Real Estate as an investment option has been around for long; and has become an important component of an investor’s portfolio in recent times, as it offers much diversification. But there’s a catch – real estate is pricey. Buying, or even selling (when you need the money) isn’t exactly 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 REIT or Real Estate Investment Trust comes into play. Read on to find out how you can own a portion of it with a fraction of the money to buy it and also liquidate the same when you need the money or have realised the gain.
What is a REIT?
Real Estate Investment Trusts (REITs) are a unique set of stocks worth considering in your long-term retirement portfolio. They not only generate steady income but also expose you to capital appreciation over a period of time as the property value increases. The types of property can vary from apartments to shopping malls and offices, and offer wide diversification.
A REIT is an investment vehicle that pools investor money to buy real estate assets. Think of a REIT as similar to an Exchange Traded Fund (ETF) or Mutual Fund, except 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 the REIT manages.
A REIT typically specialises in a particular type of real estate. For e.g. a residential REIT pools money and invests only in apartment buildings, while a retail REIT invests in shopping mall properties. For an investor the attractiveness of a REIT is in that one can get exposure to different types of properties without having to put down a large amount of investment.
However, the main driver for investing in REITs is the dividend yield. REITs generate income from properties in the form of rental income, which is passed onto the shareholders. This dividend is similar to that paid by a company to shareholders from earnings it generates from business operations. 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, a REIT is exempt from corporate taxes. So unlike a typical corporation, which has to pay taxes on earnings, a REIT’s income is not taxed, leaving more money to pass on to shareholders.
Why should you invest in REITs?
As mentioned REITs allows investors an easy way to access real estate assets that may be otherwise unaffordable Listed below are some of the key benefits of investing in REITs.
- High Yield – This is a big one! As REITs are required to pay out most of their taxable income to shareholders they offer a high stable dividend yield. Dividend yields vary depending on the type of REIT and geography but typically they yield anywhere between 4% to 8% (paid out quarterly or semi annually).
- Hassle Free – REITs provide an easy means for the average investor to access a sometimes unaffordable property market (e.g. commercial real estate), either via an exchange or over the counter like a mutual fund. In comparison, buying and selling property directly involves higher expenses and more headache with administrative tasks. When investing in REIT there are professional managers who deal with all of these.
- Diversification – REIT returns have shown a relatively low correlation to equity stocks and fixed-income investments, which makes it a good portfolio diversifier. When most stocks are overvalued, this is the time you want more of your portfolio to be in bonds and REITs instead of stocks. 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 – In addition to income, REIT returns also capture the price appreciation of the underlying REIT properties. Hence it is a good hybrid between dividend income and growth in the stock price. With property generally having a high return potential, REITs over a period of time have shown strong returns and have outperformed the stock index. In 2019 alone REITs have 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 directly to shareholders. However, 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?
No discussion will be complete without looking at the risk factors affecting REIT investments.
A major risk of investing in REITs is that the value of the fund is solely determined by the underlying value of the real estate. Any slump in the real estate market will affect the fund price and potential losses in your portfolio. In some ways a REIT is a concentrated bet on the specific property type and is riskier compared to mutual funds which are well diversified.
Below are some of the other risks investors need to be aware of:
Market Risk – REITs behave like fixed income products in that they are sensitive to changes in interest rates. In a rising rate environment, REITs are expected to pay a premium over the risk-free rate of US government bonds and hence put a downward pressure on the stock price. Also, rising interest rates make Treasury securities more attractive, thereby drawing funds away from REITs.
Liquidity Risk – Properties generally face a liquidity challenge if there aren’t enough buyers and sellers. This in turn 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-favour type of real estate. Hence, it’s important to do research on current trends affecting the real estate market before investing in REITs.
Types of REITs
REITs fall into two main categories – Equity REITs and Mortgage REITs. Majority of REITs are Equity REITs. These own or operate income-producing real estate such as apartment buildings, offices, or shopping centres. Mortgage REITs provide financing for income generating real estate by purchasing or originating mortgages and mortgage-backed securities. It earns income from the interest on these investments.
There are multiple specialised categories for Equity REITs, listed below are the main ones:
- Residential REITs include those that specialise in apartment buildings, student housing and single-family homes to name a few. The largest residential REITs tend to focus on urban centres where home affordability is typically low. Those with the strongest balance sheets normally do the best.
- 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. 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 the real estate of hospitals, nursing facilities, medical centres, and retirement homes. Generally, an increase in the demand for healthcare services is good for healthcare real estate. A country such as Japan with the highest ageing rate in the world offer a number of healthcare REITs due to strong demand for such facilities.
- Commercial/Office REITs invest in office buildings and receive 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 and 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 under 150 REITs in Asia (Singapore, Hong Kong, Japan and Australia) worth approximately $300 billion. Below are some of the key points to keep in mind when investing in REITs.
- REITs are total-return investments. Consider companies that have done well historically at providing both dividend income and growth.
- Liquidity matters. Look for REITs 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.
- Consider diversification through REIT ETFs like the Vanguard Real Estate ETF (VNQ), instead of buying 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 flavour.
You can invest in REITs stocks or in REIT mutual funds and ETFs, by purchasing them through your broker or advisor. At Kristal.AI, we believe REITs should be an important part of your income portfolio. If you’d like to know more, do drop a line and our experts will be glad to assist you!
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