Investing in Real Estate Investment Trusts (REITs) can provide dividend investors with high yields, steadily growing payouts, nice diversification, and an attractive income stream for retirement living.
However, REITs have a number of complexities and risks that should be understood before making any investments.
Before jumping into the essential information investors need to know about REITs to make better informed decisions, it’s worth highlighting some of the sector’s appeal.
For one thing, $100 invested across all REITs in 1971 would have grown to nearly $6,000 in 2015, representing compound annual growth of about 10%:
Source: Simply Safe Dividends, REIT.com
When it comes to building wealth few industries are more time tested, or successful, than real estate. In fact, real estate is the third biggest creators of the world’s billionaires:
This is understandable given that real estate has a several built-in advantages that naturally make it appreciate in value. For example, the growing global population generally leads to both economic growth and higher demand for land and properties involved in housing and industrial development.
In addition, the ability to use leverage (i.e. buying real estate properties with debt, such as a mortgage) means that investors can generate substantial returns on investment.
Furthermore, real estate is usually a cash rich business thanks to rent income, which makes this kind of investment highly attractive to long-term investors. And finally we can’t forget the numerous tax benefits of real estate, including the ability to deduct depreciation expenses from earnings, and mortgage interest from taxable income.
But for most retail investors, the idea of investing in real estate other than their own homes can be intimidating. After all, owning a rental property can be extremely hands on and time intensive. In addition, there are numerous legal implications, as well as risks that becoming a landlord involves, that most people simply don’t have the time or desire to get involved with.
Fortunately, there is a much simpler way for long-term income investors to profit from real estate, one that is no more difficult than buying shares on a stock exchange.
What are Real Estate Investment Trusts?
Real Estate Investment Trusts, or REITs, were created in 1960 as a new, tax efficient means of helping America fund the growth of its rapidly increasing demand for all types of real estate.
Basically, REITs are pass-through equities in which the company pays no federal income tax as long as it pays out at least 90% of its taxable income as unqualified dividends to investors.
The result is a naturally high-yielding class of equities in which the business model is predicated on constantly raising new external growth capital from the debt and equity markets in order for management to grow its portfolio of cash producing properties; thus allowing dividend growth over time.
And since market studies show that a good rule of thumb for long-term total returns, which include dividend reinvestment, is yield + dividend growth, rising dividends generally result in share price appreciation.
REITs: A Proven Long-term, High-yield, Equity Class
Over the last few decades REITs have proven themselves one of the best long-term ways for investors to build income, and wealth over time. As you can see, REITs have not just held their own nicely against both large cap companies, such as make up the S&P 500, but also small cap stocks. Meanwhile they have handily outperformed bonds, and inflation, as one would hope from equities, which have more built in risk than bonds, and should thus offer an appropriate risk premium.
This great long-term performance has resulted in the REIT industry growing over the decades to over $1 trillion in market capitalization, and holding over $2 trillion in total assets. The industry has grown so large in fact, that S&P has recently changed its Global Industry Classification Standard, or CIGs system to make REITs its own sector, rather than grouping REITs into finance.
This change represents the growing importance of REITs to the overall stock market, and is likely to result in far more interest from institutional money, thanks to the need to hold prominent REITs as part of increasingly popular index funds. Which means that, going forward REITs should represent a potentially even more popular, liquid, and potentially less volatile asset class.
There are Many Different Types of REITs
While all REITs are similar in many ways, investors need to realize that this sector encompasses a vast array of differing real estate assets:
- Shopping Center
- Single Family units (rental homes)
- Data Centers
- Student Housing
- Triple Net Lease Retail
- Manufactured Homes
Investors can view a complete list of REITs here.
Note that there is also a separate class of REITs known as mortgage REITs, or mREITs. These are a far more complex, volatile, and challenging higher-yielding class of equities that isn’t suitable for investors seeking steady and growing incomes. That’s because the business model of mREITs is extremely interest rate sensitive.
It’s based entirely on buying and selling mortgage backed securities, and involves little or no owned properties. Therefore it should be owned only by the most risk-tolerant investors, who are willing to put in the extra effort to find only the best mREITs, hold throughout periods of falling dividends, extreme volatility, and buy on the corresponding dips, corrections, and crashes.
Getting back to traditional property-based REITs, as you can see from the above list there is a vast universe to potentially own, each with its own various nuances that investors need keep in mind. However, all REITs share common characteristics in that they derive the majority of their cash flow, which is what secures and grows the dividend, from real estate properties and rental income from tenants.
Important REIT Financial Metrics
Of course, being that REITs are generally owned as high-yield, dividend growth investments, naturally the dividend profile is the first thing that you’ll want to look at when performing your due diligence before investing. This consists of three factors: yield, dividend safety, and potential long-term growth prospects.
The most important of these is dividend safety, because nothing can potentially generate permanent losses of investor capital than a dividend cut, which generally sends shares crashing. However, because of the way REITs are structured for tax purposes, traditional methods of measuring dividend safety, particularly the EPS payout ratio, are not good means of knowing whether or not a payout is actually safe.
That’s because under generally accepted accounting practices, or GAAP, a company must include depreciation and amortization of its assets into its earnings calculations. However, the unique nature of real estate assets, particularly that well-maintained properties tend to appreciate rather than depreciate over time, means that GAAP earnings don’t actually represent a REIT’s ability to cover its dividend or grow it over time.
What you instead want to look at is funds from operations, or FFO. This is