Kristal Insights5 Mins Read
Everything You Need To Know Before Investing in REITs
Real Estate as an investment option has been around for long. It has become an important component of an investor’s portfolio. But here’s a catch – real estate is pricey. Buying, or even selling (when you need the money) isn’t a cupcake. What’s even worse is if you made a real-estate investment, (say you invested in a piece of land three years back) and are not able to sell your holding because of a market shift.
Sounds scary, right? This is where REITs or Real Estate Investment Trust comes into play.
What is a REIT?
Real Estate Investment Trusts (REITs) are a unique set of stocks worth considering in your long-term retirement portfolio. They are good for generating a steady income. And they expose you to capital appreciation over a period as the property value increases. The diverse choices range from apartments to shopping malls and offices.
A REIT is an investment vehicle that pools investor money to buy real estate assets. Think of it as similar to an Exchange Traded Fund (ETF) or Mutual Fund. Except that instead of investing in a basket of stocks or bonds, a REIT uses investors’ money to buy and operate a portfolio of properties. In a sense, you become a shareholder or part-owner of the properties that it manages.
A Real Estate Investment Trust specializes in a particular type of real estate. A residential REIT pools money and invests only in apartment buildings. Retail REITs invest in shopping mall properties. To an investor, this provides exposure to different property types without a large lumpsum investment.
However, the main driver for investing is the dividend yield. REITs generate income in the form of rent, which passes onto the shareholders. This dividend is similar to that paid by a company to shareholders. However, to qualify as a REIT, the company must fulfill certain requirements.
A REIT, therefore:
- Must be structured as a corporation
- Must have at least 100 shareholders
- Must invest at least 75% of the funds in real estate, cash or government assets
- Must derive at least 75% of income from real estate
- Must pay out at least 90% of taxable income to shareholders annually
As long as it satisfies these requirements, it is exempt from corporate taxes. So unlike a typical corporation, which has to pay taxes on earnings, a REITs’ income is not taxed. This leaves more money to pass on to shareholders.
5 Reasons to invest in REITs
REITs provide easy access to real estate assets that may be unaffordable otherwise. Listed below are some of the key benefits of investing in REITs:
- High Yield – This is a big one! REITs pay out most of their taxable income to shareholders. Thus offering high stable dividend yield. Yields may vary depending on the type of REIT and geography. Usually, it is anywhere between 4% to 8% (paid out quarterly or half-yearly).
- Hassle-Free – REITs make it easier for an investor to access unaffordable properties. Buying and selling the property directly would, in fact, involve higher expenses. When you invest in REITs, you don’t have to worry about administrative requirements. There are professional managers who deal with that.
- Diversification – Their returns have a low correlation to equity stocks and fixed-income investments. This makes it a good portfolio diversifier. When most stocks are overvalued; a good strategy is to invest more in bonds and REITs instead. REIT share prices are also less volatile than equity stocks. This is because rental income and expenses are predictable over the short and long term.
- Total Return – Besides income, REIT prices also capture the price appreciation of the underlying properties. Hence it is a good hybrid between dividend income and growth in the stock price. Since real estate has a high return potential. REITs (in the long term) show strong returns and outperform the stock index. In 2019 alone REITs rallied by ~15%, outperforming the S&P 500 index.
- Tax Advantage – REITs are not taxed on the corporate level as long as they pass most of their earnings to shareholders. But, investors do need to pay taxes on dividend income and capital gains from sales of the REITs.
Now the question everyone’s asking. Are REITs safe?
Let’s look at the risk factors affecting REIT investments. A major risk of investing in Real Estate Investment Trusts is that the value of the fund depends upon the underlying value of the real estate. Any slump in the real estate market will affect the fund price. This could mean potential losses in your portfolio. In some ways, a REIT is a concentrated bet on the specific property type. This makes it riskier compared to mutual funds which are well diversified.
Below are some of the other risks investors need to be aware of:
- REITs behave like fixed income products in that they are sensitive to changes in interest rates.
- If interest rates rise, REITs are expected to pay a premium over the risk-free rate of US government bonds. Hence put downward pressure on the stock price.
- When interest rates rise Treasury securities become more attractive, thereby drawing funds away from REITs.
- Properties generally face a liquidity challenge if there aren’t enough buyers and sellers. This affects the REIT stock price, which may be less liquid compared to funds investing in financial securities.
- There is also a risk of choosing the wrong REIT which has exposure to an out-of-favor type of real estate.
It’s important to do research on current trends affecting the real estate market before investing.
Types of REITs
REITs fall into two main categories – Equity REITs and Mortgage REITs. The majority of REITs are Equity REITs. These own or operate real estates that generate income e.g. apartment buildings, offices, or shopping centers. Mortgage REITs finance real estate projects. It earns income from the interest on these investments.
While there multiple types of Equity REITs, below are the 4 main ones:
- Residential REITs invest mostly in apartment buildings, student housing, and single-family homes. The largest residential REITs focus on urban centers where home affordability is low. Those with the strongest balance sheets normally do the best. We have a REIT ETF which has a 14.19% stake in the residential sector.
- Retail REITs own roughly a quarter of the REIT market. These REITs invest in shopping malls and other retail stores. Retail REITs generate cash flows from rent charged to tenants. The performance of such REITs depends on tenants generating steady cash flow. As it is hard to find a new tenant. It is crucial to invest in retail REITs with strong anchor tenants such as grocery stores.
- Healthcare REITs invest in hospitals, nursing facilities, medical centers, and retirement homes. An increase in the demand for healthcare services is good for healthcare real estate e.g Japan. It has many good healthcare REITs as it has the highest aging rate in the world. They increase the demand for health care services, leading to better investment opportunities.
- Commercial/Office REITs invest in office buildings. It receives rental income from tenants who sign long-term leases. Office REITs lease offices for longer terms (7-10 years) than other types of property.
How to evaluate a REIT?
The REIT market has been dominated by the US since its inception in 1960. It has grown in size and market acceptance globally. There are currently 225 REITs in the US with a market cap of $1 trillion. In comparison, there are only 150 REITs in Asia worth ~$300 billion.
Below are some of the key points to keep in mind when investing in REITs:
- REITs are total-return investments. Look for companies that have historically provided better dividend income and growth.
- Liquidity matters. Look for strategies that are actively traded on an exchange.
- Strong management makes a difference. Look for companies with a long-term track record.
- Quality counts. Invest in REITs with great properties and tenants that generate solid cash flow.
- Think diversification. REIT ETFs like the Vanguard Real Estate ETF (VNQ), are less risky than individual REIT stocks.
The Bottom Line
Investing in REITs may be a passive, income-producing alternative to buying property or investing in bonds. However, don’t be fooled by the high dividend yields. Instead, choose the right management team and quality properties based on current trends and stay invested in the long term. Consider exchange-traded REITs over non-traded REITs and pay attention to interest rates. If you regard your retirement portfolio as a pie, one of the slices should be REITs. In the long run, it will likely improve the flavor.
You can invest in REITs stocks or in REIT mutual funds and ETFs, whatever you like. At Kristal.AI, we believe real estate should be an important part of your income portfolio. If you’d like to know more, you can check out our real estate offerings here. Or, drop a line and our experts will be glad to assist you!
The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.
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