15 Things to Know Before Investing in REITs

Thanks to a Congressional ruling in 1960, investors no longer have to buy and manage real estate to invest in it. Instead, they can purchase shares in a real estate investment trust, REIT for short. These special real estate stocks offer investors exposure to the diverse real estate industry through high-quality institutional properties for a fraction of the cost.

If you're considering investing in REITs (pronounced REET), here are 15 things you should know before buying your first share.

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REITs are required to earn the majority of their income from real estate or real estate-related securities. That could include anything from owning and renting real property -- such as office space, apartments, single-family homes, or industrial buildings -- to earning interest on a commercial or residential mortgage.

REITs are put into two main categories. The first, mortgage REITs (mREIT), invest in real estate-related securities like mortgages and mortgage-backed securities (MBS). Second are equity REITs, which own and lease physical assets, like self-storage facilities, data centers, land, and retail buildings, among a slew of other property types. And there are also hybrid REITs, which are a mix of both.

REITs can be either private or public. Publicly traded REITs are the more popular choice for most investors because they can be purchased through a simple brokerage account and don't have investment requirements like accreditation or minimums like many private REITs.

According to the National Association of Real Estate Investment Trusts (NAREIT), there are over 225 public and 900 private REITs.

ALSO READ: Non-Traded REITs vs. Traded REITs

REITs were created to provide everyday investors access to high-quality investments that would otherwise be out of reach. Most investors couldn't own part of the Empire State Building, but now they can by purchasing shares in Empire Realty Trust.

Iconic buildings aren't the only appealing aspect, though. REITs own properties across the globe in many of the most expensive real estate markets with super-high barriers of entry, making the quality of their portfolios unmatched.

Dividends aren't optional for REITs -- they are required. REITs must follow a strict set of rules to benefit from the tax advantages of the REIT structure, like paying no corporate taxes. In exchange for tax savings, they must pay 90% or more of their taxable income in the form of dividends. That means investors can rely on REITs to be consistent dividend payers, many of which pay super-attractive dividend yields.

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Income earned from REIT dividends is slightly more complicated than income earned from standard dividend stocks, which are usually taxed as qualified income at a lower tax rate. REIT dividends are most commonly taxed as ordinary income at a nominal tax rate determined by your income level. But income can also be taxed as both.

This earning structure can make taxes difficult, which is why REITs are great investments for retirement vehicles like IRAs.

Paying such consistent dividends and higher dividend yields means investors usually choose REITs for the income they can provide. But they can be growth stocks, too. Innovative Industrial Properties, a REIT that leases industrial property to medical marijuana operators, has outperformed the S&P 500 by over three times, with shares growing over 203% in the last five years.

Since 1972, when data for tracking REITs were established, REITs have outperformed the S&P 500. As of late, REIT performance has fallen behind the S&P 500, but over the past 20- to 25-year period, it's provided superior returns with superior dividend yields to boot.

ALSO READ: REITs vs. Stocks: What Does the Data Say?

Since REITs pass more of their taxable earnings onto shareholders through dividends, their dividend yields, on average, are notably higher than the S&P 500. At the time of this writing, the average return for all public REITs was 3.8%, over two times higher than the S&P 500's 1.56%.

Since REITs have to pay 90% of taxable income in dividends, dividend increases are common with REITs. That means the yield investors earn from REITs can compound much more over time.

Federal Realty Trust, a net lease REIT owning and operating outdoor shopping centers and some multifamily buildings, has increased its dividend for 54 years, making it a prized Dividend King. But it's not the only great dividend payer. Realty Income pays dividends monthly and boasts over 116 dividend raises.

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Because REITs invest in real estate, they can utilize certain tax advantages of this asset class, like depreciation. That can make traditional valuation metrics, such as earnings per share or free cash flow, distorted representations of profitability.

Instead, REIT investors should look at metrics like funds from operations (FFO), net operating income (NOI), occupancy levels, and blended lease rates for guidance on how the company is doing.

ALSO READ: How to Value a REIT

REITs are impacted by stock market movement but are, more importantly, driven by the real estate market movement. Things like supply and demand for each property type in the local market will determine its occupancy levels and how much rent it can charge.

Too much supply and insufficient demand can hurt a company's earnings, even in a healthy economy. So, knowing the industry's growth opportunities and the challenges and markets in which the company operates are very important before investing.

Mortgage REITs are known for their higher-than-average dividend yields -- ranging from 6% to 10%, sometimes even higher. However, they do come with much more risk. Mortgage REITs' high-leverage nature makes it a volatile market easily impacted by demand trends, interest rate swings, and the state of the economy.

ALSO READ: Investing in Mortgage REITs

Equity REITs are considered the safer investment option of the two because there is usually far less leverage and fewer impacts from interest rates on their core business: earning income through rent. Safety comes at a price, though; equity REITs can offer dividends in the range of 1% to 5%, sometimes more; however, 3% to 4% is the average.

REITs' dividend yields are the rate of return investors receive from their dividends based on their investments. These yields are determined by the stock price.

So, if stock values go down but dividends don't change, the yield increases. Conversely, the yield decreases when the stock's value increases but dividends stay the same. Down markets mean yields will be higher.

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Volatile markets like we're seeing today are a great time to buy REITs because they offer diversification into real estate -- a completely different asset class from most traditional stocks -- and can provide reliable passive income streams.

Down markets also mean pricing is more favorable, giving investors opportunities to earn higher dividend yields. Several high-quality REITs are trading for 20% to 40% off recent highs, pushing dividends above historic averages.

Liz Brumer-Smith has positions in Innovative Industrial Properties. The Motley Fool has positions in and recommends Innovative Industrial Properties. The Motley Fool recommends Empire State Realty Trust. The Motley Fool has a disclosure policy.