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How to Invest in REITs: A Step-by-Step Guide

By Matthew Frankel, CFP® - Jun 17, 2017 at 7:03AM

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REITs can be excellent long-term investments -- here's how to get started.

A real estate investment trust, or REIT, can be an excellent type of dividend stock to invest in. Not only do REITs often produce above-average dividends, but they can produce excellent returns over time as property values rise. There are REITs for many different property types, so here's a quick introduction to REIT investing to help you get started.

Specifically, before investing in your first REIT, you should learn or do the following things:

  • Know why REITs can be good investments.
  • Learn the basics of how REITs work.
  • Know the different types of REITs available.
  • Understand the risks involved.
  • Know the proper metrics to evaluate REITs.
  • Understand the tax implications of investing in REITs.
  • Open a brokerage account and buy your first REIT.

Note: This article is about equity REITs, which are companies that own properties. The points I'll discuss here don't necessarily apply to mortgage REITs, which invest in mortgages and mortgage-backed securities.

Apartment buildings,

Image Source: Getty Images.

1. Know why REITS can be good investments

Equity REITs were created to make investing in commercial real estate accessible to everyday investors. For example, before REITs existed, you had to be pretty wealthy to invest in a shopping mall, but now you can take advantage of this type of investment by purchasing a single share of a REIT that specializes in mall properties.

The primary reason for investing in REITs is for a combination of income and growth. REITs generally offer above-average dividends and have the ability to grow significantly over time as their properties appreciate in value. This combination can produce some impressive total returns.

In fact, leading healthcare REIT Welltower has averaged a 15.6% total return since its IPO 46 years ago, and leading net-lease retail REIT Realty Income has averaged 16.9% total returns since its 1994 New York Stock Exchange listing. Compare this to the overall stock market, which has historically returned about 9%-10% per year.

2. Learn the basics of how REITs work

In a nutshell, REITs invest in commercial properties, either by acquiring them, or developing them from the ground up. The properties are then rented to tenants, and the rental income generated is used to distribute to shareholders as dividends.

REITs are legally required to distribute at least 90% of their taxable income to shareholders every year, effectively allowing them to avoid the "double taxation" that most corporations face. For example, when Microsoft earns a profit, it's taxed at the corporate level, and the dividends it pays are taxed again at the personal level. Effectively, the same money is taxed twice.

REITs, on the other hand, avoid paying corporate tax. As a result, REITs tend to pay above-average dividends, since they have more of their profits left to distribute to shareholders.

Because of their tax-advantaged income status and because REIT dividends are generally counted as ordinary income (not qualified dividends -- more on that later), REITs can make excellent retirement account investments. In fact, more than 47% of all publicly traded REIT shares are held in retirement accounts such as pension plans, 401(k)s, and IRAs.

3. Know the different types of REITs

While there are some diversified REITs, most specialize in a single property type. This isn't an exhaustive list, but common REIT specialties include:

  • Retail: Subcategories include malls, shopping centers, outlets, and freestanding retail. Examples include Simon Property Group (malls), Kimco Realty (shopping centers), Tanger Outlets (outlet malls), and Realty Income (freestanding).
  • Healthcare: Properties such as senior housing facilities, medical offices, hospitals, skilled nursing facilities, and others. Some healthcare REITs specialize in a single type of property, while others invest in a combination. Welltower and Ventas are two major healthcare REITs.
  • Industrial: Warehouse and factory properties are good examples of industrial REIT assets. STAG Industrial is an example.
  • Residential: Most residential REITs invest in apartments, but some own single-family homes, as well. AvalonBay Communities and Mid-America Apartment Communities are two good examples of residential REITs.
  • Hotel: There are REITs that own destination resorts, luxury hotels, and/or budget-friendly motels. Apple Hospitality Trust is a good example of a hotel REIT.
  • Self-storage: Public Storage is the largest self-storage REIT.
  • Data Centers: REITs such as Digital Realty own buildings that lease space for data storage.

4. Understand the risks involved

It's important to realize that, just like any other stocks, REITs have their own set of risks investors need to be aware of. Interest-rate risk is a big one, as higher interest rates tend to create downward pressure on REIT stock prices.

There are also sector- and company-specific risks to be aware of. Specifically, some types of real estate are more defensive, while others tend to do very well in strong economies, but get hit hard by recessions.

Healthcare real estate is an example of a defensive investment. During tough times, people still need to see doctors and go to the hospital. Plus, most healthcare tenants sign long-term leases, which minimizes vacancy risk.

On the other hand, hotel REITs are an example of a recession-prone type of real estate. These companies have the ability to change their rental rates -- the price of the hotel rooms -- daily, a great luxury to have in strong economic times. When things turn sour, however, supply and demand can cause income to collapse.

5. Know the right metrics to use when evaluating REITs

REITs are unique types of companies, and because of this, it's important to use the right metrics when evaluating them. Specifically, traditional accounting methods don't accurately reflect income and valuation for real estate businesses.

The first metric you need to learn is funds from operations, or FFO, which is the REIT version of "earnings." This metric adds back in property depreciation and makes a few other adjustments to accurately show a REIT's income and, therefore, its ability to pay dividends. From this you can use a Price/FFO multiple when valuing REITs, just like you might use a P/E multiple to value a blue chip stock.

There are other important metrics you can learn, such as intrinsic value, cap rate, net asset value, and debt coverage, just to name a few, and you can read how these work here.

6. Understand the tax implications of REIT investing

Because of their favorable tax treatment, REIT dividends generally don't qualify for the same preferential dividend tax rates as most other stocks. Unless the REIT distribution is specifically classified as a return of capital, or another qualifying classification (not common), REIT dividends are taxed as ordinary income.

Since REIT dividends can be taxed at a rate of up to 39.6%, plus a 3.8% investment-income surtax, they make excellent candidates for tax-deferred or tax-free retirement accounts. As I mentioned earlier, nearly half of all publicly traded REIT shares are held in retirement accounts.

7. Open a brokerage account and buy your first REIT

Here's the final step. Find a broker whose features and pricing meet your needs, and buy your first REIT, or buy your first several. As long as you've educated yourself on REIT investing basics, you should be able to create a portfolio of REITs that can provide income and growth in your portfolio, while still letting you sleep at night.

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