Real estate investing isn’t a narrow field. If you want to get involved in real estate, you have plenty of options and strategies at your disposal. And if you aren’t sure where to begin, perhaps a real estate investment trust (REIT) could be the right choice.
What is a REIT?
A real estate investment trust, or REIT, is a company that owns, operates, or finances income-producing real estate. This is typically done by pooling investors’ money together to buy and manage commercial and/or residential buildings. The company then collects money from tenants and passes the profits on to investors.
In essence, a REIT is a big landlord that’s managed by financial professionals who understand how real estate works and what it takes to maximize revenue. And while the REIT managers takes some money off the top, they’re required, by law, to pass the majority of the earnings on to the investors (also known as shareholders).
REITs almost always land into one of two broad categories: equity REITs (eREITs) or mortgage REITs (mREITs). Equity REITs are most common. They own and operate income-producing real estate – such as apartment buildings, industrial warehouses, or shopping centers. For the most part, equity REITs focus on a particular type of property. (For example, a REIT might invest all of its assets into student housing or shopping centers, but probably won’t dabble in both.)
“mREITs help provide essential liquidity for the real estate market. mREITs invest in residential and commercial mortgages, as well as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS),” Nareit explains. “mREITs typically focus on either the residential or commercial mortgage markets, although some invest in both RMBS and CMBS.”
Risks and Benefits of REIT Investing
People invest in REITs for a variety of reasons, but they’re typically chosen as forms of diversification. Because of the way they’re structured, they’re relatively safe (compared to investing in a single property on your own).
“REITs are unique because they have to follow a specific set of operating requirements in order to meet REIT qualifications,” Fundrise explains. “For example, REITs are required to derive at least 75% of their gross income from real estate-related sources and invest at least 75% of their total assets in real estate. In addition, REITs must distribute no less than 90% of their taxable income every year to their shareholders by paying dividends.”
The rules and guidelines of REITs create some pros and cons for investors. Some of the benefits include:
For the most part, REITs produce a pretty high yield that tends to mimic the stock market’s long-term returns, without huge spikes or dips. This makes it a much more stable, yet conservative investment.
REITs don’t pay taxes at a corporate level. Instead, they tax shareholders at their individual rates. Shareholders receive a Form 1099-DIV at the end of the year and file it with their personal tax return. It’s very straightforward.
One of the biggest knocks on traditional real estate investing is the low liquidity. If you want to sell, it’s an intensive process that takes months to see through. But with a REIT, all you have to do is buy and sell shares. This can usually be done in a single business day.
But REITs aren’t perfect. If you’re going to pursue an investment in this class, you also need to be cognizant of some of the risks/cons:
REITs are required to pass on 90 percent of income to shareholders. While this is a good thing, it’s also a double-edged sword. This prevents many REITs from acquiring new properties without taking on large amounts of debt. Just something to think about.
For someone in a low tax bracket, REITs make a lot of sense. But if you’re in a high bracket, you could see rates as high as 37 percent on dividends. This can quickly eat away at your profits.
3 Tips for Successful REIT Investing
If you’re giving serious consideration to REIT investing, it’s imperative that you do some research and understand what you’re getting into. Here are a few tips for success:
Stay Away From New REITs
Over the last few years, a number of new REITs have entered the market. Some of them have been extremely successful – outpacing decades-old funds. Others have been fairly lackadaisical. But the best piece of advice is to stay away.
New REITs lack the track record of their more established peers. This makes it hard to judge how the fund will produce over three, five, or ten years. It’s best to give these funds time and wait to invest until you have more financials to review.
Go With Publicly Traded REITs
There are two types of REITs: nontraded and ones that are on the stock exchange. For the most part, publicly traded REITs outperform nontraded ones. They also tend to recover faster from downturns.
“The Financial Industry Regulatory Authority also has a warning,” Constance Gustke writes for Bankrate. “The independent financial watchdog says nontraded REITs have several drawbacks, including lack of transparency. They must often be held for eight years or more, since there are limited secondary markets, and front-end fees can run up to 15 percent of the REIT’s share price.”
Don’t Go Too Heavy
Don’t get too greedy with REITs and throw a huge percentage of your net worth into various funds. While they often outperform various exchanges, REITs tend to closely mimic the direction of the stock market. A portfolio that’s too heavy in REITs and stocks is risky.
Experts recommend investing just 5 to 15 percent of your portfolio into REITs and diversifying with stocks, bonds, insurance, and other types of investments.
Diversify Your Portfolio
There are few investment classes that offer the sort of flexibility and yield that real estate does. And while most people think there are only a couple of ways to invest, the truth is that you can get involved in dozens of different ways.
For more information on how you can benefit from income-producing real estate investments, please contact Green Residential.