Real estate investment trusts (REITs) allow individuals to invest in large-scale, income-producing real estate. A REIT is a company that owns and typically operates income-producing real estate or related assets. These can include things like office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, mortgages or loans et al. Unlike other real estate companies, a REIT does not develop real estate properties with the intention of reselling them. Instead, a REIT buys and develops properties primarily to operate them as part of its own investment portfolio.
REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership – without actually having to go out and buy commercial real estate.
Types of REITs you can invest in
A lot of REITs are registered with the SEC and are publicly traded on the stock exchange. These are known as publicly traded REITs. On the other hand, some may be registered with the SEC but are not publicly traded. These are called non- traded REITs (also known as non-exchange traded REITs). Before investing in a REIT, you should understand whether or not it is publicly traded, and how this could affect the benefits and risks to you.
While there are some diversified REITs, a lot of them are in a single property type. Common REIT specialties include:
- Retail: Subcategories include malls, shopping centers, outlets, and freestanding retail.
- Healthcare: Properties such as senior housing facilities, medical offices, hospitals, skilled nursing facilities, and others. Some healthcare REITs specialize in a single type of property, while others invest in a combination.
- Industrial: Warehouse and factory properties are good examples of industrial REIT assets.
- Residential: Most residential REITs invest in apartments, but some own single-family homes, as well.
- Hotel: There are REITs that own destination resorts, luxury hotels, and/or budget-friendly motels.
- Data centers: these REITs specialize in owing buildings that lease space for data storage.
Benefits and Potential Risks Associated With REITs
REITs provide a very good way for one to include real estate in one’s investment portfolio. Also, some REITs may offer higher dividend yields than some other investments.
That said, it is good to note that REITs investment is not without risks. The risks tends to increase when you invest in non-exchange traded REITs, because they do not trade on the stock exchange. Here are some of the risks that you expose yourself to when you invest in REITs.
- Lack of Liquidity: Non-traded REITs are illiquid investments and as such, they generally cannot be sold readily on the open market. If you need to sell an asset to raise money quickly, you may not be able to do so with shares of a non-traded REIT.
- Share Value Transparency: While the market price of a publicly traded REIT is readily accessible, it can be very difficult to determine the value of a share of a non-traded REIT. Non-traded REITs typically do not provide an estimate of their value per share until 18 months after their offering closes. At times, this can be many years in the future after you must have made your investment. As a result, for a significant time period you may be unable to assess the value of your non-traded REIT investment and its volatility.
- Distributions May Be Paid from Offering Proceeds and Borrowings: Investors may be attracted to non-traded REITs by their relatively high dividend yields compared to those of publicly traded REITs. Unlike publicly traded REITs, however, non-traded REITs frequently pay distributions in excess of their funds from operations. In order to achieve this, they may use offering proceeds and borrowings. This practice, which is usually not used by publicly traded REITs, reduces the value of the shares and the cash available to the company to purchase additional assets.
- Conflicts of Interest: Non-traded REITs typically have an external manager instead of their own employees. This can lead to potential conflicts of interests with shareholders. For instance, the REIT may pay the external manager significant fees based on the amount of property acquisitions and assets under management. These fee incentives may not necessarily align with the interests of shareholders.
How to Invest in REITs
You can easily invest in a publicly traded REIT, which are listed on a major stock exchange, by purchasing shares through a broker. On the other hand, to purchase the shares of a non-traded REIT, you have to do so through a broker that participates in the non-traded REIT’s offering. You can also purchase shares in a REIT mutual fund or REIT exchange-traded fund.
Publicly traded REITs can be purchased through a broker. Generally, you can purchase the common stock, preferred stock, or debt security of a publicly traded REIT. Brokerage fees will apply.
Non-traded REITs are typically sold by a broker or financial adviser. Non-traded REITs generally have high up-front fees. Sales commissions and upfront offering fees can reach up to 9 to 10 percent of the investment. These costs lower the value of the investment by a significant amount.
Most REITS pay out at least 100 percent of their taxable income to their shareholders. The shareholders of a REIT are responsible for paying taxes on the dividends and any capital gains they receive in connection with their investment in the REIT. Dividends paid by REITs generally are treated as ordinary income and are not entitled to the reduced tax rates on other types of corporate dividends. Consider consulting your tax adviser before investing in REITs.
When looking for an REITs to invest in, you should beware of any person who want to sell REITs that are not registered with the SEC. You can verify the registration of both publicly traded and non-traded REITs through the SEC’s EDGAR system. You can also use EDGAR to review a REIT’s annual and quarterly reports as well as any offering prospectus.
In order to prevent any foul play, it is best to check out the broker or investment adviser who recommends purchasing a REIT.
How is the Value of REIT Shares Assessed?
Like all companies whose stocks are publicly traded, REIT shares are priced by the market throughout the trading day. To assess the investment value of REIT shares, analysts typically consider:
- Anticipated growth in earnings per share;
- Anticipated total return from the stock, estimated from the expected price change and the prevailing dividend yield;
- Current dividend yields relative to other yield-oriented investments (e.g., bonds, utility stocks and other high-income investments);
- Dividend payout ratios as a percent of REIT FFO (see below for discussion of FFO and AFFO);
- Management quality and corporate structure; and underlying asset values of the real estate and/or mortgage and other assets.
How do REITs measure earnings and ability to pay dividends?
REITs use net income as defined under the Generally Accepted Accounting Principles (GAAP) as their primary operating performance measure. Additionally, REITs use funds from operations (FFO), a measure of cash generated, as a supplemental indicator of their operating performance.
FFO can be defined as net income excluding gains or losses from sales of most property and depreciation of property, since real estate typically appreciates rather than depreciates. Securities analysts also use a measure called Adjusted FFO (AFFO), which adjusts FFO for rent increases and certain capital expenditures.
What factors typically drive REIT earnings growth?
Growth in REIT earnings is typically generated by higher revenues, lower costs and new business opportunities. The most immediate sources of revenue growth are higher rates of building occupancy and increased rents. Additional property acquisition and development programs also create growth opportunities, provided the economic returns from these investments exceed the cost of financing.