Understanding diversified REITs
A diversified REIT owns a diversified portfolio of commercial real estate assets, which can include:
Many diversified REITs focus on owning single-tenant net lease real estate. These are properties secured by long-term triple net (NNN) leases with the occupying tenant. This lease structure makes the tenant responsible for maintenance, building insurance, and real estate taxes, enabling the REIT to collect steady rental income.
However, some diversified REITs will own multi-tenant properties with rental income that is more variable due to shorter-term lease structures or variable expenses. In addition, some own properties that they operate alongside a third-party manager (e.g., hotels and self-storage facilities). These properties can experience even greater income variability, as occupancy and rates can decline quickly during a recession.
Diversified REITs don't buy properties at random. They develop an investment strategy that focuses their efforts on a specific theme. For example, some diversified REITs focus on a particular type of property (e.g., global net-lease real estate or service-related properties). Meanwhile, others focus on owning a diversified real estate portfolio in a specific city.
Advantages of investing in diversified REITs
Investing in diversified REITs provides investors with many benefits, including:
- Passive income: Many industrial REITs pay high-yielding dividends, enabling investors to generate an attractive passive income stream.
- Broad exposure to commercial real estate: Diversified REITs typically invest in several property types, providing investors with instant diversification across the sector. In some ways, owning a diversified REIT is similar to investing in a REIT ETF.
- Lower-risk profiles: The diversification and dividend income provided by diversified REITs tend to make them lower-risk real estate investments.
Risks of investing in diversified REITs
While diversified REITs can help reduce an investor's risk profile, they aren't without risk. Here are some risk factors to keep in mind before investing in diversified REITs:
- Higher dividend payout ratios: Because of their diversified operations, many diversified REITs have chosen to pay out the bulk of their cash flow through dividends, resulting in high dividend payout ratios. While that typically means they are high-dividend REITs, it increases the risk of a dividend reduction if a property segment runs into trouble.
- Slower growth: Because diversified REITs retain less cash, they tend to be slower-growing companies.
- Potential for financial issues: The high dividend payout ratio often leads these REITs to rely heavily on debt and stock sales to fund expansion. This can cause financial troubles if a property segment faces issues or market conditions grow more challenging.
- Property type-specific issues: While diversification reduces some risks, it increases others, such as the risk that one property type could drag down results. For example, office and retail properties have experienced headwinds in recent years. This issue has led several formerly diversified REITs to shift their strategies by narrowing their investment focus to property types with the best long-term growth prospects.
- Interest rate risk: As interest rates rise, it becomes more expensive for REITs to borrow and refinance debt. In addition, higher interest rates make lower-risk, yield-focused investments, such as government and corporate bonds, more attractive to income investors. As a result, REIT stock prices tend to fall, pushing up dividend yields to compensate investors for the higher risk.
Factors to consider before investing in diversified REITs
Investors need to evaluate a few things before buying shares of a diversified REIT, including:
- Portfolio quality: Diversification alone isn't everything. Investors should evaluate whether a diversified REIT owns high-quality properties that can deliver stable and growing rental income.
- Dividend payout ratio: Many diversified REITs have run into trouble in the past by paying out a high percentage of their funds from operations in dividends. That didn't give them enough cushion to weather a down market or to retain much cash to fund new investments.
- Financial strength: Having a strong financial profile would enable a diversified REIT to continue growing its dividend and portfolio during more challenging periods.
Tips for Investing in Diversified REITs
Here are some practical tips for investing in diversified REITs:
- Focus on portfolio quality (properties benefiting from durable demand leased to high-quality tenants) rather than diversification for diversification's sake.
- Ensure it has a strong financial profile (a conservative dividend payout ratio and an investment-grade balance sheet).
- Look for REITs focused on properties secured by long-term triple-net leases.
- Ensure it has a well-defined growth strategy.
Diversified REITs can be great options for real estate investors
Diversified REITs enable investors to own a diversified real estate portfolio through one investment, reducing risk. However, it's essential to know what's in a diversified REIT's portfolio.
That's because most of these companies develop a strategy around a particular theme, which has its pros and cons. While some of these strategies have worked well over the years, others have faced headwinds, leading the REIT to shift gears.
