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My FI Journey » Investing » A Brief Primer on REITs (Real Estate Investment Trusts) Part 1: What are REITs, why should you invest in them, and how do they compare to being a landlord.

A Brief Primer on REITs (Real Estate Investment Trusts) Part 1: What are REITs, why should you invest in them, and how do they compare to being a landlord.

1370254_lots_of_apartmentsReal estate investment trusts (REITs) are companies that specialize in investing in real estate by owning and renting commercial properties or by collecting mortgage interest.  Investing in REITs is a great way to get your feet wet in real estate without becoming a landlord.  You simply buy and sell shares of a REIT on a stock exchange like you would any other stock.  Because REITs usually pay out almost all (>90%) of their taxable earnings you can earn substantially higher dividend yields through REITs than you could with traditional stocks.

A short history of REITs

In 1960, Congress created REITs as a way for individual investors (people like you and me) to directly invest in large scale commercial properties (things like shopping malls, or massive apartment complexes).  Currently, there are about 150 publicly traded REITs in the US, with a combined worth of around $400 billion.  In the old days, you would have had to save millions of dollars (and probably partner with other investors) in order to be able to invest in a shopping mall or giant apartment complex.  Now you can buy shares of a REIT on a stock exchange, just like you would any other stock.

 

Flavors of REITs

REITs can make money through two primary means, and come in three main flavors depending on the nature of their income.

  • Equity REITs - Invests in and owns physical properties like shopping malls, apartments, commercial property, industrial property, health care property, etc.  If a property investment class exists, there is a REIT investing in it.  Their profits come from collecting rents.
  • Mortgage REITs - Invests in and owns mortgages.  They may directly loan money to a property buyer for a mortgage or they may purchase mortgage backed securities.  Mortgage REITs borrow money at lower short-term interest rates and then loan it back (in the form of a mortgage) at a higher interest rate.  They make money on the spread between these two interest rates.  The bigger this spread the more money they can make.
  • Hybrid REITs - These use both both of the above strategies.

 

Within the world of mortgage REITs, there are two more investment styles that you need to be familiar with, agency and non-agency. “Agency,” when used in the world of REITs, refers to government backed or supported agencies that gaurantee repayment of the mortgage principal, such as Ginnie Mae, Freddie Mac, and Fannie Mae.

  • Agency REITs - Invest in mortgages backed by government supported agencies.  Because their investments are government supported, these REITs have less risk associated with them.
  • Non-Agency REITs - Invest in mortgages NOT backed by government supported agencies.  These have more risk associated with them.

 

Characteristics of a REIT (the short version)

To make a long story short and simple, REITs are corporations that invest almost entirely in real estate with shares that can be publicly traded on stock markets.  REITs have access to corporate level debt and equity, which puts them in a much more favorable borrowing situation than you or I would be as individual real estate investors.  By law, REITs must pay out at least 90% of their taxable earnings to shareholders.  Because REITs must distribute almost all of their earnings, they tend to provide much higher dividend yields than traditional stocks.  The REIT does not pay taxes on these earnings, instead the dividends are considered “ordinary” and the investor pays pays taxes at the higher “ordinary dividend” rate.

 

Characteristics of a REIT (the long version)

REITs aren’t just glorified landlords.  According to US tax laws, in order to qualify as a REIT, a company must (*):

  • Be structured as a corporation, trust, or association
  • Be managed by a board of directors or trustees
  • Have transferable shares
  • Be taxable as a domestic corporation
  • Not be a financial institution or an insurance company – Bank of America can’t be a REIT just because it owns a lot of foreclosed properties.
  • Be jointly owned by 100 persons or more – If you and your friend Bob buy a 4-plex together, you can’t claim to be a REIT.
  • Have 95% of its income derived from dividends, interest, and property income.  Basically, REITs must specialize in real estate.
  • Pay dividends of at least 90% of the REIT’s taxable income
  • Have no more than 50% of the shares held by five or fewer individuals during the last half of each taxable year (5/50 rule)
  • Have at least 75% of its total assets invested in real estate
  • Derive at least 75% of its gross income from rents or mortgage interest
  • Have no more than 25% of its assets invested in taxable REIT subsidiaries (a fancy tax term for subsidiary companies that provide services to tenants such as cleaning, landscaping, concierge, etc.).

 

How do REITs compare with being an individual real estate owner?

Many financial independence hopefuls (myself included) are either considering investing in real estate, or have already committed to investing in real estate.  This begs the question – Should you direct your money towards buying property or investing in REITs?  The “correct” answer depends on the investor.  But here are a few things to consider.

Rental property is a business.  Rental property is not a passive investment, it’s a business.  You (the owner) are in charge of buying the property, selecting tenants, collecting rents, ensuring that maintenance and renovations are done, etc.  You can outsource some or all of these tasks to a management company (for a fee), but you are still responsible for ensuring that they get done.

REITs are just like stocks – passive income.  You don’t have to actively manage a REIT.  In fact, you don’t have do much of anything except check in on your stock periodically and collect your dividend checks.  The tradeoff is that someone else is making all the decisions about how the company is being run.

Liquidity.  You can sell your REIT holdings in an instant.  It takes several months at a minimum to sell a rental property.  Depending on your situation and personality, this may or may not be an issue for you.

Returns are roughly equal.  I’ve been scouring the internet trying to see what a landlord can expect in terms of return on investment.  People have reported numbers ranging from the negatives (yes, people lose money on investment properties all the time) to the double digits.  On average, people seem to report around a 7% yield on rental property.  All real estate markets are different, so the expected yield for property near you might be higher or lower.  On the other hand, it’s not very hard to select a REIT, or a basket of REITs, yielding around 7%.  In the long run, as the mortgage is paid off and the property value rises over time, I suspect that you’ll do better buying property, but I don’t have any solid information yet on how much better.  Like all things in real estate, it’s probably local.

 

Why invest in REITs?

1. Diversification into real estate - REITs allow diversification into real estate, something which would normally only  be available to you if you were willing to become a landlord.

2. High yields - Because REITs must pay out at least 90% of their taxable income to shareholders, they tend to have much higher yields than more traditional stocks. Usually between 4%-10%, with some REITs even moving into double digit yields.  Many REITs do not consistently raise their dividends, like traditional dividend growth stocks do, because their payout ratios are so high that they do not have a buffer against income fluctuations.

3. REITs can show solid dividend growth - Some REITs do have characteristics of good dividend growth stocks – a minimum of a 10 year history of increasing dividend payments.  Here’s a short list of some REITs with a consistent history of increasing dividend payments pulled from the dividend champions and contenders lists.

  • HCP Inc. (HCP – 27 years of consistent increases)
  • Universal Health Realty Trust (UHT – 26 years of consistent increases)
  • Federal Realty Investment Trust (FRT – 44 years of consistent increases)
  • Essex Property Trust (ESS – 18 years of consistent increases)
  • National Health Investors (NHI – 10 years of consistent increases)
  • Omega Healthcare Investors (OHI – 10 years of consistent increases)
  • Tanger Factory Outlet Centers (SKT – 19 years of consistent increases)
  • National Retail Properties (NNN – 23 years of consistent increases)
  • Realty Income Corp. (O – 18 years of consistent increases)
  • Urstadt Biddle Properties (UBA – 18 years of consistent increases)

 

4. Liquidity. REITs are traded just like stocks and as such are very liquid investments.  You can dump your REITs any time with the push of a button.

 

Conclusions

REITs can be a valuable addition to your dividend portfolio, giving you exposure to the real estate market.  REITs tend to produce high yields, and some companies exhibit all the characteristics of dividend growth stocks.  REITs can also substitute for owning rental property and being a landlord if you are not interested in the hassles of running a business.

(*) List adapted from Wikipedia

Disclosure: I have nothing to disclose.

Readers:  What do you think about REITs?  Do you currently invest in them?

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11 Responses to "A Brief Primer on REITs (Real Estate Investment Trusts) Part 1: What are REITs, why should you invest in them, and how do they compare to being a landlord."

  1. Nice overveiw. I’ve read quite a bit about REITs recently and they seem like a decent option to help diversify your portfolio without having to go out and buy a rental property. Plus, like you said, it’s completely passive whereas a rental property needs to be continually managed.

  2. Pauline says:

    I have discovered REITs recently, looks like a nice way to be a “landlord” without the headache. You can also invest less than the value of a property, although you can’t leverage your investment with a mortgage.

  3. Great write up on REITS! I have invested in them in the past and am thinking of getting back into one or two in the near future.

  4. Will says:

    I love REITs, and I have over 50% of my portfolio invested in them. Very high dividends, and less volatile than most stocks. Also seem to perform well even in a down market because they are based on predictiable earnings. Great choice for the dividend investor mainly interested in income as opposed to stock appreciation.

    I love AGNC, MTGE, ARR, NRF, MFA, OHI to name a few.

    1. MFIJ says:

      That’s a nice REIT portfolio. I’ve been wanting to dip into OHI for a while, but just haven’t had the opportunity yet.

  5. Martin says:

    Great write up. Thanks for the list of other REIT companies with long term dividend history. I only had Realty Income under my radar (and also being invested in). I will review the others.

    Also will you be focusing on how to evaluate REITs and what are the differences in metrics compared to regular divi paying stocks?

  6. Will says:

    AGNC is a great buy right now, trading right right around book value and offering a dividend yield over 17%. I plan to buy more in the next week or so.

  7. I have thought about investing in REITs since I love real estate. And you’re right, owning rental homes is not at all passive. It takes a lot of hard work and can be time consuming when tenants move or you have to make repairs, etc.

  8. Will says:

    I have a hard time understanding why anyone would want to be a landlord, does not seem worth the hassle at all. Dealing with unreliable tenants, making repairs, legal issues, tenants not paying rent on time, evictions, etc. Investing in REITs is just as profitable and requires zero effort.

  9. Thanks for the overview. I knew about the basics of REITs and am looking forward to the rest of the series. I’ve been wanting to get a bit of REIT exposure because I think real estate is still a good holding long-term. Becoming a landlord still interests me, but I know there’s no way I could do it right now because I’d have to pay a management company to look over the property and I have a feeling their cut would eat into the margins.

    Do you have a list of the equit REITs? Those are the ones that most intrigue me because they are essentially a landlord diversification play. I’m still not really sure how to go about valuing REITs and need to look a lot more into them.

  10. Nice writeup. I own a REIT index in a few of my retirement accounts but haven’t dabbled with buying individual REIT’s just yet. I’ll definitely give them more of a look as I build my dividend portfolio in my taxable account.

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