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Investing in real estate can be a great way to create income and build wealth, but owning rental property isn't for everyone. Many people simply don't have the time and patience to be a landlord, while others are turned off by the thought of inconsistent income. Because of this, the smartest way for most people to add real estate to their portfolios is through equity REITs.
What is an equity REIT?
There are two main types of REITs you can invest in: mortgage and equity. Mortgage REITs use high amounts of leverage to buy mortgage-backed securities, and they can be rather risky and volatile investments.
Equity REITs, on the other hand, are companies whose main business focus is acquiring properties with the intention of using them to generate income. There are many varieties of equity REITs, and you can find REITs that specialize in apartment buildings, retail properties, office buildings, self-storage facilities, healthcare real estate, and more.
What to look for in great REITs
There are several characteristics I look for when choosing REITs. Here are a few of the most important characteristics of great long-term REITs, and a few examples to illustrate each one.
Low-risk business: For example, popular retail REIT Realty Income (NYSE:O) invests in retail properties that have little or no threat from online competitors. Self-storage REIT Public Storage (NYSE:PSA) can break even with just 30% occupancy of its properties (currently above 90%). Mall REIT Simon Property Group has more than 3,000 tenants, so even if a handful go out of business, it won't have a big effect on the bottom line.
Strong industry trends: Ideally, the demand for the property type the REIT owns will be growing. For example, the population of Americans age 85 and above is expected to triple by 2050, which means demand for Welltower's (NYSE:HCN) senior housing and long-term care facilities will increase. Job growth, wage growth, and the higher cost of buying a home all point toward increasing demand for apartments, which is a good indicator for apartment REIT AvalonBay (NYSE:AVB).
Experienced management team: Realty Income's management team has an average of 16 years' experience with the company. As another example, Welltower's management has an average of 24 years of healthcare real estate industry experience, and an average of 16 with the company.
Strong occupancy: A good REIT keeps its properties full, no matter what the market is doing. Sure, Realty Income's current occupancy rate of 98.3% is nice, but even more impressive is the fact that occupancy has never fallen below 96%, no matter what the market or economy was doing.
Smart investment strategy: Look for REITs with an advantageous investment strategy. For instance, Welltower partners with some of the most experienced operators in the business to run its properties, such as Genesis Healthcare and Brookdale Senior Living. AvalonBay is able to build apartment buildings for about 25% less than their market value, resulting in instant value creation for shareholders.
Dividend growth: Look for REITs with a strong track record of increasing dividends. For example, AvalonBay has increased its dividend at an average rate of 5.3% over the past 21 years. Realty Income has increased its payout 83 times since going public in 1994 and is a member of the S&P High Yield Dividend Aristocrat index. Finally, Welltower has managed to keep up a 5.1% average dividend growth rate for 45 years.
Stability: Stable REITs don't carry excessive levels of debt and have investment-grade credit ratings that allow them to borrow money cheaply to take advantage of new investment opportunities as they arise. Not every REIT needs to operate virtually debt-free, as Public Storage does, but I look for less than half of a REIT's funding to come from debt. For example, Welltower's 30.4% debt-to-enterprise value ratio is similar to having an outstanding mortgage balance of less than one-third of your home's value. And, the company's 4.5 times interest coverage ratio means Welltower earns $4.50 for every $1.00 in interest it pays on its debts. Finally, Simon Property Group has an A/A2 credit rating, the best in the REIT sector, giving it the competitive advantage of cheaper funding than the competition.
The potential is tremendous
Because of the high income potential combined with property value appreciation, the right kind of REITs can deliver consistent market-beating total returns over time. In fact, all five of the REITs mentioned here have handily beaten the S&P 500's total return over the past 20 years.
To put this in perspective, consider that a $10,000 investment in each of these REITs ($50,000 total) 20 years ago would have grown into approximately $950,000 today. As you can see, strong performance like this can create serious wealth over long periods of time.
Matthew Frankel owns shares of Realty Income and Welltower. The Motley Fool recommends Welltower. 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.