House On Money

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Real estate investment trusts, or REITs, are publicly traded companies that own either properties or mortgages. And while the general concept of a REIT is easy to understand -- the owned assets generate income, which is passed on to investors -- these stocks aren't well-understood by many investors. With that in mind, here are three things you may not know about investing in REITs, as described by our contributors.

Selena Maranjian: For many people who are having trouble falling asleep, thinking about the term "real estate investment trust" (REIT) and imagining lots of little dividend payments might do the trick and send them into slumber. But that's wrong-headed thinking, because REITs can be quite powerful and exciting additions to a portfolio.

REITs focus on real estate investments, but they do so differently, with some specializing in healthcare-related properties such as nursing homes, hospitals, laboratories, and doctor offices and others specializing in niches such as office or industrial spaces, apartments, hotels, or retail properties (think of malls and outlets, for example). Whatever you fancy, or whatever you believe has the best likelihood of being stable or growing, you'll probably find it in REIT-dom.

Meanwhile, REITs don't just pay out dividends -- they often pay out dividends -- required to distribute at least 90% of their taxable earnings to shareholders. The Vanguard REIT ETF, invested in about 145 different REITs, recently had an overall dividend yield of 4.1%. You can find plenty of REITs with significantly steeper yields, such as the healthcare-focused Ventas and HCP, recently yielding 5.1% and 5.8%, respectively.

REITs can grow over time, too, delivering solid total returns. The Vanguard REIT ETF has averaged 8.4% annually over the past decade, outpacing the S&P 500's 7.8%. Public Storage, focused on self-storage facilities, has averaged 15.2% over that period, while Simon Property Group, focused on retail properties, has averaged 14.2%. In short, be sure to consider REITs for your portfolio.

Jordan Wathen: While their earnings are relatively predictable, REIT stocks can be especially volatile. With the markets trying to predict when, exactly, interest rates might rise, REITs have become a go-to way for investors to bet on interest rates.

When rates rise, REIT stocks should drop so that their dividend yields are higher. When rates fall, REIT stocks should rise, pushing down their dividend yields. 

This is best observed in high-quality triple-net REITs like National Retail Properties, which traded as high as $44 per share in early 2015 when a rate increase seemed out of the cards. By September, shares were trading for less than $35, as investors believed a rate increase was just around the corner.

It's important to remember that while REITs are stocks, their share prices rise and fall more in line with long-term bonds. Thus, that your REITs are rising or falling fairly quickly from day to day or week to week generally isn't a sign of what investors think about the REIT's business model. More often, it's due solely to rates, a factor that is simply outside a REIT's control.

Matt Frankel: One thing many investors don't realize is that many of the normal metrics we use to analyze stocks aren't useful when applied to REITs.

Specifically, earnings per share and associated metrics like a price-to-earnings ratio are not good indicators of a REIT's profitability. Consider Simon Property Group, one of the most popular REITs in the market. At first glance, the company's TTM earnings of $4.80 per share may seem pretty low, as this translates to a P/E of 41.

A better metric to use is funds from operations, or FFO. When earnings are calculated, standard accounting practices allow companies to depreciate the value of assets (such as real estate) over a long period of time and deduct this amount from their earnings. However, this depreciation doesn't cost the REIT a dime – if anything, the value of its properties should increase as time goes on.

FFO takes the REIT's earnings and adds back depreciation and makes a few other adjustments to produce a more accurate picture of the REIT's profitability and ability to pay its dividends. In the case of Simon Property Group, its 2015 FFO estimate of about $10.05 per share produces a more appealing P/FFO ratio of 19.5, and also better explains how Simon is able to cover $6.20 per share in annual dividend payments.

Jordan Wathen has no position in any stocks mentioned. Matthew Frankel owns shares of National Retail Properties,. Selena Maranjian owns shares of Health Care Property Investors,. The Motley Fool has no position in any of the stocks mentioned. 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.