Many homeowners view their abode as a solid asset that can pay dividends down the road when it’s time to sell. But purchasing a primary residence and buying a self-managed rental property aren’t the only ways to capitalize on real estate as an investment. You can also put your money into a fund – called a real estate investment trust (REIT) – that invests in properties and loans and which may prove to be a safer and higher-yielding option than flipping a home or collecting rent as a landlord.
REITs are publicly traded closed-end investment funds that are traded similarly to shares of stock on major stock exchanges, including the New York Stock Exchange, which trades190 different REITs. The two main types of REITs are: (1) equity REITS, which purchase commercial, residential or industrial real estate properties, wherein income is generated primarily from rental of the properties and sales of properties that have increased in value; and (2) mortgage REITs, which provide original mortgage loans to borrowers or purchase existing loans or mortgage-backed securities and which generate income from interest earned on these loans.
“REITs were created as a special entity that allows investors to have exposure to real estate assets and enjoying the benefits associated with them without substantial capital investment,” says Vivek Sah, associate professor of real estate at the University of San Diego. “They are a great vehicle for steady cash flow, which makes them particularly attractive for people planning for their retirement.”
Robert Johnson, president/CEO of The American College of Financial Services in Bryn Mawr, Pa., says REITs offer other advantages to investors, too, including diversification.
“REITs invest in a variety of properties, whereas direct real estate investing is often limited to a small number of properties,” Johnson says. “Also, REITs are very liquid investments compared to direct real estate investing that can involve significant costs in terms of time and money.”
What’s more, REIT investors get paid dividends (distributed quarterly, semi-annually or annually), they benefit from capital gains as the fund appreciates over time, and the properties within a REIT’s portfolio are supervised by asset and property management professionals.
“A REIT investor doesn’t get a call in the middle of the night because a tenant’s heater or air-conditioning unit is not functioning,” Johnson says.
The downside of this arrangement is that “the investor has relatively little control over the REIT’s activities,” says Andrew Maguire, an attorney at Devon, Pa.-based McCausland Keen + Buckman, who represent various REITs. “Also, like any other publicly traded company, the value of any public REIT’s shares can go down.”
Yet the performance of some REITs in recent years has been impressive: Johnson and research colleagues found that, from 1972 through 2013, during rising interest rate environments, equity REITs produced a 9.8 percent rate of return versus 8.5 percent for the S&P 500 over the same span. Mortgage REITs didn’t fare quite as well over that period, losing 4.1 percent.
“Equity REITs have performed very well in rising rate environments. With interest rates expected to rise in the near future, equity REITs are an asset class that investors should be considering at this time,” says Johnson, who suggests holding no more than 10 percent of your total portfolio in REITs. He also cautions against dabbling in private REITs not traded on exchanges.
Arturo Neto, founder and chief investment strategist for Orenda Partners LLC in Coral Gables, Fla., recommends taking a closer look at REITs that invest in hotels, student housing and self-storage asset classes, “because these property types have shorter leases and can adjust prices faster in an inflationary environment or when interest rates rise.”
Before jumping into the REIT investment pool, be prepared to do your homework.
“Be sure to educate yourself on the different types of properties and how each performs in different market environments. Targeting a fund with the highest-paying dividend isn’t usually the best strategy. The company has to be fundamentally sound to be able to continue to pay out a nice dividend,” Neto says.
Sah recommends evaluating REITs based on several important criteria, including property type/asset class (for example, office, retail, hotel, apartment, etc.), dividend history, dividend payout ratio (as a percentage of funds flow from operations, or FFO), quality of management and portfolio of properties (including economic strength of the cities where they are located).
“REITs are very transparent entities and easy to read, study and analyze compared to non-REIT funds, and a lot of information about their operations can easily be obtained from their annual reports and balance sheets,” Sah says.
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