Here’s a little-known secret about investing in real estate: You don’t have to be a Trump-style property mogul to get a piece of the action. You also don’t have to get your hands dirty playing landlord or flipping houses. There’s an easier way to foray into wealth-growing real property investments — equity real estate investment trusts (REITs).
Here’s what you need to know about REITs
The skinny on REITs is this: These are companies that invest in real estate through direct ownership of real property. Equity REIT companies acquire commercial properties — think things like office and apartment buildings, shopping centers, healthcare centers, hotels, and timber land — and lease to tenants.
After paying the expenses associated with operating the properties, equity REITs pay out the bulk of the income annually to shareholders as dividends. In the event of a property sale, REIT companies include any capital appreciation in dividend payout. However, as with any investment, there is a risk of total loss or substantial loss of value in the properties.
In essence, a REIT is a type of security. REITs can be structured similar to stocks and some trade on major market exchanges, while others are non-traded and will have limited liquidity.
Today, publicly traded REITs in the U.S. have a market capitalization of approximately $605 billion, representing about 3% of the total stock market. Commercial real estate accounts for close to 13% of the U.S. economy. Currently, this asset class is underrepresented by about 10% in the stock market. Publicly traded REITs differ from common stocks – they’re comprised of collateralization of several individual properties, and they have a unique tax structure in which the trust pays no federal tax. Instead, the dividends from REITs are taxed as regular income on an individual’s tax return. This tax structure is most optimal for investors in a lower federal tax bracket.
If you are in a high federal tax bracket and still want exposure to real estate, then consider owning REITs inside an IRA, SEP IRA, or other tax-deferred retirement accounts. This way, the annual income generated each year from these investments can be protected from current taxation.
What percentage of your investments should you have in REITs?
The answer to this question will be different for every investor. Some investors, like President Trump, are comfortable investing the majority of their net worth in the sector. For highly risk-adverse investors, the answer may be a 0% allocation. From a risk perspective, think of publicly traded REITs as you would the stock market. Yes, REITs provide significant annual income and price appreciation potential, but they can fall out of favor and lose value quickly, just like the rest of the stock market.
The shorthand: Because of their unique characteristics, publicly traded REITs are a nice way to diversify your portfolio in a way that represents the economy as a whole while reducing the risks associated with being an equity investor.
As with any other type of investment, publicly traded REITs aren’t market-proof. Just like interest rates and the broad economy fluctuate over time, real estate moves in waves. Even within the different classes of publicly traded REITs, there will be times when one type of real estate is expanding while another contracts.
Think, for example, about affordable apartments. In a period of slow economic or job growth, these publicly traded REITs may do very well because there’s a national trend towards low-cost housing. During the same period, a REIT that owns, say, high-end resort hotels may find itself floundering.
Rising rate environments, like what we’ve seen since the summer of 2016, can also cause publicly traded REITs to behave differently. Some publicly traded REITs, like those invested in shopping malls and health care facilities, will naturally have longer-term commercial leases. The set terms of these contracts may leave these companies more vulnerable to rising rates and inflation. On the other hand, publicly traded REITs invested in hotels and resorts can readjust pricing almost daily to meet changes in demand or the underlying economy. While these publicly traded REITs may have less clarity on their cash flow in the intermediate term, they have more flexibility to adjust cash flow based on a changing economy or interest rates.
Another important point on publicly traded REITs is that rising interest rates don’t always spell trouble, especially if rates are on the rise because the economy is heating up. Instead, historical data shows that a better economy (even one with rising interest rates) is healthy for REITs.
Today, there are approximately 157 different equity REITs that trade on the U.S. stock market. If you’re looking to step into the realm of real estate investments, put REITs on your list of vehicles to research. However, as always, before investing, be sure to discuss the investment option with a financial professional, as REITs are not suitable for all investors.
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.