Investing in real estate can be a rewarding experience, offering both tangible appeal and performance potential. Like most Americans, you may think of real estate investment as purchasing a house or a plot of land. However, investment opportunities reach far beyond your front door or lot line. An investment in shopping centers, office buildings and hotels may be just as gratifying to you as home ownership, thanks to real estate investment trusts (REITs).
REITs are companies that invest in portfolios of professionally managed properties. They come in three varieties:
- Equity REITs own real estate assets and make up most of the market.
- Mortgage REITs loan money to real estate owners or invest in existing mortgages or mortgage-backed securities.
- Hybrid REITs combine the investing strategies of both equity and mortgage REITs.
REITs enjoy certain tax advantages but must meet a series of investment and operating requirements: To qualify as a REIT, a company must invest at least 75 percent of its total assets in real estate assets; it must derive at least 75 percent of gross income from rents or interest on mortgages; and most importantly, it must pay dividends of at least 90 percent of its taxable income in the form of shareholder dividends.
REITs have characteristics of both stocks and bonds, but have historically exhibited a low correlation to both. REITs combine a steady income component with dividend growth potential and the opportunity for capital appreciation. Historically, REITs have generated market-comparable returns with lower volatility. Combining each of these return characteristics suggests that REITs add significant portfolio diversification benefits.
What advantages can REITs offer to me?
- REITs that are traded on a major stock exchange offer liquidity that is not available from direct property investment.
- REITs are permitted a dividends-paid deduction that allows them to generally avoid federal and state income taxes, eliminating the double taxation of income. REITs are permitted to pass gains from property sales to shareholders at the lower capital gain rate.
- Professional management by experienced real estate professionals.
- Portfolio diversification.
- Stable, growing dividend income.
What factors should I consider when selecting a REIT?
- Management: Look for seasoned management teams that have a meaningful personal stake in the company, which align the interests of management and shareholders.
- Solid balance sheet and manageable dividend policy: High yields are tempting, but REIT yields above a certain level can mean there is not enough recurring income to fund current distributions or be reinvested for development and acquisitions, which could shortchange long-term growth. Too much debt could also hinder growth capability.
- Markets and Demographic Trends: Consider the supply and demand characteristics of the markets in which the REIT invests. In the case of apartment REITs, for example, ask about the area’s direction of vacancy rates and rents, the amount of new apartment construction, and the affordability of home ownership. The higher the cost of home ownership, the more attractive an apartment REIT might be.
Are there risks associated with REITs?
As with any investment, REITs have associated risks that you should consider before adding them to your long-term portfolio.
- REIT investments are confined to the real estate industry. Some REITs limit diversification even further by focusing on specific property sectors (e.g., apartments, office, retail) or on a single geographic region.
- REITs are subject to changes in the value of their underlying portfolios, and their prices may fluctuate with changes in their real estate holdings.
- REITs may be interest-rate sensitive over a short-term investment horizon. Rising rates can not only negatively impact the relative return of competitive yield investments, but also increase borrowing costs.
Real estate remains a classic investment in America’s future, and REITs make this investment a great way to add total return potential to a diversified, long-term portfolio. Your financial advisor can help you determine ways to incorporate these professionally managed investments into your portfolio. IBI