Real estate can be an extremely rewarding investment. Not only can real estate investments generate income streams that beat most dividend-paying stocks, but they also can appreciate in value over time. However, buying and renting out individual properties isn't practical for many people, and can be a rather risky venture.
Instead, consider investing through equity real estate investment trusts, or REITs. These investments trade like stocks, and can allow everyday investors to profit from types of commercial real estate they may not otherwise be able to afford to invest in, such as shopping malls.
The downside of investment property ownership
To be clear, I'm not saying that buying rental properties is a bad way to invest. Quite the contrary. Many people who own rental real estate achieve fantastic investment returns. What I'm saying, however, is that for most Americans, this isn't the best or most practical way to invest in real estate.
Specifically, there are several downsides to owning individual rental properties, including but not necessarily limited to:
- Vacancy risk -- If you buy a house to rent out, 100% of your cash flow depends on keeping that property occupied. Vacancies happen, and when they do, you can see your income grind to a halt.
- Maintenance expense -- While smart landlords set aside a portion of each month's rent to cover maintenance costs, this is still a highly uncertain expense. It's entirely possible to buy a property and have the $6,000 central air conditioner break almost immediately.
- Time required to manage the property (or an additional expense to hire a property manager) -- If you don't want to find and select tenants, handle property-related issues, and more all by yourself, plan to pay around 10% of your rental income to a property manager.
The solution: Equity REITs
Real estate investment trusts, or REITs, come in two main varieties -- mortgage and equity. Equity REITs invest in commercial properties, and therefore are the logical substitute for buying individual rental properties.
In a nutshell, these are a type of investment vehicle that require most assets to be invested in real estate, and at least 90% of net income to be distributed to shareholders as dividends. If a REIT meets these requirements, its profits are not taxed on the corporate level -- a big advantage for investors, especially those investors who own REITs in retirement accounts.
Types of equity REITs
Some REITs are diversified, meaning they invest in several different property types. Most, however, specialize in a specific type of property. Here are a few of the most common categories of REITs, and some of the big players in each.
Retail -- There are several subtypes of retail REITs. Some invest in mall properties or outlet centers, such as Simon Property Group, the largest REIT of all. Others invest in shopping centers, like Kimco Realty. And others invest in freestanding, or net-lease retail, and Realty Income is a very popular example. Although the retail industry as a whole has had its struggles in recent years, the long-term lease structure of retail REITs make them relatively defensive investments, especially those that focus on discount or non-discretionary retail.
Residential -- The majority of residential REITs invest in apartment buildings, although a few invest in single-family rental homes. Urban-focused apartment REITs such as AvalonBay Communities are plays on the trend toward city living, while others like Mid-America Apartment Communities invest in high-growth markets outside of urban areas. Apartment REITs are somewhat more recession prone than other REITs with longer-term leases, so keep that in mind.
Office/Industrial -- Many REITs specialize in office buildings or industrial properties such as warehouses, distribution centers, or factories. These properties tend to lease on a long-term basis, and tenants have high switching costs, so they tend to hold up well in recessions. STAG Industrial is a good example of a solid industrial REIT.
Hotels -- Hotel REITs are a more aggressive type of real estate investment. Since people rent hotel rooms by the day, these properties have extremely short "leases" from their tenants, and therefore are highly recession-prone. Some do a good job of mitigating the risks, like Apple Hospitality REIT, but it's important to be aware that hotel REITs can be more of a high-risk/high-reward-potential type of REIT than the others on the list.
Healthcare -- The American population is aging fast. Over the next 30 years or so, the senior citizen population is expected to double, which will create a surge in demand for healthcare facilities. Healthcare is a highly recession-resistant business, and healthcare tenants are on long leases, so this is perhaps the most defensive form of REIT on this list. To minimize volatility, focus on REITs with tenants that are dependent on private-pay revenue sources, such as HCP Inc.
Data Centers -- Over the past decade or so, the need for data storage facilities has exploded, and several REITs have taken advantage of this. Digital Realty Trust is an excellent example of a REIT that provides solutions to major technology companies in need of cloud data storage and other solutions.
Self-storage -- By far, Public Storage is the largest and most well-known self-storage REIT, but there are several others as well. Some aspects of the self-storage business are defensive in nature, such as low maintenance and turnover costs, while others aren't, such as the month-to-month lease terms in the industry.
There are several other specializations as well. You can find REITs that focus on recreational properties, timberlands, billboards, and more. The point is that there are REITs with various levels of risk tolerance to choose from.
How to evaluate REITs
I've included some of my favorite REITs in this discussion, but it's still important to know how to do your own evaluation before investing. At a minimum, you may want to learn these 10 REIT terms, and learn how basic REIT metrics work, particularly funds from operation, or FFO.
In a nutshell, FFO is the REIT version of net income, or "earnings." Accounting rules allow REITs to depreciate the value of their properties against their net income over time. This is great for reducing taxable income, but it also isn't an "expense" in the traditional sense of the word, and therefore doesn't actually reduce the amount of money a REIT makes. FFO adds depreciation back in and makes a few other adjustments to give a clearer picture of a REIT's earnings, and therefore its ability to pay dividends.
Amazing long-term potential
REITs are "total return" investments, meaning they have the ability to produce strong income and growth over time as property values increase.
As an example, one of my personal favorite REITs, Realty Income, pays a dividend yield of more than 4%, and has increased its dividend 92 times since its 1994 NYSE listing. When combined with the company's share price growth, the total return since that time has averaged 16.9% per year. To put this kind of performance in perspective, a $10,000 investment that grows at this rate for 30 years will be worth nearly $1.1 million.
While I'm not saying you should necessarily expect this level of performance from the REITs you invest in, the point is that while many people consider commercial real estate to be a rather boring investment, it actually has market-beating return potential that is anything but boring.