Just about everyone who lives in their own house or apartment is familiar with how real estate works: You pay your rent or a mortgage each month, creating streams of income for your bank or landlord.
Wouldn't you like to be on the receiving end of real estate's perks? It's easier than you think, and you don't need to be rich to buy buildings outright. The answer could be in real estate investment trusts (REITs); these unique entities can shower you with cash. Here's how they work, as well as three good REITs to consider for your portfolio.
Why invest in REITs?
REITs are a particular type of businesses structure created by the U.S. Congress in 1960 to give retail investors more affordable access to real estate.
A business must devote 75% or more of its assets to real estate or cash and pay at least 90% of its taxable income to shareholders as dividends. A REIT receives special tax treatment and doesn't have to pay a corporate income tax in exchange for following these rules.
REITs tend to specialize in a specific market within the real estate industry, so you will likely see dedicated REITs that accumulate properties in categories like a commercial, retail, industrial, hospitals, residential, and more. You can diversify your exposure to real estate by investing in REITs in various real estate niches.
One of the best parts of investing in REITs is the significant dividends they tend to pay to investors. Remember, the primary way to create value for shareholders is through dividends because of the rules that REITs must follow. Therefore, if you're looking for passive income, REITs may be an excellent option for you.
Each of the three REITs below is just now getting back to pre-COVID price levels. While investors may have missed out on an easy rebound opportunity, these REITs have strong fundamentals that could propel them to new highs over the coming years.
1. Simon Property Group
E-commerce has revolutionized the retail landscape, but that hasn't kept Simon Property Group (SPG 1.07%) from thriving. The REIT focuses on premier shopping, dining, and entertainment properties (primarily malls) in North America, Europe, and Asia.
Simon Group's properties are in heavily populated areas. They have strong merchant lineups, so they tend to hold their traffic better than weaker malls that have steadily seen fewer visitors over time.
COVID lockdowns hurt Simon Group, when malls shut down and tenants struggled to pay rent. This chart shows how Simon Group's cash flow per share (called funds from operations, or FFO) declined by about a third.
Management responded by cutting the dividend, but the business has already shown signs of coming back strong. This gives me confidence in moving forward in Simon Group's ability to execute its core business.
2. W.P. Carey
W.P. Carey (WPC 2.73%)isn't as flashy as Simon Property, specializing in a mix of commercial properties, including office buildings, warehouses, retail, and self-storage. It holds most of its properties in the U.S. and Europe.
W.P. Carey is a net-lease REIT, meaning that the tenants are responsible for most of the expenses and upkeep of the property. The company also builds automatic rent increases into its lease agreements, so the structure of its leases creates very predictable, steadily rising income streams for the business.
The pandemic slammed W.P. Carey's business, much like Simon Property, and the economic lockdowns hurt tenants' ability to pay rent. While W.P. Carey's FFO per share took a bit of a hit in 2020, as the chart shows, investors have enjoyed a stable dividend stream.
3. Federal Realty Investment Trust
A leading REIT in the retail market, Federal Realty Investment Trust (FRT) is a Dividend King, with 54 straight annual dividend increases. The company's tenants consist of various stores, shops, restaurants, and office buildings throughout the U.S.
Federal Realty Investment Trust has built its real estate portfolio and business around stability. The company focuses on what it calls first-ring suburbs outside major metropolitan areas, deemed to be more reliable for consumer spending, with higher-than-average income levels.
The company prioritizes its balance sheet, which carries an A- credit rating from Standard & Poor's, a rating that's considered investment grade. This strong balance sheet has helped the company weather occasional downturns, including the pandemic shutdowns. With more than five decades of dividend increases and a conservative management team, Federal Realty Investment Trust could arguably be the safest REIT on the market.