and do not enjoy the lower tax rates associated with other types of corporate dividends.
How to Get Started
You can typically invest in a publicly traded REIT by purchasing shares through a stockbroker. This type of REIT is listed on a major stock exchange, and you purchase shares through a broker. Options include buying the common stock, preferred stock, or debt security of publicly traded REITs.
Other REITs also are available that are registered with the SEC, but not publicly traded. These are often known as non-traded REITs. You can purchase these shares through a broker participating in this type of REIT.
You can purchase shares of a non-traded REIT through a broker or financial adviser who participates in the non-traded REIT’s offering. This type of REIT typically comes with high up-front fees. It’s not unusual for sales commissions and upfront offering fees to total around 9% or 10% of the investment, according to the U.S. Securities and Exchange Commission.
Finally, you can also purchase shares in a REIT mutual fund or REIT exchange-traded fund. These types of vehicles invest in a variety of REITs. Many people purchase REITs through a mutual fund provider such as Vanguard, Fidelity, or Charles Schwab.
The 3 Types of REITs
There are various flavors of REITs offered by many different companies, but the SEC says they can be broken down into three major categories:
This type of REIT usually owns and operates income-producing real estate. The REIT typically earns its income from rent, property sales, and dividends. The volatility of this type of REIT tends to be reduced compared to that of mortgage REITs.
This type of REIT offers money to real estate owners and operators in one of two ways: Either through mortgages and other real estate loans, or indirectly through acquiring mortgage-backed securities.
This type of REIT often uses a lot of borrowed capital compared to an equity REIT. The SEC notes that mortgage REITs can be riskier than other types of REITs and may rely on things like derivatives and use of hedging when achieving its goals.
This type of REIT combines the investing approach of both equity REITs and mortgage REITs. It holds different types of properties while also funding new mortgages, or buying existing ones.
The Best REITs
Choosing the right REIT depends on your overall goals. There are many options to choose from, but some of the leading REITs include:
DiversyFund. This platform is a good choice for those who have relatively little to invest, as you can start with an investment as low as $500 and there are no platform fees. It is open to both accredited and nonaccredited investors.
Crowdstreet. To participate in this platform, you must be an accredited investor. Such investors must meet key SEC guidelines, including having earned more than $200,000 the prior two years and having a net worth above $1 million. Crowdstreet is a good choice for those who have a lot of money to invest, as the required minimum to start is $25,000.
RealtyMogul. This platform offers a little something for everybody. Accredited investors can access all RealtyMogul investments, while non-accredited investors can invest in the MogulREIT I and MogulREIT II offerings. Investment minimums vary depending on the investment but start as low as $5,000.
Fundrise. This is a great option for those who are just getting started with REIT investing, as you do not need to be accredited and can begin with an investment as low as $10 when you begin at the Starter level. Minimums increase from there, up to $100,000 for those at the Premium level.
EquityMultiple. This is another good option for accredited investors who have at least $5,000 to invest.
Potential Benefits of Investing in REITs
Why should you consider investing in a REIT? Here are some possible benefits:
Real estate is a separate asset class from stocks or bonds and, thus, it behaves differently. Having investments that behave differently can reduce risk through diversification because it means there is less of a chance that all your holdings could lose value at the same time.
By pooling the resources of a large group of investors, a REIT can efficiently invest in several properties or mortgages at once. Generally speaking, it is beyond the means of an average investor to buy a single piece of income property. let alone a collection of properties.
REITs are designed to produce income. With interest rates currently very low, investors are eager for alternative sources of income and REITs are a potential solution.
- Inflation hedge
Housing is a significant portion of living expenses, but REITs can act as a partial hedge against rising housing costs. In particular, REITs focused on owning residential rental properties should generally see income rise as housing costs rise.
Potential Drawbacks of Investing in REITs
No investment gives you potential benefits without some risks and complications. Here are some of the potential drawbacks of investing in REITs:
- Economic exposure
Demand for housing or commercial real estate can vary depending on the strength of the economy. In a recession, demand could fall and dampen the income earned by REITs, thereby causing the price of REITs to fall.
- Interest-rate sensitivity
Fluctuations in the interest rate could also impact a REIT’s income. Rising rates might hurt demand, but falling rates could squeeze the interest margin of mortgage REITs. The more volatile rates become, the more variability you might see in the income earned by REITs.
- Geographic concentration
Different areas of the country may go through real estate booms and slumps. The more a REIT concentrates its holdings on one geographic location, the more its returns are likely to be tied to the economic health of that region.
As with all securities that are bought and sold, the price of any REIT is determined by how popular it is with investors. Successful REITs tend to attract investors, which bid up the price. If a REIT’s price gets pushed up faster than the rate at which its income grows, it’s likely that it won’t do as well in the future as it did in the past.
- Tax treatment
Keep in mind that REITs pay out most of their income earned every year and that most of this is treated as ordinary income for tax purposes. Thus, REITs may have less favorable tax treatment than stocks.
REITs may use leverage – i.e., borrowed money – to increase the number of holdings they can buy. This can boost returns if things go well, but it can also make losses more severe in downturns. The amount of leverage a REIT uses can increase the riskiness of that REIT.
8 Things to Know Before You Invest in REITs
How can you weigh the trade-off between the potential benefits and risks of a REIT? It helps to know these eight things before you invest in REITs.
1. Type of investment vehicle
Some REITs are traded directly on the stock market; others can only be bought privately, while still others are held in mutual funds that specialize in investing in REITs.
Privately sold REITs are likely to be less liquid than publicly traded REITs. Investing in REITs via mutual funds may subject you to an extra layer of fees. When it comes to REITs, it’s not just what you invest in but how you invest in it that matters.
The companies that manage REITs charge fees for their services. The way they assess these fees depends on how you buy the REIT.
REITs that aren’t listed on the stock market may charge an up-front sales charge when you buy in. This can be very expensive unless you hold the REIT for a long time afterward.
Buying REITs via mutual funds can mean you are paying fees to both the REIT management company and the mutual fund company.
Generally speaking, buying directly on the stock market should be the most cost-effective way of buying a REIT, but the specifics can vary with each one. No matter how fees are assessed, they eat into the potential return you can earn, so you should research and compare fees before choosing a REIT.
3. Management team
The skill of the management team that’s choosing and overseeing the investments in a REIT is critical to its success. It is important to know with whom you’re dealing.
You’ll want to make sure it’s the same management team that has been responsible for the REIT’s past successes. Look for a team that has earned a long track record, rather than one that may have just benefited from recent real estate conditions.
Finally, the depth of the management team – how much talent is involved in managing the REIT – is important to cushion against the impact of staff turnover and to allow for growth.
4. Geographic concentration
REITs take different approaches to where they make investments. Some want to broadly diversify across different regions while others want to focus on one particular real estate market.
The approach you choose depends on what you want to get out of the REIT. If you are trying to capture the benefits of participating in the real estate market in general, a REIT with broad geographic diversification might suit you best. If you like the outlook for the real estate market in a particular region and hope to profit from it, then you might prefer a REIT concentrated in that region.
In either case, knowing the holdings and investment objective of any REIT you consider will help you identify which best matches your investment goals.
5. Sector concentration
REITs can specialize in different types of properties. Different sectors of the real estate market benefit depending on economic conditions, so you should make sure you invest in REITs that fit well with your outlook for the economy.
Broadly speaking, the real estate market is divided between residential and commercial properties. A REIT is likely to specialize in one or the other, so you should make sure you decide which you want.
Within the commercial market, there are several specific sectors such as office space, health care facilities, industrial properties, etc. This allows you to invest in a specific segment of the real estate market that you believe will do well.
Knowing what sector a REIT specializes in should be a central part of your investment decision.
6. Occupancy rate
For REITs that depend on rents from residential or commercial tenants, the occupancy rate is an important thing to know because it’s a measure of the demand for that type of property.
For example, a property that is nearly fully occupied should have no problem maintaining or even raising its current rental rates. On the other hand, one that’s only half-occupied may have to reduce rents to fill up the property. This could negatively impact the potential income earned by a REIT that owns the property.
It’s important to know both the occupancy rate of the properties owned by the REIT you are considering as well as the occupancy rates of competing properties in the same market. The relationship of supply and demand for a particular type of property in any market will have a lot to do with how much those properties can earn.
7. Dividend yields
Since the investment returns a REIT generates for you depend on the income they earn on their holdings, the dividend yield is a crucial factor to consider when choosing a REIT.
Dividend yields represent the income paid out by a REIT as a percentage of the REIT’s price. This will put the REIT’s earning power in perspective with the price you would have to pay for the REIT.
Dividend yields are more important than the past performance of REITs. Past performance may partly represent how a REIT’s price has been driven up due to its growing popularity – something that might detract from future performance. Dividend yields can give you a sense of whether a REIT’s underlying earnings have kept up with the growth in its price.
8. Amount of leverage
Using borrowed money can help a REIT generate more income. However, it can also make the management of the REIT look better than it really is, by boosting returns due to greater risk rather than due to smarter decisions.
Worse, that risk can prove to be very damaging during a downturn if the underlying investments lose value and/or if the income from them is not sufficient to cover the interest on the borrowed money.
Like any investment, REITs can be the right choice or the wrong choice depending on the circumstances. The more you understand how REITs work and the specifics of any REIT you are considering, the better chance you have of making the right choice.
Frequently Asked Questions (FAQs)
How do the returns of REITs compare to those of other investments?
As with any investment, the returns of REITs can vary greatly over a given period of time. Morningstar notes that at the beginning of 2020, REITs had lagged the broader stock market for the previous four years. Yet, from May 1972 to December 2019, REITs beat the Standard & Poor’s 500 index by more than 1% per year.
If you are looking for investments that pay dividends, REITs might be worth considering. The SEC notes that REITs can offer higher dividend yields compared to some other types of investments.
What are the tax implications of owning REITs?
When you invest in a REIT, you will likely receive dividends and/or capital gains for each year that you hold the investment. If you hold REITs in a taxable account, you will have to pay taxes on those amounts in the year you earn them.
For this reason, many experts suggest keeping REITs in a tax-advantaged account, such as an IRA or 401(k). If you keep your REITs in a traditional IRA or 401(k), you will not have to pay taxes until you withdraw the money.
Meanwhile, if you keep your REITs in a Roth IRA or Roth 401(k), you will never owe taxes on your dividends and capital gains.
What are some of the other potential drawbacks to owning non-traded REITs?
In addition to higher fees, the SEC notes that non-traded REITs lack liquidity and cannot be easily sold on the open market. In addition, it is not easy to determine the value of a share of a non-traded REIT.
Unlikely publicly traded REITs, non-traded REITs often pay distributions that exceed their funds from operations. To accomplish this goal, the REIT often uses offering proceeds and borrowings, which lowers the share value and the cash available to the company to purchase more assets.
How can I protect myself from fraud when investing in REITs?
You should never buy REITs from anyone not registered with the SEC. In addition, you can verify the registration of REITs — both publicly traded and non-traded — by using the SEC’s EDGAR system.
The Bottom Line
- REITs can be a great option for people who want to invest in commercial real estate without purchasing and managing an actual property.
- Some REITs are publicly traded, while others are not.
- REITs must pay out at least 90% of their taxable income to shareholders each year. This can create tax implications for those who invest in REITs.
- The three main types of REITs are equity REITs (less volatile), mortgage REITs (more volatile), and hybrid REITs ( a combination of the two).
- Top REITs include DiversyFund, Crowdstreet, RealtyMogul, Fundrise, and EquityMultiple.