Real estate investment trusts (REITs) can be some of the most attractive dividend stocks in the market and can also be excellent for growth.

In this segment from Industry Focus: Financials, host Michael Douglass and Motley Fool contributor Matthew Frankel give a rundown of what a REIT is, and why income investors might want to add them to their portfolios.

A full transcript follows the video.

This video was recorded on June 4, 2018.

Matt Frankel: In the simplest form, a REIT is an investment vehicle that pools investors' money to buy real estate. Think of them in terms of how a mutual fund is a pool of investors' money that buys stocks or bonds. A REIT is a pool of investors' money that buys real estate. It's real estate that investors generally didn't have access to before. That's why they were created. I don't know about most listeners, but I personally could not run out and just buy a shopping mall today if I wanted to. That's why REITs can be such a great investment vehicle. They allow everyday investors access to property types that they normally wouldn't.

Before we go any further, one distinction to make is, REIT is kind of a broad term. There's two main classifications of REITs. You have equity REITs, which is what we normally are talking about when we say the term "REIT," which means companies that own physical properties; and mortgage REITs, companies that invest in mortgage-backed securities and other assets. Generally, if we're talking about mortgage REITs, we will specify. But if you just hear the term "REIT" come out of our mouth, then we're generally referring to equity REITs.

Michael Douglass: And that's in part because we tend to really prefer equity REITs as businesses, so we tend to not talk about the mortgage REITs as much. As well, they're a much narrower subset. If we're ever talking about them, as Matt noted, we'll really call that out. Today, we're just discussing equity REITs.

Frankel: Right. Just to go through a few of the things of what makes a REIT a REIT, the rule is, they have to have at least three-quarters of their assets invested in real estate, and must also derive at least three-quarters of their income from rents, interest payments, sales of real estate, or other sources derived from the real estate itself. They also have to pay out most of their income as dividends, which is one of the reasons investors tend to love these, especially in retirement accounts where they don't have to pay taxes. REITs tend to pay higher dividends than most other companies. They also have to be owned by at least 100 people, and no one can own a majority of a REIT. The rule is that no more than 50% of a REIT can be owned by five or fewer people. Generally, REITs limit individual ownership to a 10% stake.

Douglass: Right. There are a couple of issues with REITs that bear noting. As Matt pointed out, REITs are required to pay out a lot in dividends. That's how they get that tax benefit where they aren't otherwise paying income taxes or business taxes. This issue, then, is that, because they're having to pay out so much in dividends, they can really only effectively fund growth one of three ways. One is by selling old properties and buying new ones. That doesn't necessarily translate to growth, but sometimes it can. The second is by taking on debt. You tend to find that REITs tend to be very debt-laden, and they tend to be very interest rate-sensitive. We'll talk about that more in a minute. Thirdly, issuing equity, AKA diluting shareholders, AKA putting more shares out on the market and selling them. So, what you'll tend to find with REITs is that they usually do some sort of combination of all three of those.

Talking about interest rates for a minute, REITs basically make their money, in a lot of ways, by taking money in from outside lenders and then positioning it in properties, and then making money off those properties, more than they're paying out to the lender. As interest rates increase, even if REITs don't have floating-rate debt, even if their debt is fixed, it becomes more difficult for them to take on more debt because those interest rates have increased, therefore the debt becomes more expensive, therefore they can only profitably invest in fewer properties in the future.

Frankel: It's also worth pointing out, some REITs are much better than others when it comes to selling properties to finance new properties. This you'll see more in, say, apartments, when one real estate market has gone up a whole lot. Let's say a company owns a ton of properties in San Francisco, where we all know that real estate has gone crazy over the past decade or so. They could sell those and reinvest the profits in a lower-cost market, in more properties that could have a better return on their investment.

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