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Real estate is one of the most popular investments in the world, but buying and managing individual properties is not for everyone. Fortunately, there is another way to get in on the action. With real estate investment trusts, or REITs, you could become a real estate millionaire without the hassles of property ownership.

What is a REIT and how do they make money?
A REIT is a company that essentially pools investors' money together to invest in a portfolio of properties.

For individual investors, buying into REITs offers exposure to real estate and its potential for income and growth, without the risks of owning an individual investment property. For example, if you buy a house to rent out, the property can sit vacant for several months at a time, or you could be forced to evict nonpaying tenants. In an REIT that owns hundreds or thousands of properties, shareholders are freed from issues like these.

Real estate investment trusts make money in two main ways. First, their properties generate rental income, which generally increases over time. They also benefit when the values of their properties increase. Rental properties derive most of their value from their ability to generate income, so property values tend to increase alongside rising rent. Most REITs also use some degree of leverage (borrowed money) to acquire more properties and boost returns.

Many types of REITs
There are REITs that specialize in all sorts of property types. Just to give you an idea of your options, there are REITs that allow you to invest in:

  • Residential real estate: Most residential REITs invest in large apartment complexes, but some buy single-family homes. Some specialized residential REITs also invest in student housing communities on or near major universities.
  • Retail properties: Retail real estate is advantageous for several reasons. Tenants sign long-term leases with increases built in and pay the property taxes, insurance, and building maintenance. Many of the large retail REITs have extraordinary occupancy rates and lease most of their properties to well-known national corporations.
  • Healthcare properties: The growing need for healthcare facilities, particularly for senior housing and long-term care, has created an excellent opportunity for REITs.
  • Office and industrial properties: Similar benefits to retail REITs, but office and industrial REITs generally have fewer tenants occupying larger spaces.
  • Specialized property types: To cite a few, there are REITs that specialize in storage facilities, data centers, and other specific property types.
  • Mortgages: This category of REIT does not invest in properties at all, but in mortgages. These tend to be highly leveraged, which can make them very volatile and sensitive to interest rate fluctuations. Mortgage REITs don't make a good long-term investment (in my opinion), but for the sake of completeness they are included in this list.

The potential for returns is huge
When compounded over long periods of time, REITS' returns can really add up. Let's consider the performance of some of the largest REITs. Bear in mind that the time period referenced includes one of the worst real estate crashes in history.

REIT company name Symbol Property type Dividend yield 20-year annualized return
AvalonBay Communities AVB Residential 3% 15.8%
Realty Income O Retail 4.6% 15.3%
Health Care REIT HCN Healthcare 4.4% 13.7%
Simon Property Group SPG Shopping Malls 2.9% 15.7%
Public Storage PSA Storage Facilities 2.9% 16%
Average     3.6% 15.3%

Note: Data is current as of 4/14/2015.

For comparison, the S&P 500 has averaged a 9.5% annual total return over the past 20 years, which this group of REITs easily beats. To put this kind of performance in perspective, if you invest $5,000 per year and your money grows at this rate (15.3%), you'll end up with $530,000 after 20 years. After 30 years, the total of $150,000 you invested would grow to $2.3 million. So, REITs can literally make you a real estate millionaire without you ever having to buy an actual investment property.

PSA Total Return Price Chart

The best investment on Earth?
There is an old quote attributed to the late real estate investor Louis Glickman that "the best investment on Earth is earth." The rationale is that real estate is one of the few investments that will naturally increase in value over time, since there is a limited supply of buildable land and a growing population that needs places to live and work.

By investing in a well-constructed portfolio of REITs, you too can take advantage of this great investment and its incredible potential.

A word of caution
Having said all of this, it's wise to approach any investment with an understanding of the risks involved. First and foremost, past performance is no guarantee of future investment results, and REITs are no exception to this rule. All of the REITs I discussed here performed well during the financial crisis, but there are many that did not. While I believe that the REITs I mention here will outperform in good times and bad, not even the best REITs are completely immune to adverse conditions.

For example, most REITs finance a portion of their portfolio, which leaves them somewhat vulnerable to interest rate fluctuations. If interest rates were to spike, the cost of borrowing would increase for the REIT, which could eat into the company's profit margins. Also, when interest rates rise, lower-risk income investments such as bonds become more attractive, and REITs could see increased selling pressure. Finally, because most REITs specialize in one property type, they can be vulnerable if that particular sector of real estate faces tough times.

The bottom line is that no investment is a sure thing. However, I truly believe that high-quality REITs such as these offer some of the most favorable risk-reward ratios in the market.

Matthew Frankel owns shares of Realty Income.. The Motley Fool recommends Health Care REIT. 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.