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REITs: What They Are and How They Work

| MoneyRates.com Senior Financial Analyst, CFA
min read

REIT-investmentReal Estate Investment Trusts (REITs) are investment vehicles that help ordinary investors own real estate holdings. They open up possibilities beyond traditional stock and bond investments, but along with those possibilities come risks.

As is generally the case with investment vehicles, knowledge is power. The more you know about REITs, the better able you'll be to manage the risks and take advantage of the possibilities.

What Are Real Estate Investment Trusts (REITS)?

REITs are investment funds specializing in the real estate sector. They can invest across a range of different properties or other holdings and typically focus more on generating income from those investments than gains from buying and selling.

According to Nareit, a REIT trade organization, REITs are required to invest at least 75% of their assets in real estate and must derive 75% of their income from rents, mortgage interest or property sales.

Ordinary REITs invest directly in real estate properties and derive income from the leases on those properties. Another category called mREITs invest in mortgages or mortgaged-backed securities; they derive income from the spread between the interest charged on mortgages and the cost of financing mortgages.

In either case, the REIT's management team chooses which properties or mortgage investments to own and is responsible for overseeing the management of those assets.

REITs are registered with the SEC and made up of pooled investments from 100 or more shareholders. They are required to return at least 90% of the income they earn to those shareholders annually, so they are designed to produce income on a regular basis.

Potential Benefits of Investing in REITs

Why should you consider investing in a REIT? Here are some possible benefits:

  1. Diversification

    Real estate is a separate asset class from stocks or bonds and, thus, it behaves differently. Having investments that behave differently can reduce risk through diversification because it means there is less of a chance that all your holdings could lose value at the same time.

  2. Efficiency

    By pooling the resources of a large group of investors, a REIT can efficiently invest in several properties or mortgages at once. Generally speaking, it is beyond the means of an average investor to buy a single piece of income property. let alone a collection of properties.

  3. Income

    REITs are designed to produce income. With interest rates currently very low, investors are eager for alternative sources of income and REITs are a potential solution.

  4. Inflation hedge

    Housing is a significant portion of living expenses, but REITs can act as a partial hedge against rising housing costs. In particular, REITs focused on owning residential rental properties should generally see income rise as housing costs rise.

Potential Drawbacks of Investing in REITs

No investment gives you potential benefits without some risks and complications. Here are some of the potential drawbacks of investing in REITs:

  1. Economic exposure

    Demand for housing or commercial real estate can vary depending on the strength of the economy. In a recession, demand could fall and dampen the income earned by REITs, thereby causing the price of REITs to fall.

  2. Interest-rate sensitivity

    Fluctuations in the interest rate could also impact a REIT's income. Rising rates might hurt demand, but falling rates could squeeze the interest margin of mortgage REITs. The more volatile rates become, the more variability you might see in the income earned by REITs.

  3. Geographic concentration

    Different areas of the country may go through real estate booms and slumps. The more a REIT concentrates its holdings on one geographic location, the more its returns are likely to be tied to the economic health of that region.

  4. Overpricing

    As with all securities that are bought and sold, the price of any REIT is determined by how popular it is with investors. Successful REITs tend to attract investors, which bid up the price. If a REIT's price gets pushed up faster than the rate at which its income grows, it's likely that it won't do as well in the future as it did in the past.

  5. Tax treatment

    Keep in mind that REITs pay out most of their income earned every year and that most of this is treated as ordinary income for tax purposes. Thus, REITs may have less favorable tax treatment than stocks.

  6. Leverage

    REITs may use leverage - i.e., borrowed money - to increase the amount of holdings they can buy. This can boost returns if things go well, but it can also make losses more severe in downturns. The amount of leverage a REIT uses can increase the riskiness of that REIT.

8 Things to Know Before You Invest in REITs

How can you weigh the trade-off between the potential benefits and risks of a REIT? It helps to know these eight things before you invest in REITs.

1. Type of investment vehicle

Some REITs are traded directly on the stock market; others can only be bought privately, while still others are held in mutual funds that specialize in investing in REITs.

Privately sold REITs are likely to be less liquid than publicly traded REITs. Investing in REITs via mutual funds may subject you to an extra layer of fees. When it comes to REITs, it's not just what you invest in but how you invest in it that matters.

2. Fees

The companies that manage REITs charge fees for their services. The way they assess these fees depends on how you buy the REIT.

REITs that aren't listed on the stock market may charge an up-front sales charge when you buy in. This can be very expensive unless you hold the REIT for a long time afterward.

Buying REITs via mutual funds can mean you are paying fees to both the REIT management company and the mutual fund company.

Generally speaking, buying directly on the stock market should be the most cost-effective way of buying a REIT, but the specifics can vary with each one. No matter how fees are assessed, they eat into the potential return you can earn, so you should research and compare fees before choosing a REIT.

3. Management team

The skill of the management team that's choosing and overseeing the investments in a REIT is critical to its success. It is important to know with whom you're dealing.

You'll want to make sure it's the same management team that has been responsible for the REIT's past successes. Look for a team that has earned a long track record, rather than one that may have just benefited from recent real estate conditions.

Finally, the depth of the management team - how much talent is involved in managing the REIT - is important to cushion against the impact of staff turnover and to allow for growth.

4. Geographic concentration

REITs take different approaches to where they make investments. Some want to broadly diversify across different regions while others want to focus on one particular real estate market.

The approach you choose depends on what you want to get out of the REIT. If you are trying to capture the benefits of participating in the real estate market in general, a REIT with broad geographic diversification might suit you best. If you like the outlook for the real estate market in a particular region and hope to profit from it, then you might prefer a REIT concentrated in that region.

In either case, knowing the holdings and investment objective of any REIT you consider will help you identify which best matches your investment goals.

5. Sector concentration

REITs can specialize in different types of properties. Different sectors of the real estate market benefit depending on economic conditions, so you should make sure you invest in REITs that fit well with your outlook for the economy.

Broadly speaking, the real estate market is divided between residential and commercial properties. A REIT is likely to specialize in one or the other, so you should make sure you decide which you want.

Within the commercial market, there are several specific sectors such as office space, health care facilities, industrial properties, etc. This allows you to invest in a specific segment of the real estate market that you believe will do well.

Knowing what sector a REIT specializes in should be a central part of your investment decision.

6. Occupancy rate

For REITs that depend on rents from residential or commercial tenants, occupancy rate is an important thing to know because it's a measure of the demand for that type of property.

For example, a property that is nearly fully occupied should have no problem maintaining or even raising its current rental rates. On the other hand, one that's only half-occupied may have to reduce rents to fill up the property. This could negatively impact the potential income earned by a REIT that owns the property.

It's important to know both the occupancy rate of the properties owned by the REIT you are considering as well as the occupancy rates of competing properties in the same market. The relationship of supply and demand for a particular type of property in any market will have a lot to do with how much those properties can earn.

7. Dividend yields

Since the investment returns a REIT generates for you depend on the income they earn on their holdings, dividend yield is a crucial factor to consider when choosing a REIT.

Dividend yields represent the income paid out by a REIT as a percentage of the REIT's price. This will put the REIT's earning power in perspective with the price you would have to pay for the REIT.

Dividend yields are more important than the past performance of REITs. Past performance may partly represent how a REIT's price has been driven up due to its growing popularity - something that might detract from future performance. Dividend yields can give you a sense of whether a REIT's underlying earnings have kept up with the growth in its price.

8. Amount of leverage

Using borrowed money can help a REIT generate more income. However, it can also make the management of the REIT look better than it really is, by boosting returns due to greater risk rather than due to smarter decisions.

Worse, that risk can prove to be very damaging during a downturn if the underlying investments lose value and/or if the income from them is not sufficient to cover the interest on the borrowed money.

Like any investment, REITs can be the right choice or the wrong choice depending on the circumstances. The more you understand how REITs work and the specifics of any REIT you are considering, the better chance you have of making a right choice.

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