Real estate investment trusts, or REITs, should be held in any solid long-term investment portfolio. However, just like any other form of investing, it's important to diversify. Fortunately, there are REITs that specialize in all sorts of real estate, and each has its own benefits and drawbacks. Here are five REITs, each with a different focus, which you could combine to form a solid portfolio of real estate investments.
Residential real estate can be lucrative, but has its risks
When most people hear the term "invest in real estate," they think of residential properties such as houses and apartments. However, this is just one type of the real estate you can invest in with REITs.
One of the best residential REITs is AvalonBay (NYSE:AVB), which invests in apartment buildings in "high barrier to entry" markets, where buildable land is scarce and the building process is complicated (think New York or Boston). Currently, AvalonBay owns 277 apartment communities with more than 82,000 homes, and all but four of these communities are located in the company's core markets.
In its 20-year history as a public REIT, AvalonBay has averaged a 16.2% annual total return, and has increased its dividend by an average of 5.3% per year. However, investing in residential properties carries certain risks, and they are somewhat more recession-prone than other types of real estate, as we'll see in the next section.
Retail has some great returns, while minimizing risk
Investing in retail properties eliminates some of the risks that come with residential real estate. For starters, tenants sign longer leases (15 years or more) and there are usually annual rent increases built into the lease. So, this minimizes the risk of tenants leaving or market rental rates dropping during a recession.
Retail tenants are on "net" or "triple-net" leases, which make the tenant responsible for fluctuating expenses such as taxes, insurance, and building maintenance, which are the responsibility of landlords in residential situations.
One great way to invest in retail real estate is with National Retail Properties (NYSE:NNN), which owns a diverse portfolio of more than 2000 properties, which it leases to strong, national tenants such as AMC Theaters, Sun Trust Banks, and Best Buy, just to name a few. The trust has a remarkable 98.6% occupancy rate and has about 12 years remaining on its average lease, so this is about as stable as it gets.
Finally, National Retail Properties is a "dividend aristocrat", which means it has increased its dividend for more than 25 consecutive years. During the past 25 years, the company has produced average annual returns of 15.9%, making it a fantastic choice for growth and income.
Mortgages can offer great income, but can be volatile
There is a special class of REITs that doesn't invest in properties at all, but instead buys mortgages and mortgage-backed securities.
The problem with most of these is that they use high leverage, and this leaves them extremely susceptible to interest rate fluctuations. Just as an example, if a mortgage REIT uses five-to-one leverage and the spread between the cost of borrowing and the return on its investments shrinks by 10%, its earnings could be cut in half. Of course, this is an oversimplification, but the general idea is correct.
One mortgage REIT that works a little differently is PennyMac Mortgage Investment Trust (NYSE:PMT). This company mainly invests in distressed, agency-backed mortgages, which it can buy at a significant discount and therefore produce higher returns all by themselves. As a result, PennyMac uses a significantly lower leverage ratio than its peers in order to achieve the same yield. In fact, PennyMac uses just 2-to-1 leverage right now, while most other mortgage REITs use 5-to-1 or more.
This strategy has worked well so far. While other mortgage REITs have been forced to make dividend cuts over the past few years, PennyMac has actually increased its payout steadily since going public.
The need for healthcare will only go up
With an aging population and more widely available health insurance, the demand for healthcare facilities is expected to rise considerable in the coming years and decades. The population of Americans age 75 and older is expected to grow at about five times the rate of the rest of the population. Health Care REIT (NYSE:HCN) could be an excellent way to profit from this trend.
The first REIT of its kind, Health Care REIT currently owns 1,300 properties, which mainly consist of senior housing, long-term care facilities, and medical offices. At a total property value of $37 billion, the company is one of the largest REITs in the world, of any kind.
Since its inception, Health Care REIT has delivered an impressive 16.1% average annual total return, and currently pays a healthy 4.3% dividend yield.
Tech companies need to store more and more data
One specialized REIT worth a look is Digital Realty Trust (NYSE:DLR), which owns and operates data centers on four continents around the world. High-tech companies have an exponentially growing need to store data, so the trust should have no problems with increased demand in the coming years.
Digital Realty's tenants include more than 600 firms in a variety of sizes and industries, including such large corporations as IBM, Facebook, and AT&T. The company has an average of more than six years left on its leases, with 2.5%-3% annual rent increases built in.
Through development and acquisitions, Digital Realty has been able to grow its operations at an impressive rate, and shareholders have benefited tremendously. Since going public about 10 years ago, the dividend has more than tripled, and the share price has increased more than fivefold. With the need for secure data storage continuing to grow, I think there are still plenty of good years ahead.
Not an exhaustive list
This is by no means an exhaustive list, and just because these have done well doesn't automatically imply they will continue to do so.
There are plenty of other great REITs out there within the sectors mentioned, and in other areas of real estate as well. However, the thing I want you to take away from this list is my reasons for choosing them (strong track record, good risk management, nice income, growing demand) so you can apply them to any REIT you're considering.
Matthew Frankel owns shares of AT&T, National Retail Properties, and PennyMac Mortgage Investment Trust. The Motley Fool recommends Facebook and Health Care REIT. The Motley Fool owns shares of Facebook and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.