Investing In REITs For Beginners

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REIT investing has been around since the 1960s, when Congress decided to let individual investors partake in the returns of large-scale, income-producing real estate projects. The move was intended to stimulate the economy, and investors haven’t looked back since. Over the last 25 years, Millionacres points out that REITs have outpaced the total annual returns of the S&P 500—12.6% and 11.9%, respectively. Today, REIT investing has become a staple in diversified portfolios. These investment platforms are nothing less than a great way to break into a hot real estate market.

Real estate investment trusts (REITs) reward investors with an attractive alternative to traditional exit strategies. Traditional real estate investors spend their time investing in physical real estate assets (buying and selling properties). REIT investors are more interested in real estate companies and their respective dividends.

REIT investing has proven it can benefit investors of every level, which begs more than a few questions: What is REIT investing? Are REITs good investments? What are the most popular REITs to buy? The answers to these questions, and more, will be outlined below.

What Is A REIT?

REITs, otherwise known as real estate investment trusts, are companies that own, finance, or operate income-producing real estate assets. That said, not all income-producing real estate assets are cut from the same cloth. Real estate investment trusts hold a wide variety of assets. Office buildings, malls, apartment complexes, hotels, self-storage facilities, and warehouses are all common holdings.

Most REITs have developed a reputation for owning physical real estate assets, and generating income by leasing them. Retail mall REITs, for example, make money by leasing storefronts to subsequent business. Apartment REITs generate income by leasing units to individual tenants. While their target “customer” may be different, the business strategy is the same: own physical real estate to lease for profits.

Not all REITs own physical real estate assets. Mortgage REITs (mREITs) offer financing for others to acquire income-producing real estate. While mREITs don’t collect rent like their counterparts who own physical assets, the financing they provide does allow them to generate income off of the interest on each investment.

There are several types of REITs, but each company’s business strategy can be broken down into a simple purpose: to generate income off of real estate assets. REITs are in the business of owning and financing real estate. People can invest in REITs like every company that’s publicly traded on Wall Street. Of course, there are differences between REITs and investing in stocks for beginners, but we’ll get into that later.


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What is REIT investing?

What Is REIT Investing?

REIT investing isn’t all that different from trading on the stock market. Real estate investment trusts are molded after the same mutual funds most people are familiar with. The money spent on shares is used by the respective REIT to invest in the assets they choose. While investors are contributing the money, the REIT is actually deciding what to do with it. More importantly, REITs award investors the opportunity to take advantage of this historically prosperous real estate market without having to take out a loan.

Real estate investment trusts allow investors to invest in real estate without actually buying physical assets. They grant access to the companies which invest in real estate. Not to paint with a broad brush, but all investors need to do is sign up with a brokerage, mind due diligence, and invest wisely. There is more minutia that must be taken into consideration, but that’s the gist of it.

Not unlike every other type of investment vehicle, REIT investing comes with an inherent degree of risk. Investors must acknowledge this risk, but also understand that the proper education and knowledge can reduce their exposure to it. No investment is risk-free, and REITs are no exception. However, a well-devised investment strategy can potentially lead to years of lucrative profits.

What Are The Requirements To Become A REIT?

There are a number of criteria which distinguish REITs from other stocks traded on Wall Street. Real estate investment trusts must have the majority of their assets tied to real estate investments. Unlike their traditional real estate counterparts, REITs are required to distribute at least 90.0% of their taxable income to shareholders annually in the form of dividends.

Real estate investment trusts have limited growth potential due to their dividend requirements. However, the distribution of profits is not without its own benefit. Qualifying REITs are permitted to deduct all of the dividends they pay out each year from their corporate taxable income. This significantly reduces their taxable obligations.

In order to be classified as a REIT, the company must also:

  • be structured as an entity that would be taxable as a corporation if it wasn’t for its REIT status.

  • be managed by either a board of directors or trustees.

  • have shares that are fully transferable.

  • accumulate at least 100 shareholders within its first year of being recognized as an REIT.

  • not have more than 50.0% of its shares held by five or fewer individuals during the last six months of a taxable period.

  • invest at least 75.0% of its total assets between real estate and cash.

  • receive at last 75.0% of its gross income from real estate-related assets.

  • receive at least 95.0% of its gross income from rents, interest, financing, and dividends.

  • not have more than 25.0% of its real estate assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.

The requirements to become a REIT are strict, but the companies that meet the criteria will receive significant tax benefits.

REIT Dividends And Tax Implications

The dividends received from investing in REITs can turn into a powerful wealth-building vehicle. Done correctly, there’s no reason investors couldn’t supplement their entire income with annual dividend payments. However, there are tax implications which can’t be ignored. Dividends are viewed as income, and Uncle Sam will want his cut at tax time.

Individual shareholders who receive dividend payments must report their profits to the Internal Revenue Service (IRS). With a few exceptions, dividends received over the course of the year are treated as ordinary income and will be subject to income tax. However, Matt Frankel at Millionacres suggests there is a great way to simultaneously compound profits and shelter dividends from taxes.

According to Frankel, “tax-advantaged retirement accounts are ideal for REIT investing. You won’t have to pay any taxes on your dividends in an IRA or other retirement account, so your investment can compound much more over the years. On the other hand, REIT dividends can have a complex tax structure, so they can complicate your tax situation if held in a standard (taxable) brokerage account.”

Investors must also report their short and long-term capital gains earned by selling their REITs. Those who hold their REITs for less than a year will be subject to short-term capital gains. Investors who sell their REITs for a profit after owning them for longer than a year will be subject to long-term capital gains. Long-term capital gains are less than short-term capital gains. The rate can be 0.0%, 15.0%, or 20.0%, depending on the shareholder’s current tax bracket.

In 2020, single investors who make less than $40,000 a year won’t have to pay a long-term capital gains tax. Individuals who make between $40,001 and $441,450 will be subject to a 15.0% long-term capital gains tax. Single investors who make more than $441,451 will pay a capital gains tax of 20.0% on their dividend income.

It is considered a general rule of thumb to hold REITs for longer than a year, as any capital gains will be subject to lower taxes. However, it is important to note that REITs sold for a loss can be deducted from their taxes. While it may hurt to sell a REIT for a loss, at least investors can take advantage of this little tax break.

Are REITs Good Long-Term Investments?

REITs can be great long-term investments, but not in the traditional sense. Whereas the most attractive long-term stock investments are the result of decades of growth, REITs rely on dividends to appease investors.

REITs are required (by law) to pay at least 90.0% of their taxable income to shareholders in the form of dividends. Doing so inherently limits the growth potential of just about every company that is considered a REIT. In return for paying dividends to their shareholders, REITs aren’t required to pay corporate taxes.

That’s not to say REITs can’t exhibit tremendous growth potential, but rather that the most attractive benefit about investing in REITs for a long period of time is the accumulation of dividends. Anyone who owns a share of a REIT will receive a dividend payment (in the form of a percentage of the share price). Most REITs distribute dividends quarterly, but dividend disbursements can range from monthly to annually. The number of times a REIT distributes dividends will depend on the company and its financial fortitude.

REITs aren’t the only stocks that pay dividends. Many stocks on the S&P 500 pay dividends to shareholders. Nonetheless, REIT dividends are usually larger than their stock counterparts, and typically more frequent.

As recently as July 2020, traditional stocks (not REITs) on the S&P 500 boasted a 1.68% dividend yield, according to REIT.com. All tax-qualified REITs listed on the NYSE, the American Stock Exchange, or the NASDAQ National Market List boasted a dividend yield of 4.06%.

Those who invest in REITs are commonly referred to as income investors, as each dividend granted to an investor is seen as income in the eyes of the IRS. With a large enough position in a number of quality REITs, there’s no reason today’s best REIT portfolios couldn’t generate enough passive income to replace an annual salary; that’s why they call it income investing.

Frankel suggests investors pay close attention to two indicators if they want to optimize their long-term returns. “The first is growth potential—you want to focus on REITs that invest in growing markets. Think healthcare properties, warehouses, and data centers as opposed to shopping malls. Next, take a look at the REIT’s track record of growth and dividend payments.”

“Looking at the REIT’s credit ratings can also give you some insight to the risk level—you want investment-grade credit ratings. Essentially, for long-term REIT investments, you want to look for quality and sustainability,” said Frankel.

Investing In REITs Vs Real Estate

REIT investing allows investors to tap into the potential of the real estate industry without actually buying any physical assets. Instead of buying properties, those investing in REITs can actually invest in companies that invest themselves. REIT investors can capitalize on a market that has performed historically well without actually buying property, and instead buying what are essentially stocks traded on Wall Street. With the exception of a few years, annual REIT returns have actually outpaced the S&P 500, dating all the way back to 1972.

Physical real estate will place a lot more control in the hands of the investor. Real estate investors naturally have a larger role to play in their own investments, which means their success and failure is mostly dependent on their own actions.

Despite the less-passive approach, physical real estate investors have proven “flipping” can produce attractive returns. According to Attom Data Solutions, “Homes flipped in the first quarter of 2020 were sold for a median price of $232,000, with a gross flipping profit of $62,300 above the median purchase price of $169,700. That gross-profit figure was up from $62,000 in the fourth quarter of 2019 and from $60,675 in the first quarter of last year.”

There is no definitive claim to be made in the “investing in REITs vs real estate debate.” Both investment vehicles have proven they would make a valuable addition to any investment portfolio. The biggest differentiation between the two is really the passive nature of REIT investing and the active nature of rehabbing physical assets.

What Are The Types Of REITs?

REITs are nothing, if not diverse; they are simply one of the easiest ways for real estate investors to gain exposure to several different industries. It is entirely possible to invest in commercial buildings, single-family homes, shopping malls, movie theaters, and just about any other form of income-producing properties. If that wasn’t enough, there’s even more diversity offered up by the type of REIT investors choose to invest in. There isn’t a single type of REIT investors must choose from, but rather four:

  1. Equity REITs

  2. Mortgage REITs (mREITs)

  3. Public Non-Listed REITs (PLNRs)

  4. Private REITs

Equity REITs

These REITs make up the majority of REITs publicly traded on today’s major market indices. Equity REITs are ubiquitous with companies that own or operate income-producing real estate. Anyone investing in equity REITs is actually investing in companies which invest in portfolios of income-producing real estate. As companies that invest in physical real estate, it’s quite common for equity REITs to own and operate real estate in each major sector. Office buildings, shopping centers, and apartment complexes are all common holdings. Equity REITs are required to distribute at least 90.0% of their income to invested shareholders.

Mortgage REITs (mREITs)

Mortgage REITs do not invest in income-producing real estate, but rather in mortgages and mortgage-backed securities. These REITs act as the bank and collect interest on the financing they provide for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities. In other words, mortgage REITs invest in mortgages. By offering the capital other REITs need to invest in real estate, mortgage REITs can sit back and collect interest on the money they lend out.

Public Non-Listed REITs (PLNRs)

Public non-listed REITs own and operate (or finance) income-producing real estate portfolios. However, they aren’t traded on major securities exchanges and they face strict redemption restrictions levied by the U.S. Securities and Exchange Commission (SEC). Public non-listed REITs are required to make regular SEC disclosures, which hurts their ability to remain liquid.

Private REITs

Private REITs do not trade on national stock exchanges. Unlike PLNRs, private REITs are exempt from SEC registration. The exemption does not subject private REITs to the same disclosure requirements as other REITs, which means they do not need to publicly announce financial reports. Instead of trading like the previous REITs, private REITs are generally reserved for institutional investors.

Different REIT Specializations

Within each type of REIT, businesses may operate in a number of different sectors (or specializations). Here is a list of the sectors most REITs choose to operate in:

  • Data-Center REITs: As technology evolves, data-center REITs are growing in popularity. As their names suggest, data-center REITs own real estate which is specifically equipped to house data centers; they tend to have increased security measures, sizable plots of land, and temperature regulation specifications.

  • Healthcare REITs: Healthcare REITs own a variety of physical real estate assets that can range from medical care facilities like hospitals, senior housing, and wellness centers to doctors’ offices and life science operations.

  • Self-Storage REITs: As perhaps the most straightforward of today’s REIT specializations, self-storage REITs own self-storage facilities. These business rent storage units to generate income on a monthly basis.

  • Office REITs: Not unlike their residential counterparts, office REITs can invest in a number of unique assets within the office industry. While their primary focus is on commercial office space, the field may be expanded to include high-rise buildings and single-story offices in suburban neighborhoods, and everything in between.

  • Hospitality REITs: Hospitality REITs cater to the hospitality industry, which means the majority of companies in this specialization tend to own hotels, restaurants, and perhaps even retail outlets.

  • Industrial REITs: Industrial REITs have developed a reputation for owning large industrial spaces. Most industrial REITs, for example, tend to own large facilities like warehouses, factories, and distribution centers.

  • Residential REITs: Most residential REITs build portfolios around apartment complexes, but some choose to specialize in single-family assets. Either way, residential REITs invest in residential housing that spans across a number of unique assets, not the least of which include housing on college campuses and apartment buildings located in the middle of today’s most populous cities.

  • Retail REITs: Retail REITs diversify themselves among malls, shopping centers, and net-lease properties.

  • Infrastructure REITs: Infrastructure REITs own a wide variety of properties (and land) which house the foundation of our daily lives. For example, infrastructure REITs can own cell towers used by communication companies, fiber optic networks utilized by tech companies, and any type of infrastructure asset that requires land or a physical real estate asset to operate.

  • Timberland REITs: Timberland REITs own large plots of land, which they use to grow a variety of trees. The trees are harvested to produce products, which the companies then sell to make a profit.

  • Diversified REITs: Not all REITs fit into a single specialization. A lot of REITs own a combination of the assets listed above, which is why they fall into this category.

  • Specialty REITs: The sheer volume of real estate assets is too large to contain to a single list, which is why many of the real estate assets that don’t fit anywhere listed above will fall under the “specialty” category. Properties reserved for educational purposes, farmland, and prisons, for example, belong in the specialty REIT category because they don’t meet the criteria of anything else; they are too unique.

REIT Investing Pros And Cons

Investing in a REIT is just like investing in everything else: there are pros and cons that need to be addressed. Most investors will suggest the pros greatly outweigh the cons. The real estate industry has performed historically well, and REITs are a great way for investors to tap into that potential. However, investors must mind their own due diligence. As a result, here’s a list of REIT investing pros and cons.

Pros Of REIT Investing

The pros of REIT investing are attractive enough to capture the attention of even the most entry-level investors. Here are some of the best reasons most people start investing in REIT companies:

  • History Of Competitive Performance: Historically speaking, REITs have outpaced the returns exercised by traditionally traded U.S. stocks. From 1972 to 2019, the total annual return on the S&P 500 was about 12.1%. Over the same period, FTSE NAREIT ALL EQUITY REITS returned 13.3% annually.

  • Liquidity: Due to their placement on most major stock indices, REITs remain particularly liquid. Unlike physical real estate, the money investors have in REITs can be accessed relatively easily, and quickly. Therefore, transferring capital or reinvesting it isn’t difficult, at least compared to other investment vehicles.

  • Dividend-Based Income: In order to be classified as an REIT, companies need to pay at least 90.0% of their taxable income to shareholders. The disbursement of funds that REITs are required to maintain is a great wealth-building vehicle for savvy investors. Dividends can really help grow an investor’s bottom line, and it certainly doesn’t hurt that REITs have to pay them.

  • Diversification: REITs enable investors to buy into not only different industries but different REITs as well. Investors can invest in REITs that specialize in income-producing properties, or they can choose to invest in REITs that specialize in mortgages. On top of that, the REITs themselves are about as diverse an industry as any other; you can invest in everything from apartment buildings and commercial properties to movie theaters and malls.

  • Transparency: Regulated by the SEC, most REITs are required to divulge important information like earnings reports, so there’s a lot more transparency in the REIT world than in a number of other investment vehicles. For the most part, investors can know what to expect, outside of predicting the actual market itself.

Cons Of REIT Investing

What is REIT investing, if not for another way to diversify your portfolio? As an investment, REITs are not without their own caveats, however. Along with the pros, there are cons, and they are worth paying attention to. Here are some of the cons of investing in REITs you’ll want to consider before making any big decisions for yourself:

  • Limited Growth Potential: Their upside is limited by the very thing that makes them attractive to investors: dividends. REITs, therefore, have less money to reinvest in their own company, and are essentially their own worst enemy; it’s very much so a double-edged sword scenario.

  • Tax Exemptions: Some of the dividends shareholders receive are taxed as ordinary income, whereas most other dividends are taxed at a lower rate.

  • Interest Rates: The performance of REITs are inherently tied to interest rate trends. When rates increase, they eat into the profit margins of REITs. What’s more interesting, however, is that interest rates usually rise when the economy is strong enough to handle them.

  • Susceptible to Market Fluctuations: While the performance or REITs are generally tired to the real estate market, they can be influenced by volatile market fluctuations, from time to time.

The Most Popular REITs To Buy

The most popular REITs to buy are entirely contingent on each individual’s exit strategy. Investors must first understand why they are investing in REITs before they actually open a position in any business. Some REITs are better for income investors, while others offer more growth potential without high dividend yields.

Today’s most popular REITs are in no way indicative of the best REITs to own in the future. It is impossible to predict the stock market, as evidenced by the selloff resulting from the recent pandemic, and perhaps the even more incredible return to historic highs in less than six months.

There’s no telling what tomorrow holds for REITs, and anyone telling you they know what to expect is lying. However, it is possible to look at current trends and extrapolate them out over the next several years. With that in mind, these REITs look poised for a long, prosperous run:

  • STAG Industrial, Inc. (STAG): STAG Industrial owns a number of factories, manufacturing plants, and other similar industrial locations, not the least of which are leased to clients and generating income. More importantly, STAG appears well-positioned to benefit from the growing e-commerce trend and tensions with China. E-commerce giants like Amazon will look to industrial REITs like STAG for everything from warehouses to factories, and STAG is more than ready to meet their demand. Additionally, the trade war is expected to boost domestic manufacturing jobs, many of which could be located in STAG assets.

  • Digital Realty Trust, Inc. (DLR): As a data-center REIT, Digital Realty Trust is the primary beneficiary of twenty-first-century digitization. With more employees working from home,  more companies are turning to “the cloud” in order to ensure operations continue. DLR has seen demand for its warehouses increase exponentially, and there’s nothing to suggest the demand will slow down.

  • American Tower Corporation (AMT): American Tower is one of the best REITs out there, and it’s trading at a fair price. The most promising trend working in favor of AMT at the moment appears to be its position in the upcoming 5G revolution. American Tower expects nothing less than strong growth for its assets in the 5G transformation, and there’s no reason to believe one of the biggest REITs in the world can’t deliver on its promise.

Summary

With a successful track record spanning nearly half a century, REIT investing strategies should be included in most well-diversified portfolios. The ability of the best REITs to reward investors with both growth and dividend income can’t be replicated. Long-term investors, in particular, can compound income growth over decades with a proper dividend reinvestment (DRIP) plan, all while enjoying the passive nature of REIT investing.

Have you been toying with the idea of REIT investing? Better yet, are you already investing in REITs and in need of some direction? Let us know how we can help you in the comments below:

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