11 Things Investors Need to Know About REITs

Real estate investment trusts (REITs) can be a fantastic way to diversify your portfolio while earning reliable dividend income in the stock market.

Like stocks, these liquid investments can provide growth opportunities for patient investors and access to high-quality real estate that otherwise would be unattainable for the average investor.

Here are 11 things investors need to know about REITs.

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Like stocks, there is a wide variety of REITs that investors can invest in. Publicly traded REITs are the most common investment option because they are easily traded through a brokerage account on major stock market indexes, but private REITs are another option for investing.

Equity REITs are companies that invest in physical real estate that are most commonly leased to long-term tenants. Almost any sector within commercial real estate and even some aspects of residential real estate can be found in an equity REIT such as self-storage, timberland, health care, industrial, office, retail, hotels, data centers, telecommunication towers, apartments, and single-family homes.

Mortgage REITs (mREITs) are companies that originate, buy, or invest in mortgage debts and other securities not physical real estate. While they often offer higher dividend returns they are more volatile and risky REIT investments compared to Equity REITs.

ALSO READ: Investing in Mortgage REITs

To qualify as a REIT, the company must pay at least 90% of taxable income to shareholders. Doing so gives the company some major tax advantages, including paying zero corporate tax, and rewards investors with higher than average dividend returns.

Average dividend returns from REITs fall between 4% and 5%, while average dividend returns for stocks alone fall between 1% and 2%.

ALSO READ: 3 Dividend REITs Yielding More Than 3%

Publicly traded REITs, including both equity and mortgage REITs, as tracked by the National Association of Real Estate Investment Trusts (NAREIT) since 1972, show that from 1972 to 2020, REITs outperformed the S&P 500 providing an annualized return for 11.42% during that period. REITs have also outperformed Treasury yields by 1.28% on average over the past 15 years.

REITs were created in 1960 by the government to allow everyday investors access to high-quality, institutional-grade real estate investments that otherwise would be out of reach for most investors. Meaning investors purchasing shares in a REIT are gaining access to the income and growth potential of real estate, and further diversifying a stock portfolio.

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Unlike many other avenues of real estate investing, including crowdfunding or private lending, public REITs can be bought or sold through a brokerage account, making them a liquid investment.

REITs are required to report their earnings according to generally accepted accounting principles (GAAP), but also provide additional REIT specific information that is more commonly used to evaluate the REIT.

Instead of looking at "earnings per share," REIT investors should look at "funds from operation," or FFO, which illustrates how much money the company makes.

Ideally, a REITs FFO will grow quarter-over-quarter, and earn enough to cover things like dividend payments.

ALSO READ: Your Guide to GAAP

While you may earn more dividends from a REIT, its dividends generally don’t meet the IRS definition of "qualified dividends," which is taxed less than standard ordinary.

However, REITs do qualify as pass-through investment vehicles, allowing investors to take advantage of the 20% pass-through deduction as part of the Tax Cuts and Jobs Act.

Because most REIT dividends don't meet the definition of "qualified dividends" netting in a higher tax rate for income earned, REITs are great investments for a ROTH IRA. This is because the investment and any dividend returns earned grows tax-free in a tax-sheltered retirement account.

Leveraging assets is a key facet of REITs business model. Utilizing mortgages, and other financing methods to buy, develop, or renovate assets is common practice, which means some REITs carry a great deal of debt.

Mortgage REITs in particular utilize debt leveraging in order to purchase more debt, which adds an element of risk. You can see how much debt a REIT is carrying through a debt-to-EBITDA ratio or debt coverage ratio.

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The stock market is directly tied to economic activity, but REITs have an additional layer of vulnerability because they are impacted by other factors outside of the macro economic environment.

For example, overdevelopment and supply-and-demand for a given asset class or property can result in volatility within a REIT sector.

REITs can be an extremely powerful way to invest, diversify, and earn passive income, but it's important investors understand the industries they are investing in.

Having a basic, if not thorough, understanding of how real estate works, including its supply-and-demand, leasing structure, or business model, will help investors make the most of their REIT investments.

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