Last updated on March 2nd, 2022 , 10:24 am
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REITs for Beginners
Real estate investment trusts (REITs) offer investors a great way to diversify their equity holdings. In the past, investing in real estate was a time-consuming and cumbersome process. Today, with the introduction of exchange-traded REITs, investing in real estate is only a few clicks of your mouse away.
According to the Internal Revenue Code (IRC), a business must meet the below criteria in order to qualify as a REIT:
- Receive at least 75% of gross income from real estate. This includes real property rents, interest on mortgages financing the real estate property or from sales of real estate property
- Invest at least 75% of total assets in real estate or cash
- Have at least 100 shareholders at the termination of the trust’s first year
- No more than 50% of its equity shares are held by five or fewer investors
If an investment company does indeed meet the above criteria, that business will be considered a REIT. They are therefore considered a “pass-through” business, which has added tax benefits.
Though owning real estate outright may be more tax advantageous than investing in REITs, REITs do come with their own tax advantages when compared to traditional equity investing. Let’s explore the tax implication of a “pass-through” business next. (Taxation can be fun when you learn about NOT paying taxes!)
Pass-Through Companies
Pass-through businesses (which qualified REITs are) pay ZERO corporate tax on their profits.
For example, let’s say that you are invested in JNJ stock. Before JNJ pays you a dividend, JNJ must pay corporate taxes on these proceeds. With REITs, however, the proceeds are passed on without JNJ ever paying this tax (which is currently 21%). This means more money for you!
So that’s taxation on the corporate level; what about on the individual level?
REITs Advantage for Individual Tax Rate
Investors in REITs can also save money on the individual tax level. So long as the business qualifies as a REIT, investors can take advantage of a 20% rate reduction to individual tax rates on the ordinary income portion of these distributions.
Now that we understand a little more about REITs, let’s take a look at a few of their advantages when compared to traditional real estate investments.
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REITs Advantages Over Traditional Real Estate
- 1. Zero Maintenance Required
Traditional real estate management requires extensive hands-on maintenance. With REITs, you’ll never have to worry about repairing the roof or unclogging a toilet!
- 2. No Rent Collection Worries
Perhaps the most awkward and tedious job of the landlord is collecting rent. With REITs, you never have to worry about chasing down tenants, nor do you need to worry about eviction scenarios should you have tenants who can’t make the payments.
- 3. Most REITs are Incredibly Liquid
The process of buying and selling real estate introduces great inefficiencies. You never know the exact price you can purchase property for, nor will you know for sure what you can sell that property for. With REITs, all you have to do is click “sell” and your position is liquidated at the current market price.
- 4. REITs Do Not Require Financing
Many real estate investors take on loans or mortgages to purchase their properties. Rent payment is often used to pay off debt. In a scenario where you can either not rent the property, or your tenant can not pay the rent, you may be at risk of defaulting on your loan. This may result in a poor credit score that could tarnish your future plans.
- 5. Diversified REITs Do Not Require Multiple State Income Tax Filings
If an individual owns investment property across numerous states, tax time can be a nuisance. With REITs, however, you do not have to file income taxes for every state. This can save a lot of time and money, not to mention headaches!
So now that we know a little bit more about REITs, let’s explore the two different types of REITs; Equity REITs (eREITs) and Mortgage REITs (mREITs). Additionally, we will do an overview of “blended” REITs, which, you guessed it, offer a combination of the two.
With Equity REITs being the more popular option, let’s take a look at them first.
What are Equity REITs?
Equity REITs (eREITs) – reits.com – are indirect investment vehicles that invest in tangible real estate. They make their money from rental income derived from a pool of real estate investments.
This income is passed on to investors through dividends (the tax advantages of which we touched on earlier). Additionally, equity REITs allow for share price appreciation. When the value of an eREITs holdings rises, so does the value of your stock position. This is in addition to your monthly dividends.
So what exactly do eREITs invest in? Pretty much anything. Here are a few of the more popular categories.
- Office REITs
- Industrial REITs
- Retail REITs
- Lodging/Resorts REITs
- Residential REITs
- Self-storage REITs
- Timberlands REITs
- Health Care REITs
- Data Centers REITs
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Why to Invest in Equity REITs
Equity REITs offer investors many advantages. Let’s look at a few of them now.
- Stable Dividends
Rental income is one of the most reliable sources of income. It doesn’t matter what market cycle we are in, when the rent comes due we (must of us anyway!) must pay.
- Transparency
Real estate can be a shady business. I just moved into a high-rise that I recently discovered is going to require brand new copper pipes in the near future. With REITs, you don’t have to worry about the nitty-gritty of property. Investing on the corporate level allows for great transparency.
- Low Volatility Investments
In addition to having comparable returns when compared to stocks, equity REITs have less exposure to volatility, allowing investors more peace of mind.
- Returns Through Appreciation
Over time, equity REITs can appreciate in price quite a bit. Some have even beat the stock market. This isn’t the case with Mortgage REITs (which we will get to soon!).
- Exchange-Traded
Most equity REITs trade on exchanges, making the process of entering and exiting positions very seamless.
Equity REIT Risks
No investment comes without risks. Though the risk that comes with investing in equity REITs is relatively low, there are indeed some risks.
- 1. Property Value Risks
Sometimes the housing market finds itself in a bubble, and just as many times, that bubble bursts. When the value of real estate falls dramatically, the value of equity REITs will fall with them. Therefore, it may be wise to avoid investing in equity REITs when housing markets are teetering near all-time-highs, as they are presently in 2021.
- 2. Long-Term Interest Rate Risk
In order to purchase properties, equity REITs must borrow money. These loans are subject to long-term interest rate risk. When interest rates rise, so do yields. The higher the yield, the lower the value of the REIT. You can look at the 10 or 20-year treasury as a good benchmark for equity REIT interest rate risk.
- 3. Lack of Diversification
Before investing in an equity REIT, it is important to understand the properties that that particular REIT invests in. There are over 1,000 REITs. Some of these have very narrow scopes. For example, if you were invested only in timberland REITs, you may experience higher volatility due to the narrowness of the fund.
Now that we know what eREITs are, let’s explore a few promising equity REITs!
Best Equity REITs
| Ticker | Company | Dividend Yield | Sector |
|---|---|---|---|
|
American Tower |
1.73% |
Communications |
|
|
UMH Properties, Inc |
3.12% |
Home Communities |
|
|
Stag Industrial Inc |
3.49% |
Warehouses
|
|
|
Healthcare Trust of America, Inc. |
4.27% |
Medical Office Buildings |
|
|
Easterly Government Properties Inc |
5.02%
|
Government Facilities |
What are Diversified Equity REITs?
Equity REITs can either invest in a single sector or diversify their holding across numerous sectors. Diversified REITs (reit.com) own and maintain two or more of the property sectors we listed earlier.
Generally speaking, the more diversified your portfolio is, the better. The most successful property investors have holdings across numerous sectors. If you can diversify in the REIT space for no additional cost, why not?
Here are a few of the more popular diversified eREITs.
Best Diversified Equity REITs
What are Mortgage REITs?
Mortgage REITs (mREITS) – reit.com are unlike equity REITS in that these funds do not actually own the property. Mortgage REITs make money by providing financing for both commercial and residential properties.
They accomplish this by both investing in and owning mortgages. They rely on short-term financing to do this, and in turn loan this money out at higher rates. The difference, or “spread”, is passed onto the shareholder in the form of dividends.
Why Invest in Mortgage REITs?
- No Physical Real Estate Risk
Since mREITS don’t invest in tangible real estate, the price of these funds is not at the mercy of the housing market. Of course, there are risks, just no direct risks pertaining to housing cycles.
- High Dividend Yields
mREITs usually pay higher dividends than equity REITs. Income thirsty investors not seeking capital appreciation may be attracted to mREITs for this reason.
- Residential mREITs Have Little Principal Risk
The loans which constitute many mREITs are backed by agencies. Because of this, default risk can be minimalized.
- Exchange-Traded
Like equity REITs, most mortgage REITs trade on exchanges, thus making the process of entering and exiting positions very seamless.
Mortgage REIT Risks
Mortgage REITs are inherently more risky than equity REITs. This is mainly because of the high-risk nature that comes with short-term lending. Let’s next explore this specific risk, as well as a few other mREITs risks.
- 1. Mortgage REIT Short-Term Interest Risk
Just like Equity REIT, Mortgage REITs have interest rate risk, but of a different kind. Mortgage REITs typically loan money for their businesses at short-term interest rates (remember, equity REITs borrow at the long-term interest rates).
Mortgage REITs make money from mortgage payments. As long as the interest rate on these long-term mortgages is higher than the short-term rate they borrow at, they will make the difference in profit and pass that on to you, the shareholder.
But what happens when short-term interest rates spike higher? The spread narrows and the income of mortgage REITs go down, thus resulting in a lower dividend for you.
However, most mREITs hedge against this risk using financial instruments such as options contracts.
- 2. Mortgage REIT Dividend Volatility
The dividends of equity REITs are derived from a steady stream of rent income. The dividends of mortgage REITs are subject to short-term interest rates, which are volatile and in constant flux. This results in less reliable dividend payments.
Mortgage REITs make money from mortgage payments. As long as the interest rate on these long-term mortgages is higher than the short-term rate they borrow at, they will make the difference in profit and pass that on to you, the shareholder.
But what happens when short-term interest rates spike higher? The spread narrows and the income of mortgage REITs go down, thus resulting in a lower dividend for you.
However, most mREITs hedge against this risk using financial instruments such as options contracts.
- 3. Mortgage REITs and Share Dilution
In order to fund new investments, mortgage REITs are known to issue new stock. When new stock is issued, the value of pre-existing shares goes down in value. And who wants the value of their stock to go down!
Let’s now take a look at a few of the more popular mortgage REITs.
Best Mortgage REITs
| Ticker | Company | Dividend Yield | Sector |
|---|---|---|---|
|
Annaly Capital Management, Inc. |
9.93% |
Very Diversified |
|
|
New Residential Investment Corp |
8.90% |
Very Diversified |
|
|
PennyMac Mortgage Investment Trust |
9.36% |
Home Loan Lender
|
|
|
Chimera Investment Corporation |
8.55% |
Residential Mortgage Loans |
|
|
AGNC Investment Corp |
8.85% |
Agency Backed MBS (Mortgage-Backed Securities) |
Equity REITs v Mortgage REITs
In a nutshell, mREITs tend to be more risky than eREITs. This is mainly due to mREITs exposure to short-term interest rate risk.
The below table highlights some of the main differences between eREITs and mREITs
| Equity REITs | Mortgage REITs | |
|---|---|---|
|
Interest Rate Risk |
Moderate: Long-Term Rate Risk |
High: Short-Term Rate Risk |
|
Business Revenue |
Rental Income on Commercial Real Estate Property |
Loaning Money in Commercial and Residential Properties |
|
Shareholder Value |
Price Appreciation and Income |
Income |
|
Share Dilution Risk |
Low |
High |
|
Dividend Yield |
High |
Very High |
|
Overall Risk |
Moderate |
Moderate to High |
What are Hybrid REITs?
If you’re interested in investing in both equity REITSs and mortgage REITs, hybrid REITs allow you to do this by investing in a single fund.
Hybrid REITs combine the strategies of equity and mortgage REITs. These funds both buy properties and finance real estate. They offer the benefit of both categories while simultaneously reducing risk in the form of diversification.
Transcontinental Realty Investors (TCI) and Simon Property Group Inc (SPG) are two popular hybrid REITs.
Final Word
REITs offer diversification seeking investors a great opportunity to expand their portfolio. It is important to remark that not all REITs are created equally. 2020-2021 proved that. Retail, hotel and office REITs plummeted on the tail of Covid-19. A few did not survive.
Having a general pulse of the real estate market is crucial before investing in a REIT fund. Make sure to always check the historical share and dividend performance before investing. Although past results are not indicative of future performance, this is a great starting point.
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