Everyone dreams of owning a piece of real estate for themselves, either as a home or an apartment. Purchasing real estate is an expensive proposition however and remains nonviable for a large majority of people who are starting out investing.
Real estate investment trusts or REITs (pronounced Reets) are a fantastic way to get into the real estate space without breaking the bank. Here's the lowdown on how they work and why you should make space for them in your portfolio.
So, What Are They?
Simply put, REITs are companies that own or finance income producing real estate. An investor can purchase share in these companies, and the underlying real estate, by purchasing a unit of the REIT on a stock exchange.
Thus, investing a real estate is as straight forward as investing in any other market sector. More importantly, you do not need to take a mortgage or a loan of any kind to purchase REIT units since you can limit the maximum amount you wish to invest.
Thus, instead of buying an entire apartment building, by purchasing your chosen investment amount in a REIT, you can own a fraction of that building and partake in your share of profits from that piece of real estate.
How They Operate
REITs earn their money in, broadly, two ways:
Rental income
Mortgage financing
Based on their source of income, they can be referred to as Equity REITs or Mortgage REITs. Equity REITs usually own physical property like apartment blocks and shopping malls etc.
There is no restriction on the type of property they own and you will find many REITs specializing in office buildings or hospitals for example.
Mortgage REITs make their money by originating mortgages for pieces of real estate and by acting as the financer of these projects, earn money in the interest payments. They may also originate and purchase mortgage backed securities.
A key distinction of a company classified as a REIT is that it is obligated to payout at least 90% of its income back to its shareholders. Indeed, most payout a higher percentage than that.
As a result, REITs have the highest dividend yields amongst publicly traded investments and form a major part of many investors' retirement portfolios, thanks to their income producing nature.
Investment Performance
The key question that everyone wants to know of course, is how do REITs compare to other asset classes? Are they good investments?
From an income producing standpoint, yes they absolutely are. Given the 90% distribution rule, REITs generate cash flow right off the bat and are attractive.
There are however, two sides to consider when making any investment decision. One is the yield and the other is the price appreciation. While REITs score high on the yield metric (with an average yield of around 7-8%), the price appreciation metric is bit less certain.
That doesn't mean to say that REITs are a bad investment. Its just that you will not be seeing any major advantages by investing in them for capital gains compared to investing in any regular stock. You will be exposing yourself to the vagaries of the real estate cycle by investing in them so that needs to be taken into consideration.
Given that the real estate cycle fluctuates at a different frequency to the economic and stock market cycle, REITs certainly belong in a well diversified portfolio. Given their income producing characteristics, they do make an attractive investment.
Concentration
A key decision to make when choosing a REIT is to take into account its sector concentration. For example a mortgage REIT focused on office buildings is going to have different performance characteristics from a diversified residential equity REIT.
The key is to determine whether you understand where the money comes from. In other words, how easy is it for you to understand what this REIT does? Following this line of reasoning you can choose to invest in a more concentrated or broadly focused REIT.
For example, if you happen to be living in an area where you're familiar with the commercial real estate market, purchasing a highly focused and narrow REIT might make more sense since you understand the vagaries of that market better than the broader one.
As always, ensure you follow diversification guidelines and avoid over exposure to any asset class.
PNLRs and Private REITs
REITs can be traded in private as well as public. A publicly traded REIT is available on a major stock exchange and most brokers will be able to purchase them for you. They tend to be quite liquid (i.e easily available) and don't have any investment minimums attached to them, usually.
PNLRs or Publicly Non Listed REITs are, as the name suggests, traded in more esoteric exchanges are not freely available to the public. These instruments tend to have higher transaction costs and higher investment minimums, usually over 1500$.
Their non public nature doesn't given them any major advantage, performance wise, and given the lower liquidity, its best the average Joe investor stays away from them.
Private REITs are even more exclusive than PNLRs and are available only to large financial institutions or accredited investors. Given these restrictions, it doesn't make much sense to examine them too closely.
Taxation
REITs provide a bit of a tax headache to their investors but its not something that is unwieldy. REIT income can be classified as ordinary income as well as capital gains.
Ordinary income is what the REIT receives and distributes to you, from the money from rentals etc. So whatever rent the tenant pays the REIT company is classified as ordinary income.
On your part, you will need to pay taxes at the rate of your income tax bracket.
Capital gains occur when a REIT decides to sell an asset (property) and is the profit they make over the price they paid when purchasing it. This is taxed at a fixed rate.
REITs will always separate the two streams of income when distributing the amounts to you so there's nothing extra special you need to do when it comes to filing taxes.
Conclusion
All in all REITs definitely belong in a diversified portfolio thanks to their stable income characteristics and the opportunity to isolate a portion of your portfolio from the usual market cycles.
Investing in REITs is as easy as purchasing any common stock. An excellent resource to explore REIT data is the NAREIT website (https://www.reit.com/).
While this is an organization dedicated to promoting REITs, they do an excellent job of listing out market data, even if you could excuse them of talking REITs up quite a bit.