Have you ever wanted to invest in real estate but didn’t have the tens of thousands of dollars to buy an investment property that gives you passive income? Would you believe me if I said you actually don’t need all that money to invest in real estate?
Have you ever wanted to invest in real estate but didn’t have the tens of thousands of dollars to buy an investment property that gives you passive income? Would you believe me if I said you actually don’t need all that money to invest in real estate?
It’s called a REIT, Real Estate investment Trust, and what these are is a company that owns, operates, or finances income-generating real estate. It’s modeled after mutual funds, which pool the capital from numerous investors. This makes it possible for individual investors to earn dividends from real estate investments without having to buy, manage, or finance any properties themselves. Sounds awesome right? Well, before you make up your mind, stick around and make sure this is an investment you want to take on.
So how do REITs work exactly? Let’s jump back to the 1960’s real quick when congress established REITs as an amendment to the Cigar Excise Tax Extension. Originally only available to wealthy individuals through large financial intermediaries, the provision allows investors to buy shares in commercial real estate portfolios.
These portfolios are made up of healthcare facilities, data centers, apartment complexes, hotels, office buildings, retail centers, warehouses, and even cell towers, energy pipelines, and self-storage. For example, a company may invest into creating senior living homes as a REIT or popular shopping centers such as Tanger Outlet Malls.
What do REITs do to make money you ask? It truly is an easily understood business model, but let me break it down for you. When a company leases their space or collects rent on their real estate investment properties, the company would then generate income which is then paid out to shareholders in the form of dividends.
The cool part is, REITs must pay out 90% of their taxable income to the shareholders, whereas some pay out 100%. The shareholders would then pay income taxes on those dividends MREITS or mortgage REITS are a little different, as the real estate isn’t owned directly, but rather they finance the real estate and earn income from the interest on the investments.
Why would you ever invest into REITs anyway? Well, if you’ve followed along with the real estate market or any highly successful person in the world, they almost always have a real estate investment portfolio of some kind. The average return on investment for real estate is 8.5-10.5% a year depending on if it’s a residential property or commercial property.
Listed REITs are publicly traded companies that are professionally managed with a goal to maximize shareholder value. So you can guarantee in order for a company to be successful doing that, they will position themselves correctly to always be attracting tenants.
Before I jump into how you can invest in REITs, let me break down what the different types of REITs are and how a company can qualify as a REIT. There are three types of REITS: Equity, where the income-producing real estate is owned and operated. Mortgage, when a mortgage is held on real property, and hybrid, which is a mixture of both. These three types can then be further classified as: publicly traded, publicly Non- traded, and private.
To break it down even more, mREITs or mortgage REITS provide the financing for real estate and earn income from the interest on the investments. Equity REITS are publicly traded, and own or operate income-producing real estate. These are just your standard REITs.
Public Non-Listed REITs are registered with the SEC but do ot trade on national stock exchanges. Last but not least, Private REITs. Private REITs are exempt from SEC registration and whose shares do not trade on the national stock exchanges. Individuals can also invest in real estate mutual funds, which are funds professionally managed and pooled together to invest in stocks and bonds. Real estate mutual funds typically invest in REITS using expert research and portfolio managers. It would give you diversified exposure to the real estate market without needing so much capital.
With that in mind, how do you invest in REITs or Real estate mutual funds? You can buy shares in a REIT listed on major stock exchanges just like any other public stock. When it comes to a company qualifying as a REIT, according to naREIT they must:
Just like with any investment, the last thing you’d want to do is hop on a trend because you were on Reddit for 5 minutes and stonker1671 recommended a REIT you need to invest in, because it’s “going to the moon.” It’s crucial to do your due diligence and the best way to assess any REIT is by following Investopedia's 6 tips:
REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides without being locked in long-term. Liquidity matters.
Depreciation tends to overstate an investment's decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess a REIT, look at its funds from operations (FFOs) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide it by the FFO per share. The higher the yield the better.
Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
Quality counts. Only invest in REITs with great properties and tenants.
Consider buying a mutual fund or ETF that invests in REITs, and leave the research and buying to the pros.
I’ve defined it, I’ve told you how to assess them, I’ve thrown out some additional knowledge about them, so what are the advantages and disadvantages of REITs? Starting with advantages, they have very high-yield dividends. Having a requirement to dish out 90% of the taxable income to shareholders is a huge plus. There’s also alot of portfolio diversification possibilities as well, and REITs are highly liquid, as they can be bought and sold with the click of a button.
Jumping to the disadvantages of REITS, the dividends are taxed as ordinary income. The IRS doesn’t make these “qualified dividends” so REITs tend to be taxed at a higher rate than most dividends out there. As a home buyer I'm sure you see the constant fluctuation of interest rates. Well, REITs have a sensitivity to interest rates. When the Federal Reserve raises the interest rates to try and balance spending,
REIT prices tend to fall. It’s important to assess a REIT properly to ensure you aren’t investing in something that will perform poorly due to market shifts or economic downfall.
Going off that point brings us into the first question of the frequently asked questions, are REITs safe during a market downturn? Depending on the type of REIT, for example, hotel REITs may not do too well during an economic downfall, as they provide a luxury more than a necessity, but investing in retail or healthcare would be more of a longer approach as their leases are structured long term.
Number two, Can I lose money on a REIT? With any investment out there, there’s always a risk. REITs have a risk of losing value when interest rates rise. Number three, What REITs should I invest in? The best way to combat risk is by diversifying, so don’t think you should just focus all your time and money in one sector.
Invest in a few different REITs or a mutual fund that pools them altogether. Number four, Are REITs even a good investment? As I mentioned before, REITs are a good way to diversify your portfolio, whether you’re a seasoned investor or just starting out, especially with their strong dividends and long-term appreciation. Number five, What is the best allocation to REITS in a portfolio standpoint? This question is based on your personal goals, but most studies have found that it’s typically between 5% and 15%. Wilshire Funds Management stated that you could start at 15% with a 45-year investment horizon and decline gradually to 7% at retirement and 6% after 10 years of retirement. Number six, how many REITs are there in the U.S? There are more than 225 REITs in the United States that are registered with the SEC and trade on one of the major stock exchanges. They have a combined market capitalization of over $1 trillion.
There are pros and cons to any investment in the world today, but for a lot of investors out there, the diversification of an investment portfolio that REITs create outweighs the risks. As I've said again and again, make sure you do your due diligence, and don’t just take all the money you were saving for a house and throw it into one of these funds, be smart with your money and seek investment guidance when you feel the need.
Cheers,
Andrew
Andrew McManamon is a Michigan REALTOR® with Signature Sotheby’s International Realty and provides real estate services to Buyers, Sellers and Investors throughout SE Michigan including Livingston County, Oakland County, Washtenaw County, Genesee County & beyond. Andrew has become one of the rising stars of Michigan real estate agents. Prior to his real estate career Andrew was responsible for managing a senior living facility in Brighton, Michigan as a dining supervisor and an activities assistant. Andrew’s passion to help people is unlike any other, and he continues to strive to be best resource he can be. Andrew graduated from Cleary University in Howell, Michigan with a double major and currently resides in White Lake, Michigan.