Have you ever heard of Real Estate Investment Trusts (REITs)? Did you know the market for REITs was already valued at $1.47 trillion in 2020 and on track to add another trillion by 2028?
REITs are a type of investment that allow you to invest in real estate properties without owning them physically. It’s a great way to get exposure to large-scale real estate investments and receive a steady income stream.
In this beginner’s guide, we will cover everything you need to know about REITs, including their advantages and risks, how to invest in them, how to evaluate them, and their tax implications. So, let’s get started and learn how you can invest in real estate without breaking the bank!
What Are REITs?
So, what exactly are REITs? Essentially, they’re a way for you to invest in real estate properties without actually owning them. REITs own, operate, and finance income-producing real estate properties such as apartments, hotels, office buildings, shopping centers, and warehouses. This means that you get to invest in large-scale real estate projects that you might not have access to otherwise.
What’s cool about REITs is that they’re required by law to distribute at least 90% of their taxable income to their shareholders in the form of dividends. This means that you can receive a steady income stream from your investment, which is great if you’re looking for regular cash flow.
REITs can be divided into three main types:
- Equity REITs: These invest in and own income-producing real estate properties, and their income is mainly generated through rental income.
- Mortgage REITs: These invest in and own real estate debt, such as mortgages and mortgage-backed securities, and their income is generated through interest income.
- Hybrid REITs: These invest in both income-producing real estate properties and real estate debt.
Advantages of Investing in REITs
So, what are the advantages of investing in REITs? There are several of them which makes them an attractive investment option for many investors. Some of these advantages include:
Steady Income Stream
For starters, REITs provide a steady income stream to investors. They’re required by law to distribute at least 90% of their taxable income to their shareholders in the form of dividends, so if you’re looking for regular cash flow, REITs might be a great option for you.
Another advantage of investing in REITs is diversification. By investing in REITs, you get access to a diversified portfolio of real estate assets. This reduces the risk of relying on a single property or asset class.
Access to Large-Scale Real Estate Investments
REITs also provide access to large-scale real estate investments with smaller amounts of capital. Investing in real estate properties directly can be expensive and time-consuming, but REITs allow you to invest in large-scale projects without having to deal with the day-to-day management of the properties.
Another great thing about REITs is that they’re managed by professional teams, so you don’t have to worry about the day-to-day management of the properties. This means you can sit back and relax while your investment generates income.
Finally, REITs are more liquid than direct real estate investments. They’re traded on stock exchanges, which means that they’re more easily bought and sold. This provides investors with flexibility, as they can easily adjust their investment portfolio if necessary.
Risks of Investing in REITs
While investing in REITs has several advantages, there are also risks associated with this type of investment. Some of the risks that investors should consider before investing in REITs include:
Interest Rate Risk
When interest rates rise, the value of REITs may decline. This means that if you’re invested in REITs, you might see a decrease in the value of your investment if interest rates go up.
Another risk to keep in mind is market risk. Like other equity investments, REITs are subject to market risk. This means that the value of their shares may decline due to economic conditions, industry trends, and geopolitical events.
Liquidity risk is another factor to consider when investing in REITs. While they’re more liquid than direct real estate investments, they can still be subject to liquidity risk. This means that there may not be enough buyers or sellers in the market at a given time.
Real Estate Market Risk
REITs are also subject to real estate market risk. This means that they’re subject to the same risks as direct real estate investments, such as changes in real estate values, occupancy rates, and rental rates.
Finally, it’s important to consider the tax implications of investing in REITs. Because REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends, investors may be subject to higher tax rates on their REIT dividends.
How to Invest in REITs
Investing in REITs is easier than you might think, even if you’re a novice investor. There are several ways to invest in REITs, including publicly-traded REITs, non-traded REITs, REIT mutual funds, and REIT exchange-traded funds (ETFs).
- Publicly-traded REITs are listed on stock exchanges and can be bought and sold like stocks. This means that you can buy shares of publicly-traded REITs through a brokerage account.
- Non-traded REITs, on the other hand, are not listed on stock exchanges and are sold through broker-dealers or financial advisors. Keep in mind that non-traded REITs may have higher fees and lower liquidity than publicly-traded REITs.
- REIT mutual funds invest in a diversified portfolio of REITs, and you can buy shares of REIT mutual funds through a brokerage account.
- Finally, REIT ETFs invest in a diversified portfolio of publicly-traded REITs. You can buy shares of REIT ETFs through a brokerage account as well.
- Before investing in REITs, it’s important to consider factors such as your investment goals, risk tolerance, and investment horizon. You should also research the performance of the REIT, the quality of the management team, and the composition of the portfolio before making an investment.
Before investing in REITs, investors should consider factors such as their investment goals, risk tolerance, and investment horizon. It is also important to research the performance of the REIT, the quality of the management team, and the composition of the portfolio before making an investment.
When investing in REITs, it is important to evaluate the performance and potential of the REIT to make informed investment decisions. Here are some key metrics to consider when evaluating REITs:
- Dividend yield: This is the percentage of the REIT’s share price that is paid out in dividends each year. A higher dividend yield can provide a steady income stream, but it may also indicate that the REIT is taking on more risk.
- Funds from operations (FFO): This is a measure of the REIT’s cash flow from operations, and it is used to evaluate the REIT’s ability to generate income from its properties.
- Price-to-FFO ratio: This ratio compares the REIT’s stock price to its FFO per share. A lower ratio may indicate that the REIT is undervalued.
- Occupancy rates: This is the percentage of a REIT’s properties that are occupied by tenants. Higher occupancy rates indicate that the REIT is generating steady rental income.
- Debt-to-equity ratio: This ratio compares the REIT’s debt to its equity, and it is used to evaluate the REIT’s financial leverage. A higher ratio may indicate that the REIT is taking on more debt and may be more risky.
In addition to these metrics, it is also important to research the quality of the REIT’s management team, the composition of the portfolio, and the performance of the real estate assets. Some REITs may have management teams with experience working in the real estate industry, such as those who have worked for companies like Zillow or other real estate firms.
Investors should also review the REIT’s financial reports, such as its annual reports and quarterly earnings reports, to gain a deeper understanding of the REIT’s financial health.
As you can see, evaluating REITs requires a thorough analysis of various financial metrics and research into the quality of the management team and the composition of the portfolio. Investors should carefully consider these factors before investing in REITs.
Taxation of REITs
Investors in REITs should also be aware of the tax implications of investing in these types of securities. REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. As a result, investors may be subject to higher tax rates on their REIT dividends than they would be on other types of investments.
Here are some important tax considerations for investors in REITs:
- Dividend taxation: REIT dividends are generally taxed as ordinary income, which means that they may be subject to higher tax rates than qualified dividends from stocks.
- Capital gains taxation: When an investor sells their shares of a REIT, they may be subject to capital gains taxes on any profits they have realized. Long-term capital gains are generally taxed at a lower rate than short-term capital gains.
- Tax-deferred distributions: Some REITs may make tax-deferred distributions to investors, which means that the investor will not be subject to taxes on these distributions until they sell their shares of the REIT.
- Foreign taxation: If a REIT invests in real estate properties in foreign countries, investors may be subject to taxes in those countries on any income generated by the REIT.
And there you have it, a beginner’s guide to Real Estate Investment Trusts (REITs)! We’ve covered the basics of what REITs are, their advantages and risks, how to invest in them, how to evaluate them, and their tax implications.
So, what have we learned? REITs can be a great investment option for individuals looking for exposure to large-scale real estate projects without the hassle of owning physical properties. They provide a steady income stream, diversification, access to professional management, and liquidity.
However, investing in REITs does come with some risks, such as interest rate risk, market risk, liquidity risk, real estate market risk, and tax implications. Before investing, it’s important to carefully consider these factors and do your research.
In summary, REITs can be a valuable addition to your investment portfolio, but it’s important to weigh the advantages and risks before making any investment decisions. With the knowledge and tools provided in this guide, you’re well-equipped to start exploring the world of REITs and investing in real estate without owning physical properties.
Cooper Haywood is a former equity research professional/finance analyst who holds an MBA in Financial Instruments and Markets from New York University’s Stern School of Business. He left the investment banking world in 2015 to become a full-time investor and contributor to WallStreetZen—a stock analysis site that makes fundamental analysis easy for part-time investors. They’ve automated 30+ tried and tested financial checks on stocks you’re interested in and give you the results in simple, one-line explanations.