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What is a REIT and how do they work?
Real Estate Investment Trusts (REITs) are publicly traded companies that own, operate or finance real estate. REITs pool funds from individual investors and use those funds to build a portfolio of real estate investments. When you invest in a REIT, you’re buying a share of that portfolio. REITs let you invest in real estate without having to buy, manage or finance real estate on your own, while providing a steady income steam. Many REITs specialize in specific sectors such as residential properties or commercial real estate and share their profits with investors through dividends.
Most REITs can be bought and sold on major security exchanges just like stocks. This article will help explain REITs and how you can use them to help reach your financial goals.
Types of REITs
There are several different types of REITs to choose from.
Equity REITs: Equity REITs own or manage commercial properties like apartment buildings, office buildings, and shopping centres. Equity REITs lease properties to tenants and generate revenue primarily through the collection of rents and property sales.
Mortgage REITs: Mortgage REITs (mREITs) finance income-producing properties by lending money to real-estate owners and operators in form of loans, mortgages and mortgage-backed securities (MBS). They generate revenue by collecting interest on their loaned money. Profit is often tied to the cost to fund these loans, also called the net interest margin. This makes these products more sensitive to interest rate changes.
Hybrid REITs: Hybrid REITs are a mixture of equity and mortgage REITs. While they own or manage commercial properties just like equity REITs, they also invest in mortgages and mortgage-backed securities like mREITS, thereby diversifying sources of revenue. Hybrid REITs provide the benefits of both equity and mortgage REITs and can reduce the risks of investing in equity REITs or mortgage REITs alone.
Advantages of Investing in REITs
Advantages of investing in REITs include:
- Income generation: REITs can provide investors with a passive source of income by providing investors with divided payments on a monthly, quarterly, or annual basis.
- Portfolio Diversification: Investing in REITs can help you diversify your portfolio. The real estate market tends to be less volatile in the short term than the stock market. Including REITs within your portfolio can help mitigate risks associated with investing in stocks, bonds and other assets. In addition, REITs hold a range of different properties, letting you invest in a range of real estate investments.
- Liquidity and Accessibility: Buying or investing in real estate yourself can require a significant capital investment. In addition, selling real estate takes time, which can make physical real estate investments hard to liquidate. Investing in REITs helps to avoid these two problems. REIT shares can be purchased at a relatively low price and can be sold quickly if needed.
- Inflation Hedging: REITs tend to perform well when inflation is high as the rent and value of properties held by REITs tends to increase during these periods.
Disadvantages of Investing in REITs
Disadvantages of investing in REITs include:
- Market Risks: As REITs trade on stock exchange, REIT prices are subject to market fluctuations just like other stocks. In addition, all real estate investments are subject to volatility, including investments held within REITs. Changing trends in the real estate market or the demand for certain kinds of properties can influence the value of REITs and impact the REIT price.
- Interest Rate Risks: The value of REITs can be very sensitive to changes in interest rates. During the economic growth period, REIT price and interest rates correlate positively. However, during a slower economy this relationship can turn negative. That's because if interest rates go up, the costs of carrying investment properties go up as well. This can eat into the profits generated by REITs and dividends paid to investors and decrease the value of REIT shares.
- REIT-specific Risks: REITs face many of the same risks as posed by owning real estate. Fluctuations in property values, occupancy rates, and changes in rents and geographic demand all affect the value of REITs.
How to Invest in REITs
Here are different ways in which REITS can be bought and sold.
Publicly Traded REITs: Publicly traded REITs are listed on public stock exchanges and can be purchased through an investment broker. Publicly traded REITs can be bought and sold just like stocks, making them a highly liquid form of investment.
Multiple REITs can also be pooled together in mutual fund or ETF. These also trade like traditional equity funds.
Public Non-listed REITs: Public non-listed REITs aren’t listed or publicly traded on the stock market. Compared to publicly traded, public non-traded REITs can be harder to liquidate and can incur higher fees to trade.
Private REITs: Private REITs aren’t traded on the stock market and, in most cases, can only be purchased by institutional investors.Private REITs aren’t valued as frequently as public REITs and may only undergo valuation once a year.
Publicly traded REIT stocks, mutual funds and ETFs can all be purchased through a broker. Shares of non-traded REITs can only be purchased from eligible brokers or financial institutions.
Key Factors to Consider When Investing in REITs
Key Metrics
There are several key metrics to consider when investing in REITs:
Funds from Operations (FFO): FFO tells investors how much cash flow is being generated from a REIT’s operations. It’s calculated by adding a company’s net income, depreciation, and amortization expenses and subtracting gains from property sales. When looking to invest, look for REITs with a consistent and growing FFO.
FFO=(NI+D+A+PSL)−PSG−II
where:
FFO=Funds from operations
NI=Net income
D=Depreciation
A=Amortization
PSL=Property Sales Losses
PSG=Property Sales Gains
II=Interest Income
Note, this metric is often used to compare the value of different REITs.
Dividend Yield: Dividend yield gives investors an idea of how much income they may earn from REIT dividends relative to the cost of investing. It’s calculated by dividing annual dividend payments by the current share price. Be cautious of unusually high dividend yields as they may not be sustainable over the long term.
Occupancy Rate: Occupancy rate measures the percentage of a REIT’s properties that are currently occupied by tenants. Low occupancy rates may be a sign that there is limited demand for the properties held within a REIT, while high occupancy rates may indicate that REIT properties are in high demand.
Debt-to-Equity Ratio: Debt-to-equity ratios compare the amount of debt a company carries to the equity it’s generated from shareholders. It’s calculated by dividing a company’s total debt by its total equity. It's important to note that REITs generally have higher Debt to Equity compared to other stocks because they often finance real-estate investments with debt. REITs with a high debt-to-equity ratio may be taking on too much debt and may be more likely to default on their loans.
Other Factors to Consider
Additional factors to consider when deciding to invest in REITs include:
Property Type: Different types of properties present different risks and potential returns. Rental properties may be less sensitive to economic downturns than commercial properties, but the rental income and long-term growth potential provided by commercial properties may be higher. Consider your investment goals and risk tolerance when thinking about which REITs to invest in.
Geographic Location: Consider the location of the properties held within a given REIT before deciding to invest. If you’re looking for high growth potential, consider investing in REITs that own or finance properties in high-growth areas. If you’re more interested in stability, consider REITs that hold properties in more established markets. While these properties may offer lower growth potential, they may be less susceptible to market volatility as well.
Management Team: Evaluate the track record and experience of the REIT management team as they can have a significant impact on the REIT’s performance. Look for management teams with a proven history of successful investment decisions and generating value for investors.
Regulatory Environment: Changes to tax regulations and securities laws can impact a REIT’s performance. If you invest in REITs, be aware of potential changes in the regulatory environment and how they may affect the REIT’s performance and its ability to provide dividends to investors.
FAQS
What qualifies as a REIT?
Companies must meet specific criteria to qualify as a REIT. At least 75% of their assets must be connected to real estate investment. They need to earn at least 75% of their gross income from rents, real estate sales, interest on mortgages, or capital gains from dispositions of real properties which are capital properties. They also need to distribute at least 90% of their annual taxable income to shareholders via dividends.
Do REITs pay dividends?
Yes. REITs must distribute at least 90% of their net income to shareholders in the form of dividends.
Are REITs good investments?
REITs typically generate steady stream of income; however, the chances of capital appreciation are low.
Are REITs safe during a recession?
Interest rates tend to fall during a recession. This can lower the costs incurred by REITs and increase their profits. However, the performance of REITs can depend on the type of REIT and the sector the REIT invests in. For example, mREITS are more sensitive to interest rate fluctuations; and REITs that invest heavily in commercial real estate such as offices and small business retail may be harder hit by a recession than REITs that predominantly invest in rental properties or facilities with longer-term leases like healthcare facilities.
Conclusion
REITs make it easy to invest in real estate without having to buy or manage properties yourself. They also let you invest in a portfolio of different properties, making investing in REITs less risky than investing in one or two individual properties. Different types of REITs will present different risks and potential rewards, so always consider your investment goals and risk tolerance when thinking about which REITs to invest in.
Understanding REITs and how to invest in them can help you make informed investment decisions and reach your financial goals sooner.
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