What Are REITs, and How Do They Work?

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Updated on Thursday, January 3, 2019

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One way to grow your wealth is to invest in the real estate market. For many beginning investors, however, it’s not practical to buy real estate or be a landlord. If you want to add real estate exposure to your portfolio, one option is to buy shares of real estate investment trusts (REITs).

Before you get started, though, it’s important to understand REIT investing and its potential advantages and risks. Here’s what you need to know to determine if these investment vehicles make sense for you.

REITs explained

Basically, REITs are companies that make money from owning, and often operating, real estate that produces income. Income can come in the form of rent if the REIT owns commercial property or residential buildings or from interest if the REIT owns mortgages.

“When you invest in REITs, you can add real estate exposure to your portfolio without the capital requirements that come with buying a piece of property outright or without the hassles of being a landlord,” explained financial planner Devin Carroll of Carroll Investment Management. “It’s a way to add another asset class to your portfolio fairly easily.”

For the most part, REITs are divided into equity REITs and mortgage REITs (or mREITs).

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Equity REITs

In many cases, equity REITs invest in various types of properties and often own them. The capital comes from investors who pool their resources, and the income is a result of the activities on the property.

Just as there are sectors in other asset classes, a REIT also can be classified as:

  • Residential: single-family homes, apartment buildings and complexes (including student housing), and other living facilities
  • Retail: properties in the retail space, such as malls, strip malls, and shopping and entertainment centers
  • Lodging and resort: travel and hospitality properties, such as hotels and all-inclusive resorts
  • Industrial: large industrial spaces, such as warehouses and distribution centers
  • Health care: medical office complexes, hospitals and other health-related properties

You also can find other types of equity REITs that are even more specialized, focusing on timberland, self-storage, data centers and other types of property. Choosing one of these REITs is very similar to investing in individual stocks. Even though the REIT is a collection of properties, they are so similar in type and the way income is produced that they aren’t truly diverse.

mREITs

On the other hand, a mortgage REIT invests mainly in mortgages or mortgage-backed securities. The types of property an mREIT invests in can be residential or commercial — or can include both.

Realize that an mREIT might borrow money at one rate and use that money to purchase mortgages that come with higher rates. So, an mREIT might borrow money at a 5% annual percentage rate (APR) and then purchase a mortgage from a lender that is charging the borrower 7% APR. The difference, or spread, is 2% — and that’s where a lot of the money is made with an mREIT.

It’s also possible for an mREIT to act as the lender, providing the funds to others and then collecting on the interest.

Hybrid REITs

You also can find hybrid REITs that have qualities of both equity and mortgage REITs. These types of REITs seek the benefits of diversifying to lessen the risk of investing in just one or the other.

How REIT investing works

Because a REIT is a type of company, it’s possible to buy shares — much as you would “traditional” company stock. You can find shares on a public exchange, such as the New York Stock Exchange, and purchase them through your online brokerage account. Your REIT even has a ticker symbol and can be traded in a market order if desired.

Some REITs are unlisted, though; they’re called nontraded REITs. Getting this type of REIT is a little more difficult, and it’s hard to unload it later. There aren’t any additional tax benefits associated with nontraded REITs. However, because they aren’t offered on the public market, they can be less volatile in some cases. You can use a broker to access these investments, but it’s difficult to redeem them when you’re ready to sell.

It’s also possible to buy REITs through mutual funds and exchange-traded funds (ETFs). There are whole funds comprised only of different types of REITs.

“For beginners, using an ETF can be a way to get exposure to several different types of REITs,” said Carroll. “They’re easy to invest in, and, like avoiding picking individual stocks, you don’t get stuck with just one type of property REIT.”

The advantages of REIT investing

One of the biggest advantages of REIT investing is the fact that you can add real estate exposure to your portfolio without needing a lot of capital or managing a property yourself.

In addition to that advantage, Carroll pointed out, many investors like the higher rate of dividends from REITs. “These are organizations required to pay out at least 90% of their taxable income in dividends,” he said.

REITs aren’t taxed as corporations because they’re supposed to pay out so much in dividends. As a result, they’re sometimes referred to as a kind of pass-through corporation.

However, shareholders in REITs have the dividends taxed at their ordinary tax rate. You can reduce some of your tax liability by taking advantage of the tax reform law that passed in 2017, which allows you to deduct a portion of your pass-through income.

Since REITs are essentially shares of companies, they’re fairly liquid — as long as you stick with listed REITs and REIT ETFs.

The risks of REIT investing

As with any investment, you run the risk of losing money as a result of buying REIT shares. Market and economic conditions can lead to the loss of your initial investment. Year over year, there might be volatility. Some years, you might see gains or losses of 40% or more. You can see how REITs have performed dating back to 1972 on REIT.com.

In addition to market and economic risks, there are some risks specific to REITs.

“When real estate loses value, that can bring down REITs, for obvious reasons,” said Carroll. “Right now, I think there might be a slow crash in process, and some real estate sectors have excess capacity.”

According to Carroll, that could lead to potential REIT losses, so if you’re using them, be prepared to ride out any downturns if you think that real estate eventually will recover.

Carroll also pointed out that it makes sense to pay attention to different types of REITs and where they might be headed if you’re investing in individual REITs instead of using REIT funds.

“I don’t know what it looks like where you live, but retail is struggling, and if you’re overinvested in REITs that own strip malls, you could be in trouble,” Carroll said.

Carroll also warned that interest rates can have an outsize impact on mREITs. “Some mortgage REITs are highly leveraged and relying on short-term commercial lines of credit, so rising interest rates can affect operations,” he said. “Your spreads change, and profitability decreases.”

With unlisted REITs, the biggest issue is the lack of liquidity. You’ll probably face restrictions on when you can redeem the REITs, and finding someone to buy your shares can be problematic.

“If you’re going to buy REITs, stick with the listed shares,” said Carroll. He pointed out that they are easier to buy and sell, and the barrier to entry is low, making them ideal for beginners.

Should you include REITs in your portfolio?

In the end, a real estate investment trust can help you gain access to property without having to do a lot of the heavy lifting on your own. In fact, when you buy REITs on an exchange, you have a fairly low barrier to entry. You might be able to purchase shares of a REIT for less than $50 a share — as opposed to needing hundreds of thousands of dollars to purchase a property.

Many robo-advisors also include REITs in their asset allocation models, so even if you aren’t actively buying REITs, you can have them included in your portfolio.

According to Carroll, having up to 5% of your portfolio in REITs can be a smart move for some investors. He points out, though, that some of his fellow financial planners believe that up to 20% of a portfolio can be in REITs and still provide good results.

“REITs can be a good addition to any portfolio,” said Carroll. “Like all investments, though, you need to pay attention to your own financial goals and establish what your risk tolerance is.”

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