15 Must-Knows Before Investing in REITs

Real estate investment trusts, commonly referred to as REITs (pronounced REETs), are a special type of company that invests in real estate and real estate securities. Having outperformed the S&P 500 for over 30 years, it's understandable why REITs have grown in popularity over the past few decades.

These special companies offer investors a way to diversify a portfolio into real estate while earning superior income. If you're interested in investing in REITs, here are 15 must-knows before buying your first share.

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REITs must follow certain rules to benefit from favorable tax advantages such as paying zero corporate tax. In addition to earning a minimum of 75% of revenues from real estate -- with 95% of that earned passively through things like rent or mortgage income -- REITs are required to pay 90% of taxable income in the form of dividends to shareholders. This often leads to superior dividend returns for investors.

ALSO READ: Real Estate Investment Trusts: What They Are and How to Invest in Them

Whether traded publicly on a stock index or privately outside of the stock market, REITs fall into two main categories: equity REITs or mortgage REITs.

Equity REITs invest in physical assets, leasing them to long-term tenants. This includes properties like offices, timberland, hotels and lodging, retail, single-family homes, apartments, and much more.

Mortgage REITs invest in real estate securities, originating or buying mortgage debt. REITs can also combine the two types, operating as a hybrid REIT.

There are private REITs and publicly traded REITs to invest in. Investors who aren't accredited or may be new to REIT investing tend to invest in publicly-traded REITs simply because of the ease of investing, which is done by purchasing shares of the company through a brokerage account.

Although transparency in accessing earnings and no minimum investment requirements are also benefits of public REITs. Currently, there are over 225 publicly traded REITs with a combined market capitalization of $1 trillion.

ALSO READ: Non-traded REITs vs. Traded REITs

Mortgage REITs (mREITs), which originate and invest in residential and commercial mortgages and mortgage securities, are known for having above-average dividend returns that can be well within the 5% to 12% range. While this is an attractive return for income investors, it comes with a lot of risk.

mREITs are affected by market volatility, interest rates, and inflationary pressures. To grow, they require high use of debt leveraging. So, before investing, make sure you're comfortable with the associated risks.

ALSO READ: Investing in Mortgage REITs

REITs' competitive dividend returns are appealing for income investors, but REITs can also be great for growth investors. Share prices often increase in relation to a company's potential -- REITs are no exception.

Innovative Industrial Properties (NYSE:IIPR), for example, a REIT that leases industrial space to medical marijuana operators, has seen its share price grow over 1,200% in just five years. That's over 10 times higher than the growth achieved by the S&P 500 and all while paying a competitive dividend return.

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Most dividend income from an income stock is taxed as qualified income, which is taxed at a lower rate. REIT dividends, however, are most often taxed as ordinary income, which is taxed at your nominal tax rate and determined by your current income level.

There are times when the dividend income can be taxed as both, which can make tax time a bit tricky. For this reason, holding REITs in tax-free retirement accounts like an IRA can be a great way to benefit from REIT dividends and growth without the tax headache.

ALSO READ: REIT Taxation Basics

Since REITs invest in real estate, growth potential and performance are often led by completely separate drivers. It's the reason real estate can still do exceptionally well while the stock market is in a bear market. REITs that lease physical real estate can increase revenues to match market demand or hedge inflation.

This means -- oftentimes, without expanding a portfolio's size -- a company can grow revenues simply by increasing rents as the market allows. When combined with expanding a portfolio through development or acquisitions, it's easy to see how a REIT can experience supersized growth.

Publicly traded REITs must follow the same reporting requirements' generally accepted accounting principles (GAAP) as outlined by the Securities Exchange Commission (SEC).

Many metrics on their quarterly earnings reports will appear similar to non-REIT stocks, but investors shouldn't necessarily use those metrics to evaluate profitability or performance. The next few slides will cover important metrics for evaluating a REIT.

ALSO READ: How to Value a REIT

Funds from operations, often abbreviated FFO, is a REIT's equivalent to earnings. This number accounts for things exclusive to REITs, such as the depreciation of assets, which is a legal tax write-off of a property's value over time to account for wear and tear.

Ideally, you'll see FFO improving quarter over quarter and year over year, but depending on the company's dispositions, this number can fluctuate as depreciation is recaptured at the sale.

ALSO READ: What Is FFO?

Because REITs use FFO to illustrate their earnings, investors should look toward a company's price to FFO instead of earnings per share (EPS) to help determine their value as it relates to their share price.

Generally speaking, the lower the price to FFO, the more favorably the stock is valued. REITs priced above 30 times their FFO are considered richly valued. But note that there are times when it makes sense to buy regardless of a REIT's price to FFO.

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Net operating income, NOI for short, illustrates the pre-tax profitability of a REIT. It's calculated by taking the total revenues earned after all expenses. NOI can give a good snapshot of the company's recent performance, although FFO is often a more accurate picture of profitability. Like FFO, you want to see this number grow quarter over quarter.

Leverage is an incredible tool in real estate. Mortgages allow companies to grow their businesses, improve existing properties, or expand through new acquisitions or developments.

It's not uncommon to see REITs carry a heavy amount of debt, which is calculated by looking at a company's total debt compared to its earnings before interest, taxes, depreciation, and amortization (EBITDA).

ALSO READ: What Is EBITDA and Why Does It Matter?

While REITs must pay 90% or more of taxable income to shareholders as dividends, it doesn't necessarily mean 90% of revenues are being shared. Because of certain tax advantages -- including not having to pay corporate taxes, depreciation, and other business or real estate-related deductions -- taxable income is often far less than what the company earns.

To ensure the company isn't overpaying its shareholders with unsustainable dividends, look at its payout ratio, which is calculated by dividing its FFO by its dividend. Payout ratios 80% or below are completely normal and sustainable for REITs to maintain.

Supply and demand are incredibly important factors to consider when evaluating a REIT. Too much supply and too little demand can kill even the best companies. The goal is to focus on industries, markets, or companies exposed to high-growth markets backed by solid long-term trends for demand.

Industrial real estate, data centers, and housing are three strong sectors that are doing exceptionally well today, while other industries, like retail, office, and hotel, are still recovering from pandemic-related impacts.

ALSO READ: Investing in Industrial REITs

Just because a company is publicly traded doesn't mean it's a worthwhile company to invest in. Even the biggest names in REITs can fall susceptible to poor management practices, too much debt, lack of growth opportunities, or stunted demand. The metrics above can help evaluate the company, taking a more comprehensive approach to determine the winners and losers.

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You no longer have to own or manage physical real estate to be a real estate investor thanks to REITs. REITs can be an incredible tool for growing a portfolio and diversifying your investments. But, as with any investment, there is always risk. Right now, market volatility has put a lot of high-quality and high-performing REITs on sale, making it a perfect time to jump in.

Liz Brumer-Smith owns Innovative Industrial Properties. The Motley Fool owns and recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.