Real property investments take a lot of upfront capital (or leverage). For those looking for a simpler way of capitalizing on real estate, investing in REITs is much more accessible. These investment vehicles are similar to traditional securities in how they’re bought and sold, which makes them more familiar to new investors. But there are key differences. If you’re interested in getting started with REITs, there are some things you need to consider.
Here’s a look at some of the most important factors to keep in mind when it comes to REITs and how to invest in them successfully.
What Is an REIT and How Does It Work?
A real estate investment trust (REIT) is a type of investment vehicle that leverages the profits of real property holdings to return value to shareholders. REITs typically own and/or operate revenue-generating properties. Think of the REIT like a landlord. It owns the building and collects rent; however, it’s also responsible for upkeep and maintenance.
As an investment, REITs are unique in that they return value to shareholders almost exclusively through dividends. Many REITs pay double-digit dividends to remain compliant with IRS guidelines (more on that below). As a result, REIT shareholders can expect regular income from their position – dividends that pay out as frequently as every month.
Types of REITs to Consider
Not only are REITs unique in how they generate value for shareholders, they’re also diverse in the properties they hold and how they operate. There are three different types of REITs to get familiar with before you start investing:
- Equity REITs: These are classic REITs that operate like the landlord example above. When you get a dividend, it’s coming out of the rent check from the tenant at one of the REIT’s property holdings.
- Debt REITs: These REITs are special in that they don’t hold any real property. Instead, they own the debt securities that back property. These funds typically own a lot of residential mortgage notes.
- Hybrid REITs: You guessed it – these REITs hold both equity and debt. They’re more diversified and tend to offer great dividends.
It’s also important to consider the area of focus for different REITs. What kind of property classes do they hold? For example, some REITs may focus only on standalone retail establishments while others prefer strip mall holdings. REITs can get fairly exotic as well: everything from cell towers to cannabis grow houses! Generally, there are five core areas of focus for REITs when it comes to primary holdings:
- Residential REITs
- Retail REITs
- Office REITs
- Healthcare REITs
- Industrial REITs.
Looking into these specific focuses can give investors cross-exposure to different industries. For example, you might pick up a healthcare REIT that focuses on urgent care clinics that grow rapidly alongside the burgeoning healthcare sector. There are primary and secondary benefits to picking and choosing your REIT carefully.
REITs Have Rules You Need to Know About
Remember when we said that REITs were subject to special operational guidelines? The IRS mandates that REITs meet a specific set of criteria. If you’re going to invest in them, it’s best to also familiarize yourself with these stipulations:
- REITs must return at least 90% of taxable income as dividends to shareholders.
- 75% of the total REIT assets must be in the form of real estate holdings or cash.
- REITs must receive at least 75% of gross income from real estate (rent, sale, etc.).
- REITs must maintain a minimum of 100 shareholders after 12 months in existence.
- No more than 50% of shares can be held by five or fewer individuals.
These rules exist to protect shareholders – and to prevent real estate fraud. What they boil down to for investors is a guaranteed return on investment so long as the REIT maintains profitability.
The Primary Benefits of Investing in REITs
Basically, if you’re investing in an REIT, you’re guaranteed a dividend. That’s the general appeal of investing in one. Investors take advantage of double-digit dividend percentages to quickly accumulate wealth. A DRIP plan paired with a lucrative REIT can quickly amass wealth in your portfolio!
The other benefit of REITs is that they offer you exposure to real estate investments without actually holding the property yourself. This is great for investors who don’t have the liquidity or wealth to get involved in real estate. Moreover, you don’t need to worry about managing the property or dealing with tenants. You’re in it solely for the lucrative returns that come from rental contracts.
The Drawbacks and Negatives of REITs
REITs have a few unique risks that investors need to be aware of. First is the prospect of debt. REIT balance sheets are heavily leveraged and anchored by debt. If they maintain properties and keep long-term tenants, good cash flow is enough to cover this. Unfortunately, all it takes is a few months of vacancy for an REIT to falter. When it does, expect the dividend to shrink overnight.
Speaking of dividends, prepare to pay substantial taxes on them. REIT dividends aren’t “qualified dividends,” which means they’re taxed as ordinary income. Your portfolio may boom with strategic REIT investments, but you’ll lose a hefty chunk of those gains to Uncle Sam. Prepare for this ahead of time as you decide whether an REIT strategy is best for you.
Are REITs a Smart Investment?
If you’re building out a dividend portfolio or want a low-volatility investment, investing in REITs might interest you. There’s a lot to love about an investment vehicle that’s legally obligated to generate significant ROI for shareholders! That said, REITs aren’t without risk. Heavy debt anchors most REITs and can put a strain on their ability to generate profits – especially in down real estate markets. And, if you’re a dividend investor, you’ll end up paying big-time on your lucrative gains.
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For investors who love the prospect of real estate investments, REITs offer accessibility that real property can’t match. Allocating some or all of your portfolio to REITs is a great way to lock up a real estate investment that pays dividends – all without the hassle of hiring a property manager!
