REITs can be excellent stocks to add to any long-term investment portfolio. Not only are REITs excellent income generators, but they have the potential to produce some impressive returns over time as property values rise. Investors can choose REITs that specialize in a wide variety of properties, such as apartments, offices, shopping malls, self-storage facilities, and more.

With that in mind, here's what all investors should know about REITs before they buy their first one, as well as some beginner-friendly examples of excellent REITs that could be worth a look.

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What is a REIT?

A real estate investment trust, or REIT (pronounced "reet"), is an investment vehicle that pools investor money to buy real estate assets. Think of a REIT as similar to an exchange-traded fund, or ETF, except instead of investing in stocks or bonds, a REIT uses investors' money to acquire properties.

Most REITs specialize in a certain type of real estate asset. For example, a residential REIT might use its capital to purchase apartment buildings.

The basic idea of a REIT is to allow investors to put their money to work in assets that would otherwise be unaffordable to most people. In other words, investing in a shopping-mall property isn't practical for the average investor, but a REIT could allow them to do it.

REITs earn income from their properties or other real estate assets and pass this income along to their shareholders in the form of dividends. To qualify as a REIT, a company must meet a few specific requirements:

  • A REIT must pay out at least 90% of its taxable income to shareholders. According to the National Association of Real Estate Investment Trusts (NAREIT), most choose to pay out 100% or more of their taxable income.
  • It must invest at least 75% of its assets in real estate.
  • A REIT must derive at least 75% of its income from rental income or other real estate sources.
  • It must be structured as a corporation.
  • A REIT must have at least 100 shareholders.
  • No more than 50% of a REIT's shares can be held by five or fewer individuals. Many REITs limit any one person's ownership to 10% in order to ensure compliance with this rule.

If a company meets these requirements and is classified as a REIT, it will enjoy a pretty big tax advantage, as I'll discuss later.

Equity versus mortgage REITs

There are two main categories of REITs -- equity and mortgage.

Most publicly traded REITs are equity REITs, which means that they own physical properties for the purpose of generating income. Mortgage REITs, on the other hand, invest in mortgages, mortgage-backed securities, and other mortgage-related assets.

Generally speaking, most people use the term "REIT" when referring to equity REITs, and for the remainder of this article, you can assume that I'm talking about equity REITs unless I specify otherwise. Mortgage REITs are a rather different type of investment -- in fact, they aren't even included in the S&P's Real Estate sector.

Why invest in REITs?

I already mentioned that REITs allow investors to put money into assets that they otherwise wouldn't be able to afford. In addition to that, there are several reasons to consider adding REITs to your portfolio:

  • Income -- Because REITs are required to pay out substantially all of their taxable income, most REITs pay above-average dividends. Of the 172 publicly traded equity REITs listed on the major U.S. exchanges with market capitalizations greater than $500 million, 94% have higher dividend yields than the average S&P 500 company.
  • Diversification -- While they're technically stocks, REITs can help spread some of your investment dollars to another asset class (real estate).
  • Ease of use -- You may have heard that more millionaires have been made from real estate than any other source, and it's true. Unfortunately, buying and managing individual investment properties can be quite a chore. REITs allow investors to get exposure to this potentially lucrative asset class with the ease of buying a stock.
  • Total-return potential -- One reason real estate has made so many millionaires is for its high total-return potential. (Note: Total return is a stock's dividends combined with growth in its share price.) As a group, REITs have outperformed the S&P 500's total returns over the past 25 years, and there are some well-known REITs that have averaged total returns of 15% or more over the long term.

The REIT tax advantage

I briefly mentioned before that the primary motivation for a real estate company to qualify as a REIT is because of a big tax advantage that comes with the status. Here are the specifics.

Most companies have their profits effectively taxed twice. When a company earns a profit, it typically has to pay corporate tax. This was recently reduced to a rate of 21% as part of the Tax Cuts and Jobs Act, but it can still be quite a financial burden. Then, when shareholders receive some of these profits as dividends or sell their stock at a profit, they have to pay tax again. To be sure, there are favorable tax rates for qualified dividends and long-term capital gains, but this still is a double taxation of the same corporate profits.

REITs, on the other hand, are not taxed on the corporate level as long as they pass most of their profits directly to shareholders. Investors need to pay dividend taxes on their income, as well as capital gains taxes when selling REIT shares for a profit, but avoiding corporate taxes can be a big benefit.

Because of this favorable tax treatment, REITs can be especially good investments to hold in retirement accounts such as traditional or Roth IRAs. This allows investors to effectively defer or even avoid taxes on the personal level, as well as on the corporate level.

How are REIT dividends taxed?

One potential negative is that REIT dividends are more complicated than those paid by most stocks in terms of their tax structure. Specifically, most dividends paid by U.S. stocks meet the definition of qualified dividends, which allow investors to obtain a favorable tax rate. However, most REIT dividends don't qualify.

In fact, REIT dividends are often split up into three different categories -- ordinary income, capital gains, and return of capital -- depending on how the REIT made its money during the tax year. And all three of these are taxed differently.

  • Ordinary income is taxed at your marginal tax rate (tax bracket), and high earners also can be required to pay a 3.8% net investment income tax. However, thanks to the Tax Cuts and Jobs Act, pass-through income, including that from REITs, can be deducted, which effectively lowers the tax rate you'll pay.
  • Capital gains distributions are taxed at the more favorable long-term capital gains rates, which are capped at 20% (plus the 3.8% investment income tax).
  • Return of capital is not taxable, but lowers your cost basis in the stock, which can lead to capital gains taxes when you eventually sell.

Here's a real-world example of how this works. Retail REIT National Retail Properties (NYSE:NNN) paid $1.86 per share in dividends in 2017. Of this amount, about $1.56 of this (84%) was classified as ordinary income, $0.06 (3%) was classified as a capital gain distribution, and $0.25 (14%) was classified as a non-taxable return of capital. (Note: Numbers may not add perfectly, due to rounding.)

This may sound complicated -- and it is -- but the good news is that your brokerage will keep track of your dividend categories for you. You'll receive a 1099-DIV tax form soon after the end of the year, which will contain the tax classification of the dividends you've received.

In addition, if you hold your REIT stocks in a retirement account, you won't have to worry about dividend and capital gains taxes. In a traditional IRA or other tax-deferred account type, you'll just have to pay income tax on your eventual withdrawals from the account. With a Roth IRA or other after-tax account type, you won't have to pay tax at all on qualified withdrawals.

Key metrics used to evaluate REITs

When it comes to evaluating REITs, there are a few specific metrics that are important to know.

Funds from operations, or FFO, is perhaps the most important metric for new REIT investors to learn. FFO adds depreciation back into the REIT's earnings, and also makes a few REIT-specific additions and subtractions to give investors a better picture of how much money a REIT actually made per share.

Traditional methods of calculating a company's net income, or "earnings," just don't work for REITs. Specifically, companies are allowed a deduction for depreciation of their properties each year, and this makes REIT income look far lower than it actually is. After all, properties don't actually lose value every year -- in fact, the opposite generally is true.

In addition to FFO, many REITs use metrics known as adjusted FFO, normalized FFO, or core FFO. While different REITs have different ways of calculating these metrics, the bottom line is that these are intended to give a company-specific view of a REIT's performance. For example, a REIT's normalized FFO may exclude one-time costs related to an acquisition.

Finally, another important metric for real estate investments is capitalization rate, or "cap rate." This tells you how profitable a REIT's new properties are, expressed as a property's (or a portfolio of properties') annual income relative to its acquisition cost. In other words, if a company acquires a property for $10 million at a 7% cap rate, this implies that the property is expected to generate $700,000 in annual income.

Risks of REIT investing

No discussion of any investment would be complete without mentioning the risks involved, so here are some of the key risks that REIT investors should be aware of.

First, REITs tend to be extremely sensitive to changes in market interest rates. As rates rise, investors expect their "riskier" investments like REITs to pay a premium over what they could get from risk-free investments like Treasury bonds, which puts downward pressure on stock prices. Conversely, in periods of falling market interest rates, REITs tend to rise. As far as interest-rate pressure goes, the 10-year Treasury yield is a good indicator for REITs.

REITs also have property type-specific risks. For example, many key self-storage markets are facing oversupply issues in 2018, so this has put downward pressure on many self-storage REIT stocks. Another example is the pressure put on retail REITs by the recent wave of retail bankruptcies in the U.S.

Also, keep in mind that a REIT is only as valuable as the properties it owns. If real estate has a major downturn, like it did during the financial crisis, it could make REITs' intrinsic values fall.

And finally, there are certainly company-specific risks to consider. For example, if a specific REIT takes on too much debt, it can be a big risk factor for that particular company, even though its properties may be performing just fine.

Types of REITs and examples of each

As I've mentioned, most REITs specialize in a specific property type. Here are the broad categories of REITs, and notable beginner-friendly examples of each type, which new REIT investors may want to take a closer look at.

Company (Symbol)

Type of Property-Subtype

Market Capitalization

Dividend Yield

AvalonBay Communities (NYSE: AVB)

Residential -- Apartments

$24.5 Billion

3.3%

American Campus Communities (NYSE: ACC)

Residential -- Student Housing

$5.6 Billion

4.5%

Simon Property Group (NYSE: SPG)

Retail -- Malls

$54.5 Billion

4.5%

Realty Income (NYSE:O)

Retail -- Freestanding

$15.8 Billion

4.7%

Welltower (NYSE: WELL)

Healthcare -- Senior Housing (Mostly)

$23.2 Billion

5.6%

Physicians Realty Trust (NYSE: DOC)

Healthcare -- Medical Office Buildings

$2.8 Billion

5.8%

HCP (NYSE: HCP)

Healthcare -- Diversified

$12.1 Billion

5.7%

Public Storage (NYSE: PSA)

Self-Storage

$37.5 Billion

3.7%

Life Storage (NYSE: LSI)

Self-Storage

$4.4 Billion

4.2%

Prologis (NYSE: PLD)

Industrial -- Logistics Properties

$34.9 Billion

2.9%

Boston Properties (NYSE: BXP)

Office

$19.8 Billion

2.6%

Empire State Realty Trust (NYSE: ESRT)

Office/Retail

$2.8 Billion

2.5%

Apple Hospitality REIT (NYSE: APLE)

Hotels -- Select Service

$4.1 Billion

6.7%

Host Hotels and Resorts (NYSE: HST)

Hotels -- Luxury

$15.6 Billion

3.8%

Digital Realty Trust (NYSE: DLR)

Data Centers

$25.0 Billion

3.3%

Equinix (NASDAQ: EQIX)

Data Centers

$34.9 Billion

2.1%

Hospitality Properties Trust (NASDAQ: HPT)

Hotels/Travel Centers

$4.6 Billion

7.5%

EPR Properties (NYSE: EPR)

Entertainment/Recreation /Education

$4.9 Billion

6.5%

Weyerhauser (NYSE: WY)

Timber

$25.7 Billion

3.7%

American Tower (NYSE: AMT)

Communications

$66.2 Billion

2.1%

Data Source: TD Ameritrade. Data as of 8/1/2018.

Residential REITs -- NAREIT estimates that 14% of all REITs specialize in residential properties such as apartment buildings, student housing, and single-family rental properties. Just to name a few examples of prominent residential REITs:

  • AvalonBay Communities specializes in apartment properties located in high-barrier coastal markets such as New York and San Francisco. Equity Residential is another example of an apartment REIT and has a similar business model to AvalonBay and an excellent history.
  • American Campus Communities develops and operates student housing properties located on or near major U.S. universities.

Retail REITs -- Retail REITs are the largest segment of the real estate sector, making up 17% of all REITs. These can focus on a certain type of retail property such as shopping malls, outlet centers, shopping centers, or freestanding properties. Some choose to have a more diverse strategy that includes several different types.

  • Simon Property Group is one of the largest REITs of any kind and owns a portfolio of high-end shopping malls. It also has a dominant market share in the outlet retail business.
  • Realty Income specializes in net-lease retail properties, which typically means single-tenant properties where the tenant pays for property taxes, insurance, and maintenance expenses.

Healthcare REITs -- Healthcare REITs specialize in properties such as hospitals, medical office buildings, senior living facilities, and life science properties.

  • Welltower is the largest healthcare REIT and primarily invests in senior housing and other senior-specific property types.
  • Physicians Realty Trust invests in medical office buildings, especially those associated with major health systems.
  • HCP is a large healthcare REIT that specializes in three specific property types -- senior housing, medical offices, and life science facilities -- with similar allocations to each one.

Self-storage REITs -- Self-storage REITs own storage facilities and rent space to customers.

  • Public Storage is by far the largest self-storage REIT, with well over 2,000 properties. In terms of revenue, Public Storage is larger than its next three competitors combined.
  • Life Storage is more of an up-and-comer, and recently rebranded itself from Uncle Bob's Self Storage.

Industrial REITs -- Industrial REITs own logistical properties, such as warehouses, fulfillment centers, and others.

  • Prologis specializes in distribution centers and aims to capitalize on the growth of e-commerce and the need for logistics real estate that comes with it.

Office REITs -- As the name implies, office REITs own and operate office buildings and lease the space to tenants.

  • Boston Properties is one of the largest owners of Class A (top-quality) office real estate in the U.S., and its properties are mainly concentrated in four markets -- Boston, New York, Washington D.C., and San Francisco.
  • Empire State Realty Trust owns office and some retail real estate in the New York City area, including the famous Empire State Building.

Hotel REITs -- Some REITs own and manage hotel properties, and there are several different sub-specializations within the hotel industry.

  • Apple Hospitality REIT owns a large portfolio of "select service" hotels, which is a term for the midrange of the hotel market. Major hotel brands in the select service category include Homewood Suites by Hilton and Courtyard by Marriott.
  • Host Hotels and Resorts focuses on high-end hotel properties and is the largest hotel in the market.

Data Center REITs -- A data center is a specialized facility designed to provide secure and reliable space for companies to operate servers and other networking equipment. Data center REITs have become a much larger piece of the market in recent years, thanks to the surge in connected devices worldwide.

  • Digital Realty Trust is a massive data center REIT, with operations all over the world, but a big concentration in the U.S.
  • Equinix is the largest data center REIT of all and has a geographically diverse revenue stream, with less than half of its revenue coming from the Americas.

Diversified REITs -- Diversified REITs specialize in a combination of two or more different property types.

  • Hospitality Properties Trust owns a portfolio of more than 300 hotels and about 200 travel centers adjacent to interstate highways.
  • EPR Properties specializes in three distinct property types -- entertainment, recreation (think waterparks and golf attractions), and education.

Specialized REITs -- There are several other types of specialized properties that REITs can invest in. Just to name a few examples, there are timberland REITs, communication REITs, education REITs, and casino REITs.

  • Weyerhauser is a massive timberland REIT that manufactures and distributes wood products.
  • American Tower is a REIT that owns and operates communications towers used by mobile communications providers, cable companies, and more. American Tower is the largest REIT of all in the U.S. market.

How to evaluate a REIT

As a final point, let's take a closer look at how you may want to go about evaluating a REIT. I'll use Realty Income, which I own in my personal portfolio, and I'll go through a list of questions I ask myself when choosing REIT investments.

Does the REIT trade for a reasonable valuation? A price-to-FFO multiple of 17.5 is rather low considering Realty Income's consistency and growth potential, which I'll get into shortly.

Is there a margin of safety? That is, if the economy/market took a downward turn, would this REIT's income suffer? Realty Income's net-lease structure helps to ensure high occupancy and low turnover, even in tough economic times. It's also resistant to retail headwinds, as most of its tenants' businesses are resistant to e-commerce and recessions. Realty Income's portfolio occupancy has never fallen below 96%.

Does the REIT carry lots of debt? Is it financially flexible? Realty Income's debt makes up just 31% of its total capitalization, which is low for a REIT. In addition, Realty Income's credit rating (A3/BBB+) is one of the best in the real estate sector.

Is the portfolio diverse? That is, is too much of the revenue dependent on one or a few tenants? Realty Income has more than 250 tenants, none of which account for more than 7% of the total rental income. Tenants operate in 11 different industries, and the properties are located in all 49 states and Puerto Rico.

Does the REIT have a strong dividend-payment record? Not only does Realty Income pay a 4.7% yield in monthly installments, but it has made 576 payments in a row and increased the payout for 83 straight quarters.

Is there ample growth potential? Realty Income has grown its adjusted FFO in all but one year since its 1994 NYSE listing. In that time, it has generated annualized total returns of 15.7% for investors, handily beating the S&P 500.

While this is the general methodology that I use to explain my Realty Income investment, it can easily be applied when evaluating other REITs.

Matthew Frankel owns shares of American Campus Communities, Digital Realty Trust, EMPIRE ST RLTY TR INC, HCP, Public Storage, and Realty Income. The Motley Fool owns shares of and recommends American Tower. The Motley Fool has the following options: short October 2018 $135 calls on American Tower and long January 2019 $80 calls on American Tower. The Motley Fool recommends Equinix and Marriott International. The Motley Fool has a disclosure policy.