But with so many ways to invest your money, it can be difficult to determine where you should begin. New investors tend to be most familiar with the stock market, so they often flock to investments in securities and fail to consider the real estate market.
Real estate investments can seem like an unreachable goal to the individual investor. How can one person manage the cash flow to buy and run property on their own?
What most investors don’t know is that there are more ways to invest in real estate than they think. REITs, for example, are a real estate investment opportunity too many investors skip over.
Below, we’ll cover what REITs are and why they might be a great option for your investment portfolio.
What Does REIT Mean?
REIT stands for “real estate investment trust.” They were invented in the 1960s to make real estate investment more accessible for the average investor.
The same financial thresholds that make newer investors wary of wading into the real estate market were present even back then. The difference was that, for the most part, individual property ownership was really the only option the majority of investors had at the time.
With such high upfront costs for property, most working-class and middle-class people stayed out of the real estate market because it was too costly for them. REITs changed that.
Today, real estate investment trusts make money through the financing or ownership of income-earning properties. REITs give the everyday investor the opportunity to buy into this well-regarded financial market.
Real Estate Investment for Everybody
Real estate is an appealing investment because property prices rarely, if ever, decrease. As capital appreciation and capital gains are critical aspects of attractive portfolios, REIT ETFs are highly valued by financial advisors and investors alike.
Investing in property is one of the safest ways to get a return, as land is a finite resource, and demand for its limited supply will continue to increase.
Since development cannot currently compete with the demand for real estate, it’s unlikely that supply will fall below demand for property at a national level.
Of course, looking at past performance, American real estate is not immune to volatility; however, increasing your portfolio diversification through the property is, at present, a great way to stabilize your total returns.
What Do REITs Do?
In the same way, the Ford Motor Company earns its income by manufacturing and selling automobiles, REITs earn their income from the operation of the properties in their portfolio. While Ford’s profits come from car sales, REITs earn money from leasing their properties or selling them for a profit.
Residential properties like multi-family homes, condos, or apartments produce REIT income from the rent paid by their tenants. If the REIT sells a property for a profit, that income also contributes to the overall earnings of the trust.
REITs may contain all sorts of property types — even industrial and commercial properties that were traditionally very inaccessible to the average investor. Their immense buying power allows investors to get a foot in the door with expensive income-earning properties.
Different Types of REITs
- Residential REITs
- Retails REITs
- Healthcare REITs
- Office REITs
For the most part, a given REIT is based on a particular type of property. A REIT might specialize in warehouses, factories, retail shops, restaurants, or any other kind of property. They might even be limited to your geographic area, so you can invest in real estate in the same city where you live.
With such a diverse range of properties, investors can make informed decisions on the types of REITs they want to invest in. Here are a few examples of different types of REITs.
A residential REIT consists primarily of housing properties — from prefab homes to multi-family houses. You can invest in residential REITs based on their geographical location.
A Residential REIT whose portfolio consists of housing assets in cities with high rental demand like New York City or Los Angeles will be more reliable than cities with lower demand, like Detroit.
Retail REITs are one of the most common types of REITs on the market. In fact, about 24% of all REIT capital comes from commercial retail properties.
REITs can vary by the type of retail business in their portfolio. For instance, some retail REITs may consist mostly of grocery stores, clothing shops, or even ice cream parlors. With that level of specificity, there’s a lot to consider before jumping in.
Buying into an ice cream shop-based REIT during the wintertime may not be the best investment, for example. The return on your investment will be based on the rent paid by the businesses leasing the REIT’s assets, so you’ll want to choose industries and markets where businesses aren’t likely to go bankrupt anytime soon.
Examining the specific type of industry that a given retail REIT serves can make a world of difference in the quality of your investment.
Healthcare REITs invest in properties like hospitals, urgent care clinics, retirement homes, and nursing centers. These properties are a cornerstone in every community.
Considering that healthcare facilities will always be necessary and that more people are aging into the need for assisted living, healthcare REITs are generally a reliable investment.
Office REITs specialize in office spaces that may host a number of different businesses. The stronger an economy is, the higher the likelihood that an office REIT will perform well.
How To Invest in a REIT?
Just search for the type of REIT you want to invest in, find the right one for you, and buy as many shares as you feel comfortable acquiring. Because REITs are functionally the same as any other company on the market, you can buy and sell your shares as you see fit.
The accessibility of REITs lies in the fact that they are publicly traded on the stock exchange. Instead of needing thousands of dollars to invest in real estate, investors can get involved at a fraction of that amount by buying shares of a REIT on the exchange.
The relatively low cost of REIT stocks means that even high-value real estate assets can become accessible to everyday investors.
REITs must follow a strict set of standards in order to operate. The IRS outlines the requirements necessary to qualify as a REIT to offset the chance that REITs could become a danger to the commercial real estate market — and to prevent any chance of fraud.
Here are the guidelines REITs must follow in order to trade on the market:
- They must consist of at least 100 shareholders to prevent power imbalances.
- Five or fewer investors cannot hold 50% of the shares.
- They must operate and function as a taxable corporation, and they must be run by a board of trustees.
- At least 90% of the REIT’s taxable income must be paid out as shareholder dividends.
- Cash, real estate, or US Treasury bonds must make up a minimum of 75% of gross asset investments.
- Sales on real estate, accumulated mortgage interest, or rent paid must make up 75% of total income.
These guidelines ensure that REITs operate in good faith, making them a safer investment for the everyday investor and keeping them from negatively affecting the real estate market.
What Are the Returns for REITs?
The fact that REITs are legally required to pay out at least 90% of their taxable income to investors means that they are more or less guaranteed to pay out fairly well. Indeed, REITs have been shown to perform better than other indexes on the stock exchange when it comes to returns.
For the past 20 years, the average annual return for FTSE NAREIT All Equity REIT index was 11.3% — compared to the long-term historical annual return average of the S&P 500 at 10.5%. Given the dividend income paid to shareholders when a REIT makes a profit on assets sold, REITs can generally provide investors a fairly lucrative return.
What Are the Benefits of REITs?
- Consistent Dividends
- Good Returns
- High Liquidity
To start with, being legally obligated to pay out 90% dividend yields makes REITs a solid asset. Some of the best-performing REITs will see higher payouts over time as they continue to utilize the strengths of their assets.
The relatively high returns of REITs make them a bankable investment. Compared to indexes in other asset classes, REITs generally maintain a favorable level of performance for returns.
REITs offer investors a high liquid option for real estate investment. Whereas real estate assets through property ownership can take months to liquidate, REITs can be bought and sold within days.
The Drawbacks of REITs
- Higher Correlation
- Slow Growth
Correlation describes how one asset’s performance affects another. Real estate typically has a low correlation compared to other asset classes — but because REITs are more closely associated with public trading, they tend to have a higher degree of correlation than other real estate investments.
REITs are a solid long-term investment, but their growth isn’t as explosive as other investment options. Since they are required to distribute their profits, REITs don’t have the capital on hand to grow their value as fast as other investment opportunities.
The dividends REITs that pay out are an appealing stipend for your investment. However, the REIT does not pay taxes on its sales, so the investor must pay taxes on their own dividends.
Private Equity Real Estate is the Better Option
REITs have some advantages, but for investors who want more benefits and fewer drawbacks in their real estate investment, private equity real estate funds are a better solution.
As their name suggests, private equity funds are not publicly traded like most REITs. Where REITs are subject to the volatile conditions of public trading, private equity funds are professionally managed and offer a more direct relationship with their investor pool.
Because private equity real estate funds are more exclusive, they retain lower levels of correlation than REITs. They can also see faster growth thanks to the infusion of funds from their investors. Ultimately, REITs may not be the wisest choice in the current market ecosystem; instead, you should consider investing with private equity real estate companies, like Christina.