Industrial REITs

Get to know the basics of industrial REITs before deciding whether to invest in one.

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You can find real estate investment trusts, or REITs, that specialize in just about every kind of commercial property you can think of. One type that has some particularly interesting opportunities right now is the industrial REIT. For example, many of the massive distribution centers used in the rapidly-growing e-commerce fulfillment space are owned by industrial REITs.

Having said that, there’s a lot you should know before you buy your first industrial REIT. Here’s an overview of what exactly an industrial REIT is, the risks you should know before investing, and some examples to get you started.

What is an industrial REIT?

A real estate investment trust, or REIT, is a special type of company that primarily invests in commercial properties or other real estate assets.

To officially qualify as a REIT, however, a real estate company needs to meet certain requirements. These include, but aren’t limited to, a few factors:

  • A REIT must invest at least 75% of its assets in real estate.
  • A REIT must derive at least 75% of its income from real estate.
  • A REIT must have at least 100 shareholders.
  • No five investors can own more than 50% of the shares of a REIT.
  • A REIT must pay out at least 90% of its taxable income as dividends to shareholders.

If a REIT meets all of the requirements, it gets a big tax advantage. Specifically, REIT profits are not taxable on the corporate level. Even if a REIT earns billions of dollars in profits, the IRS can’t charge a penny in corporate tax. This is a huge benefit for REIT investors. With most dividend stocks, profits are effectively taxed twice -- once on the corporate level when they’re earned, and again on the individual level when dividends are paid out.

Most REITs specialize in a certain type of commercial property. Industrial REITs, as the name implies, own and manage industrial facilities, including warehouses, distribution centers, manufacturing facilities, and more. Some specialize in a single type of industrial property, while others own a variety. These properties are then leased to tenants -- either an entire building or just a portion.

Risks of investing in industrial REITs

No stock capable of market-beating returns is without risk, and industrial REITs are certainly no exception. While I consider industrial properties to be relatively low-risk when compared with several other types of commercial real estate, there are still some key risk factors investors should be aware of.

Interest rate risk -- No discussion of REIT investing would be complete without mentioning interest rates, which can have a huge amount of influence over REIT stock price movements. While I could write several pages on the dynamics of interest rates and REIT prices, the general idea to know is that rising interest rates are bad news -- as you can see in the chart below, long-term yields on risk-free instruments (the 10-year Treasury note is a good indicator) and REIT prices typically move in opposite directions.

^CRUSREIT Chart

^CRUSREIT data by YCharts

Here's why (the short version): Investors are taking on risk by investing in a stock as opposed to a Treasury security, which is essentially risk-free, so they expect a higher yield on their investment. When Treasury yields rise, the same tends to happen with REITs. Price and yield have an inverse relationship, so higher REIT yields lead to lower stock prices.

Oversupply risk -- In prosperous economic times, like we’re in now, there’s always some risk of oversupply in commercial real estate. In other words, when times are good, investors rush to build new properties to take advantage. Well, sometimes they build new properties too fast. We’re seeing this right now in markets such as senior housing and self-storage. Because of the relatively low cost of building industrial real estate, oversupply is certainly a risk, especially in strong markets.

Economic risk -- We’ll discuss the effect of recessions and bad economic conditions in the next section, but economic risk is certainly a big factor. Strong economies translate to high consumer confidence, which leads to more discretionary purchases. This creates the need for more distribution space. On the other hand, in a recession, there can be a lot of idle space in warehouses and distribution centers.

Financing risk -- Last but not least, it’s worth pointing out that most REITs rely on borrowed money (to one extent or another) in order to fund growth. So another undesirable effect of rising interest rates could be that it becomes more expensive to borrow money, which can certainly erode a REIT’s profit margins.

How do industrial REITs hold up during recessions and tough economies?

In some ways, industrial properties are quite recession-resistant. For example, they have relatively low construction, maintenance, and operational expenses compared to most other types of commercial real estate. And tenants generally sign long-term leases with annual rent increases, or escalators, built right in.

On the other hand, industrial properties -- particularly distribution centers -- are highly dependent on economic strength. In tough economic times, consumer confidence falls, purchase volume slows, and the need for distribution space can drop significantly. In recent years, the overall growth of e-commerce as a percentage of retail has kept demand high, but this catalyst isn’t likely to last forever.

Three of the largest industrial REITs

Now, let’s take a quick look at some industrial REITs in the market to give you a better idea of what these companies actually do:

Company (Stock Symbol) Property Sub-Category(-ies) Market Capitalization Dividend Yield
Prologis (NYSE: PLD) Logistics $47.2 billion 2.9%
STAG Industrial (NYSE: STAG) Logistics/ Manufacturing $3.4 billion 4.9%
Duke Realty Corporation (NYSE: DRE) Distribution centers/ Medical offices $10.9 billion 2.8%

Data source: CNBC, Nareit.

Prologis is one of the largest REITs of any kind, and specializes in distribution centers and warehouses, which it collectively refers to as "logistics" real estate. The company owns about 3,300 properties all over the world, and there are over $1 trillion worth of products that flow through Prologis’ properties each year. Not only is it a massive REIT, but Prologis has an excellent credit rating and a strong balance sheet, which gives it tremendous financial flexibility to grow going forward.

STAG Industrial is a significantly smaller REIT, with a portfolio of nearly 400 buildings, most of which are occupied by single tenants. Unlike Prologis, all of its properties are in the U.S. Most of STAG’s portfolio is logistics properties, but it does have a significant amount of manufacturing facilities in its portfolio as well, which adds a nice element of diversification. The key point to know is that STAG focuses on finding the best values in mid-priced industrial properties, an area of the market that the larger players largely ignore.

Duke Realty is in the middle of Prologis and STAG Industrial in terms of size, and maintains a U.S.-based portfolio concentrated in 20 major logistics markets. Its facilities are significantly larger than STAG’s, and -- with 518 properties and about 1,000 customers -- tend to be occupied by more than one tenant each. In short, Duke is a good play on larger industrial properties, but is well-suited for investors who don’t want too much exposure to foreign markets.

How to invest in ­­industrial REITs the right way

As a final point, it’s important to emphasize that REITs make excellent long-term investments. In fact, I wouldn’t suggest putting any money into REITs that you’ll need in the next five years, and even that is a short time horizon. There are tons of economic and industry-related factors that can move the stock prices of industrial REITs but have little effect on their underlying business. Over time, however, the noise fades away and the business dynamics take over, which has resulted in some pretty impressive returns for investors who have bought top-notch industrial REITs and held on tight.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Stag Industrial. The Motley Fool has a disclosure policy.