REITs make money on the properties they buy by renting, leasing or selling them. Shareholders elect a board of directors, who are responsible for choosing the investments and hiring a team to manage them on a day-to-day basis. Amanda Bellucco-Chatham is an editor, writer and fact-checker with years of experience researching personal finance topics. Her specialties include general financial planning, career development, lending, retirement, tax preparation and credit.
Approximately 24 percent of REITs' investments are in shopping centres and freestanding shops. This represents the largest investment by type in the United States. Whatever mall you frequent, it is likely to be owned by a REIT. When considering investing in commercial real estate, first look at the retail sector itself.
Is it financially healthy today and what are the prospects for the future? It is important to remember that retail REITs make money from the rents they charge tenants. If retailers have cash flow problems due to low sales, they may delay or even default on those monthly payments, eventually being forced into bankruptcy. At that point, a new tenant has to be found, which is never easy. Therefore, it is crucial that you invest in REITs with the strongest possible anchor tenants.
These include grocery shops and home improvement shops. Once you have made your sector assessment, your focus should turn to the REITs themselves. Like any investment, it is important that they have good earnings, strong balance sheets and as little debt as possible, especially short-term debt. In a poor economy, retail REITs with large cash positions will have the opportunity to buy good real estate at depressed prices.
Better managed companies will take advantage of this. That said, there are long-term concerns for the retail REIT space, as shopping is increasingly moving online, as opposed to the mall model. Space owners have continued to innovate to fill their space with office and other non-retail oriented tenants, but the sub-sector is under pressure. These are REITs that own and operate multi-family rental apartment buildings as well as manufactured housing.
When it comes to investing in this type of REIT, there are several factors to consider before jumping in. For example, the best flat markets tend to be those where housing affordability is low relative to the rest of the country. In places like New York and Los Angeles, the high cost of single-family homes forces more people to rent, which drives up the price that landlords can charge each month. As a result, the largest residential REITs tend to focus on large urban centres.
Generally, when there is a net influx of people into a city, it is because jobs are available and the economy is growing. A declining vacancy rate coupled with rising rents is a sign that demand is improving. As long as the supply of flats in a particular market remains low and demand continues to increase, residential REITs should do well. As with all companies, those with the strongest balance sheets and the most available capital are typically the best performers.
Healthcare REITs will be an interesting sub-sector to watch as Americans age and healthcare costs continue to rise. Healthcare REITs invest in the real estate of hospitals, medical centres, nursing homes and retirement homes. The success of these properties is directly linked to the healthcare system. Most operators of these facilities rely on occupancy rates, Medicare and Medicaid reimbursements, as well as private payments.
As long as healthcare financing is a question mark, so are healthcare REITs. Things to look for in a healthcare REIT include a diversified group of clients, as well as investments in various types of properties. Concentration is good to some extent, but so is risk spreading. Generally, an increase in demand for healthcare services (which should occur with an ageing population) is good for healthcare real estate.
Therefore, in addition to diversification of clients and property types, look for companies with significant healthcare experience, strong balance sheets and high access to low-cost capital. Office REITs invest in office buildings. They receive rental income from tenants who typically have signed long-term leases. I can think of four issues for anyone interested in investing in an office REIT Try to find REITs that invest in economic strongholds.
It is better to own a lot of average buildings in Washington, D.C. Approximately 10 percent of REITs' investments are in mortgages rather than in the real estate itself. The best known, though not necessarily the best, investments are Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages in the secondary market. But the fact that this type of REIT invests in mortgages rather than equities does not mean that it is risk-free.
A rise in interest rates would result in a decline in the book value of mortgage REITs, which would depress the share price. In addition, mortgage REITs raise a considerable amount of their capital through secured and unsecured debt offerings. If interest rates rise, future financing will be more expensive, reducing the value of the loan portfolio. In a low interest rate environment with the prospect of rising interest rates, most mortgage REITs trade at a discount to net asset value per share.
The trick is to find the right one. According to the Securities and Exchange Commission, a REIT must invest at least 75 per cent of its assets in real estate and cash, and derive at least 75 per cent of its gross income from sources such as rent and mortgage interest. REITs have some drawbacks that investors should be aware of, particularly the potential tax liability they may generate. Most REIT dividends do not meet the IRS definition of qualified dividends, which means that above-average dividends offered by REITs are taxed at a higher rate than most other dividends.
REITs do qualify for the 20% deduction, however, most investors will have to pay a large amount of tax on REIT dividends if they hold them in a standard brokerage account. Another potential problem with REITs is their sensitivity to interest rates. Typically, when the Federal Reserve raises interest rates in an attempt to restrain spending, REIT prices fall. In addition, different types of REITs present property-specific risks.
Hotel REITs, for example, tend to perform very poorly in times of economic downturn. Dividends are taxed as ordinary income Risks associated with specific properties Investing in REITs is an excellent way to diversify your portfolio away from traditional stocks and bonds and can be attractive because of strong dividends and long-term capital appreciation. Each type of REIT has its own risks and rewards depending on the state of the economy. Investing in REITs through a REIT ETF is a great way for shareholders to get involved in this sector without having to personally deal with its complexities.
As with any investment, there is always a risk of loss. Publicly traded REITs have a particular risk of losing value when interest rates rise, often sending investment capital into bonds. Investing in certain types of REITs, such as those that invest in hotel properties, is not a great option during an economic downturn. However, investing in other types of real estate, such as healthcare or commercial properties, which have longer lease structures and are therefore much less cyclical, is a good way to protect against a recession.
Any increase in the short-term interest rate eats into profit, so if it were to double in our example above, there would be no profit left. And if it goes even higher, the REIT loses money. All this makes mortgage REITs extremely volatile, and their dividends are also extremely unpredictable. The business model of most REITs is easy to understand.
The company owns a portfolio of real estate, such as office buildings, which it leases to tenants who pay rent. REITs use this money to cover property expenses, such as the mortgage. What is left over is known as the net operating income (NOI) of the property. REITs make their money from the mortgages underlying the property development or from rental income once the property is developed.
REITs provide shareholders with a steady income and, if maintained over the long term, growth that reflects the appreciation of the properties they own. They return a minimum of 90 per cent of taxable income in the form of dividends to shareholders each year. This is a major attraction for investor interest in REITs. REITs make money from their properties, either by selling or leasing them.
Unlike other real estate companies, which develop properties with the objective of selling them, a REIT's primary objective is to develop properties, manage them and add them to its own investment portfolio. If a REIT's properties appreciate in value, the owners provide shareholders with income in the form of dividends. Equity REITs invest in properties and earn income from rent, property sales and dividends. Mortgage REITs, as the name suggests, invest in mortgages and mortgage-backed securities (a type of asset backed by a mortgage or pool of mortgages).
These types of trusts can earn income through the interest charged on mortgages, but because of this, changes in interest rates can greatly affect their performance. Finally, hybrid REITs invest in a combination of mortgages and real estate. The Code specifies that REITs must hold 75 per cent of their assets in cash, treasury bills or real estate, and must distribute 90 per cent of their taxable income in dividends to shareholders each year. A real estate investment trust - the cool kids call it a REIT, pronounced "reet" - is basically an investment fund that buys real estate instead of stocks.
A passive real estate investment is one in which you enjoy the benefits of real estate ownership without having to endure the headaches of managing the investment property. While this keeps your taxable income low, it masks the true earnings power of a REIT, which is why most use various non-GAAP metrics to show investors a more accurate picture of your cash flow. Many broker-dealers offer these funds, and investing in them requires less work than researching individual REITs to invest in. Once investors have a better understanding of these aspects, they can better analyse whether a REIT can continue to pay its investors generous dividend income even as it invests money to grow its commercial real estate portfolio.
REITs allow anyone to invest in portfolios of real estate assets in the same way they invest in other industries - through the purchase of individual shares of the company or through a mutual fund or exchange-traded fund (ETF). NerdWallet does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks or securities. Therefore, REITs may not be able to buy real estate exactly when they want to, but when investors are again willing to buy stocks and bonds in the REIT, the REIT can grow again. They also offer the most liquid shares, which means that investors can easily buy and sell REIT shares much faster, for example, than investing and selling real estate themselves.
Unlike most real estate investment income, dividends received from REITs do not enjoy preferential tax treatment. In fact, there is an intense and ongoing debate among investors as to whether real estate is a better long-term investment than equities. REITs' track record of reliable and growing dividends, combined with long-term capital appreciation through share price increases, has provided investors with an attractive total return for most periods over the past 45 years compared to the stock market in general, as well as to bonds and other assets.