Real estate investment trusts, or REITs, can not only be excellent income investments but also have the potential for massive long-term returns. Unfortunately, this potentially lucrative sector of the stock market isn't well-understood by many investors.

With that in mind, here's a rundown of the basics of REIT investing as well as five excellent top-quality REIT stocks to put on your radar now.

Looking up at several high-rise buildings.

Image Source: Getty Images.

What is a REIT?

A REIT (pronounced "reet"), or real estate investment trust, is a type of investment company that buys real estate assets. A real estate investment trust works somewhat like a mutual fund or ETF in the sense that while mutual funds pool investors money to buy stocks, bonds, or commodities, REITs pool investors money to buy commercial properties or other real estate assets.

REITs were created to allow everyday investors to capitalize on real estate opportunities that had historically only been available to the rich. For example, few people have hundreds of millions of dollars to build a high-rise apartment building in a major city, but anyone who can afford one share of an apartment REIT can now invest in properties like these.

The basic concept of a REIT is that as the underlying assets generate income, this income will be (mostly) passed to shareholders in the form of dividends. In addition, as real estate values tend to increase over time, property-owning REITs also grow their intrinsic value over time. Of course, there are other value-creating tactics REITs can use, such as developing properties from the ground-up, using leverage to boost returns, and more. You can read my complete guide to REIT investing if you want a more in-depth look at how these investment vehicles work, but we'll cover the major points in this article before we dive into specific REITs to invest in.

In order to qualify as a REIT, a company needs to meet a few specific requirements. First and foremost, it must invest at least 75% of its taxable assets in real estate and must pay out 90% or more of its taxable income to shareholders. It also must have at least 100 shareholders, and no more than 50% of a REIT's shares can be held by five or fewer individuals.

Most REITs specialize in a single property type or some other real estate asset. I just mentioned apartment REITs, and as we'll see later on, there are several other subtypes as well.

It's also important to mention that there are two broad categories of REITs -- equity REITs and mortgage REITs. From here on, when I use the term REIT, I'm talking about equity REITs, which own properties. On the other hand, mortgage REITs are a rather different type of investment and invest in mortgages and mortgage-backed securities, among other assets. In fact, mortgage REITs are so different that they aren't even included in the S&P Real Estate sector -- they are considered financial companies instead.

Why should you own REITs in your stock portfolio?

There are a few key reasons to invest in REITs. We'll discuss the tax advantages REITs enjoy in the next section, but other good reasons include:

  • Income potential -- Since REITs are required to pay most of their taxable income as dividends, they tend to have above-average yields. In fact, on the list of five of my favorite REITs later in this article, the lowest-paying one has a 3.2% dividend yield.
  • Diversification -- REITs can allow you to get exposure to a different asset class (real estate), thereby reducing your reliance on the performance of stocks and bonds.
  • Easier than owning properties directly -- While you may be able to afford a rental property such as a single-family home or small apartment building, it can be quite a chore to be a landlord. By investing in a REIT, you'll never have to deal with evictions, maintenance issues, or bad tenants on your own. And, getting back to the concept of diversification, REITs spread your money across hundreds or even thousands of properties, so a single vacancy or maintenance problem will have a minimal impact on your investment.
  • Total return potential -- As I mentioned, there are two main ways REITs make money. Their properties earn income, and also can rise in value over time. This can produce some pretty impressive long-term total returns (dividends plus share price appreciation). In fact, several of the top-tier REITs have consistently outperformed the S&P 500 for decades, as we'll discuss later.

Tax advantages and disadvantages

If a real estate company meets the requirements to be considered a REIT (distributing 90% of its taxable income, etc.), it enjoys a pretty nice tax advantage. Specifically, REIT income isn't taxed at the corporate level.

With most dividend stocks, corporate profits are effectively taxed twice for investors. The company pays corporate tax on its profits, and shareholders have to pay tax again when those same profits are distributed as dividends.

The lack of corporate taxation makes REITs especially good retirement-account investments. My own Roth IRA, for example, has several high-quality REIT stocks in it, including three out of the five I'm about to discuss.

One tax-related downside is that if you hold REIT stocks in a taxable account, their dividends generally don't qualify for the favorable "qualified dividend" tax treatment that most U.S. dividend stocks get. Even considering this, the lack of corporate taxation generally makes this work out in investors' favor, but it's important to realize before investing that REIT distributions are typically taxed as ordinary income.

How to assess REIT "earnings"

One important concept for REIT investors to understand is that traditional ways of calculating earnings simply don't work for REITs.

Specifically, there's a provision that allows for the depreciation of real estate assets over a period of several decades, which essentially means that a portion of each property's cost can be written off as a loss each year.

This reduces a REIT's "earnings," but in reality doesn't cost a dime. In fact, the opposite is generally true -- not only does real estate not typically lose value over time, but it increases in value over the years.

For this reason, there's a metric known as funds from operations, or FFO, that adds depreciation back in and makes a few other adjustments that give a better indication of how much money a REIT is actually making. Many REITs also calculate company-specific FFO metrics such as core FFO, normalized FFO, or adjusted FFO which can give you an even better idea of how much a specific REIT is earning, and therefore how much it could potentially distribute to shareholders.

Risks you need to be aware of

To be clear, no stock that is capable of a generous income stream and market-beating total returns is without risk, and REITs are certainly not an exception. So, here's a rundown of a few of the major risk factors REIT investors should know:

  • Interest rates -- High-dividend stocks tend to be very sensitive to interest rate fluctuations. The 10-year Treasury yield is a good indicator for REITs. In short, if the 10-year yield rises significantly, you can expect downward pressure on your REITs.
  • Real estate values -- One key point to remember is that a REIT is only as valuable as the properties it owns. If real estate values plunge, like they did during the Great Recession, you can bet that your REITs will lose value as well.
  • Property-type-specific risks -- There are risks that apply to certain types of properties that you need to be aware of. For example, property types that rent to tenants on a short-term basis, such as hotels and self-storage facilities, tend to be far more reactive to market downturns than long-term oriented properties such as offices and healthcare.
  • Company-specific risks -- If your REIT takes on too much debt, it can be a major risk factor, even in a relatively healthy market. Or, if your REIT has particularly high exposure to one or two tenants, it is particularly vulnerable in the event that one of those tenants declares bankruptcy. These are just a couple of examples of REIT-specific risks that you could face, so it's important to do your research before investing.

5 top REIT stocks you can buy right now

I won't keep you in suspense any longer. If you're just getting started with REIT investing, my best advice is to stick to established market leaders in their respective property types, with long-standing track records of shareholder-friendly management and smart capital allocation.

With that in mind, here are five of my favorite REIT stocks you can buy right now that would make excellent additions to any well-rounded stock portfolio, followed by a brief discussion of each one.

Company (Stock Symbol)

Recent Share Price

Dividend Yield

Price-to-FFO (2018 Guidance Midpoint)

Realty Income (NYSE:O)

$63.30

4.2%

19.8

HCP (NYSE:HCP)

$28.65

5.2%

15.9

Boston Properties (NYSE:BXP)

$126.08

3%

19.7

Digital Realty Trust (NYSE:DLR)

$110.82

3.7%

16.7

Equity Residential (NYSE:EQR)

$69.34

3.1%

21.3

Data Source: CNBC and company press releases. Data as of 11/26/2018. 

The right way to invest in retail

I've called Realty Income the best all-around dividend stock in the market, and for good reason. Not only does Realty Income pay a generous 4.2% dividend yield , but the company has made 579 consecutive monthly dividend payments (that's more than 48 years) and has increased its dividend a staggering 98 times since listing on the NYSE in 1994.

Realty Income has a portfolio of more than 5,400 properties, the majority of which are occupied by retail tenants.

Now, before you go running for the hills after hearing the word "retail," it's important to emphasize that not all retail is getting crushed by Amazon, nor are all types of retail businesses vulnerable to recessions. In fact, Realty Income specifically invests in freestanding retail properties occupied by tenants who are e-commerce and recession-resistant. Just to name a few examples from Realty Income's top tenants:

  • Walgreens (NASDAQ: WBA) is Realty Income's largest tenant and sells non-discretionary goods. That is, people need prescriptions and other items Walgreens sells, even in tough economic times. And, people generally need these items in a timely manner, which makes it an e-commerce-resistant business as well.
  • Dollar General (NYSE: DG) and several other dollar stores are major Realty Income tenants. They offer deeply discounted goods that are often better than can be found online. Plus, there's a non-discretionary component to the business as well.
  • LA Fitness and Life Time Fitness are service- and experiential-based businesses that simply cannot be duplicated online. People need to physically go to these businesses, and health/fitness remains a priority for many people, even during harsh recessions.

Not only is the tenant portfolio designed to avoid these major risk factors, but all of Realty Income's tenants are on net leases. This typically means that the tenants commit to a long initial term (15 years or more) with annual rent increases, or escalators, built right in.

In addition, net leases shift most of the unpredictable expenses of owning properties away from Realty Income. Tenants are responsible for property taxes, insurance, and most maintenance costs. Realty Income simply puts a tenant in place and enjoys year after year of predictable, growing income.

Healthcare is a compelling long-tailed investment opportunity

When it comes to healthcare real estate, there are three REITs that are in a class of their own in terms of size -- Welltower, Ventas, and HCP. The latter has been a staple in my portfolio for years, and while I'm a fan of all three companies, I think HCP is the all-around best way to add healthcare real estate exposure to a stock portfolio.

First, a little background into why healthcare real estate is such a compelling opportunity.

For one thing, the demographic trends should provide a steady increase in demand. Simply put, older people use healthcare facilities more often than younger people, and the proportion of the U.S. population that is 65 and older is growing rapidly. In fact, seniors visit healthcare facilities about 145% more on average than people under 45. There's especially rapid growth expected in the oldest age groups -- the 80-and-older population is expected to roughly double over the next 20 years.

In addition, while many other types of properties have high rates of REIT ownership, the same cannot yet be said for healthcare. The current inventory of healthcare real estate is estimated to be worth about $1.1 trillion, and less than 15% of this is REIT-owned. So, there's a major opportunity for consolidation, especially when it comes to physician-owned medical offices.

Now, why HCP? Well, of the "big three," HCP is the most diversified. Its portfolio of nearly 800 properties is dividend among three core property types -- senior housing, medical offices, and life science. All of these should benefit tremendously from the catalysts I mentioned, and HCP isn't relying too much on any single property type. In contrast, nearly all of Welltower's portfolio is concentrated in senior housing and other senior-specific property types. If property-specific headwinds, such as oversupply, remain an issue in senior housing, HCP's diversification should help it outperform its peers.

HCP pays a 5.2% dividend that's well-covered by its FFO. Although the dividend was cut a couple of years ago after HCP spun off some of its riskier assets, the company had previously maintained a multi-decade streak of increases, and I'd be surprised if that doesn't resume now that the company's repositioning efforts are largely complete.

A leading office REIT for good times and bad

Boston Properties is one of the largest owners and developers of office properties in the world. The company specializes in Class A (top-quality) office properties, and currently has a portfolio of 200 properties with 52 million square feet of space.

The company's strategy is simple -- Boston Properties develops top-quality office properties in high-demand markets (not just Boston as the name implies). Boston is indeed the REIT's largest market, but the company also has major investments in New York, Washington, DC, and San Francisco.

Developing properties, as opposed to acquiring existing ones, can be an excellent way to create shareholder value. In short, it's generally cheaper to build a property from the ground up. This creates a better yield on cost, and also results in immediate positive equity when the property is complete. As of this writing, Boston Properties has 6.6 million square feet of space in its development or redevelopment pipelines, 85% of which is pre-leased.

In addition to development, the company does acquire existing properties if it believes it can add value.

Boston Properties also has a well-diversified tenant base, with no tenant representing more than 3.3% of rental income.

One of my favorite aspects of Boston Properties is its emphasis on capital recycling -- that is, continuously selling valuable assets and reinvesting in value-creating assets in order to maximize long-term returns. As a simplified example, let's say that you spend $1 million to build a new property, which is worth $1.5 million upon completion. You could then sell the property and use the $1.5 million to build a property that will be worth $2 million, and so on and so on. Since its 1997 IPO, Boston Properties has spent $14.2 billion on acquisitions, but has taken in $10.4 billion from property dispositions.

Demand for data centers should keep growing

If you aren't familiar, data centers are commercial properties designed for housing servers and other networking equipment in a secure and reliable environment. Digital Realty Trust is a massive REIT that develops, acquires, owns, and operates data center properties all over the world.

At the end of the second quarter of 2018, Digital Realty owned 198 data centers consisting of more than 32 million rentable square feet of space. Digital Realty has more than 2,300 tenants/customers, but its top-20 make up more than 50% of its rental income.

While this does add a certain element of risk with a less-diversified tenant base than other REITs on the list, it's worth pointing out that its top tenants are essentially a who's-who of tech leaders. Just to name a few, Facebook (NASDAQ: FB), IBM (NYSE: IBM), Oracle (NYSE: ORCL), Verizon (NYSE: VZ), AT&T (NYSE: T), and Uber are all major tenants in Digital Realty's data centers.

So, why data center real estate? In a nutshell, the need for secure and reliable data storage has exploded in recent years and isn't showing signs of slowing down yet. Quite the contrary -- the number of connected devices is expected to surge over the next decade or so and with the emergence of 5G technology, the volume of data that can be transmitted will grow exponentially. Just to name a few major catalysts, the number of autonomous vehicles (very data-dependent) on the road is expected to grow at a 37% annualized rate through 2025. And, the artificial intelligence market is forecast to grow from about $4 billion in 2018 to $60 billion by 2025.

To put it mildly, demand shouldn't be an issue going forward. In its 13-year history, Digital Realty has grown its FFO at an impressive 12.4% annualized rate and has increased its dividend every single year by about 12% on average. And while past performance doesn't guarantee future results, with the catalysts I just mentioned, I wouldn't be surprised if this growth rate is sustainable for years to come.

A long-established leader in high-demand apartment properties

Equity Residential is one of the oldest REITs, founded in 1969 by real estate investor Sam Zell. The company is one of the largest apartment owners and managers in the U.S.

Equity owns just over 300 properties with 78,399 apartment units, most of which are located in high-density urban and suburban markets. In fact, the company's entire portfolio is located in just six core markets -- Seattle, San Francisco, Southern California, Boston, New York, and Washington, D.C. The portfolio is over 96% occupied, which illustrates the high rental demand in these core markets.

Why does Equity invest in these specific markets? For one thing, homeownership is extremely expensive, which leads to a greater percentage of renter households. All six of Equity's markets have home prices that are significantly greater than the national average. In addition, these markets have above-average job and wage growth, which has allowed rent growth to outpace the national average.

Just like Boston Properties, capital recycling is a big part of Equity's strategy. Equity sold $7.7 billion of properties over the past three years, which resulted in $4.2 billion in special dividends for its shareholders.

One of my favorite things about Equity is its efficiency, which is due to a combination of its scale and good management. Over the past decade, Equity's revenue has grown significantly faster than its expenses at a 3% annualized rate versus 1.9%. And, Equity's overhead is 5.6% of its total revenue, 60 basis points less than its peer group average.

In a nutshell, Equity focuses on the most in-demand rental markets in the U.S. and is very good at what it does. The company has generated strong returns for nearly 50 years, and there's no reason to believe it won't continue to do so.

Matthew Frankel, CFP owns shares of AT&T, Digital Realty Trust, HCP, and Realty Income. The Motley Fool owns shares of and recommends Facebook. The Motley Fool owns shares of Oracle and has the following options: short December 2018 $52 calls on Oracle and long January 2020 $30 calls on Oracle. The Motley Fool recommends Verizon Communications. The Motley Fool has a disclosure policy.