REIT Investing for Beginners: The Basics You Need To Know

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REITs or real estate investment trusts give investors exposure to the real estate market with no direct investment in a property. REITs were authorized by Congress in 1960 specifically to allow small investors to reap advantages usually available only to investors with larger resources.

Today, 195 REITs, worth a combined $1.37 trillion, exist in the U.S., according to Statista. Many trade on the open market and are regulated by the SEC.

What Is a REIT?

A REIT is a company that owns investment properties, such as apartment buildings, office buildings, hotels, warehouses, storage facilities, healthcare facilities or shopping malls. Some REITs may invest in mortgages or other real estate debt instead of owning properties.

REITs must follow strict rules to maintain their status. At least 75% of their assets must be invested in real estate or cash, and at least 75% of their gross income must come from real estate-related sources, such as rents from their properties and interest from any real estate-related debt they own.

How Do REITs Make Money?

By design, a REIT generates income primarily through rent collected from tenants of its investment properties, such as apartment buildings, shopping centers, warehouses, etc. They provide a stream of income that gets distributed to shareholders as dividends.

When a REIT sells a property for more than its purchase price, this is known as a capital gain. If these gains are distributed to shareholders as capital gains dividends, they are generally taxed at the lower long-term capital gains tax rates.

What Is the 90% Rule for REITs?

The 90% rule says that REITs must distribute at least 90% of their taxable income each year to shareholders. The SEC notes that because dividends are tax-exempt for REITs, many pay out 100% to avoid paying corporate income tax.

Types of REITs

REITs generally refer to three main categories, based on how the investor approaches them: equity REITs, mortgage REITS and hybrid REITs. Each approach is different, with its own set of benefits for the investor.

Equity REITs

REITs that invest in investment properties are called equity REITs. Most equity REITs operate the properties they own.

Mortgage REITs

REITs that invest in mortgages or other real estate-related debt are called mortgage REITs. Rather than purchase and operate property, mortgage REITs loan money for the purchase of real estate or invest in mortgage-backed securities, which are debts secured by mortgages.

Mortgage-backed securities are an indirect way to make loans, so they, like mortgage loans, generate interest income for the REIT and its investors.

Hybrid REITs

Hybrid REITs combine aspects of both equity and mortgage REITs, earning income from both rental properties and also real estate debt. That way, the hybrid REIT generates income from both rental properties and from interest payments, which can create a balanced and stable form of revenue.

How To Get Started With REIT Investing

If you’re interested in investing in REIT’s, follow these steps:

1. Open a Brokerage Account

Brokerage accounts without commission fees on REIT trading are a good place to start. You can choose from popular brokerage options such as Charles Schwab, E*Trade or Fidelity.

2. Research REITs That Match Your Goals

Many of these brokerages offer stock research and analysis tools to offer more insight on a REIT’s value and performance. However, if you want to think about the factors that go into selecting a good REIT, you might want to consider the following:

• Type of REIT: Equity, mortgage or hybrid
• Dividends: A higher yield might be a riskier option, but a lower one could mean steady payouts.
• REIT category: Residential REITs might have more stable income, but something like a hospital or office REIT may offer higher returns and can often bounce back from a downturn.
• Performance and growth: Look at the REIT’s past stock performance and its history of financial stability.

3. Steps To Buy Your First REIT

When you’ve chosen your REIT, follow these steps to get started:

1. Search for the REIT’s ticker symbol.
2. Select how many shares you’d like to purchase.
3. Fill out order information. Market order: is the REIT’s current price. Limit order is the maximum you are willing to pay.
4. Confirm the purchase.

Key Benefits of Investing in REITs

Here are some reasons to consider adding a REIT to your portfolio:

• Regular dividends: Shareholders receive at least 90% of a REIT’s taxable income in the form of dividends, which provide passive income.
• Adds real estate to your portfolio: Real estate REITs are another asset option to diversify your portfolio.
• Real estate exposure: They’re an easy way to gain exposure to the real estate market and potentially gain high returns.
• Easy access: You can invest in publicly traded REITs from your regular brokerage account for the price of a single share of the REIT of your choice.
• SEC regulation: The SEC regulates both publicly traded and non-traded REITs, requiring them to follow strict disclosure and reporting, which means greater transparency for investors.

Risk of Investing in REITs

However, all investments have some degree of risk. Here’s what you should know:

• Market volatility: If your REIT investment is publicly traded on the stock market, that means it’s subject to fluctuations in share prices. The share price can become volatile even if the overall fund is relatively stable.
• Interest rate risk: Interest rates can have a profound effect on the real estate market, which impacts the value of a REIT’s holdings.
• Property value fluctuations: The value of your REIT’s real estate may see a dip for various reasons, including oversupply, lack of tenants providing steady income and in an overall economic downturn. Any one of those circumstances can hurt the REIT’s performance.

Common Mistakes To Avoid When Investing in REITs

REITs can be a great way to add real estate to your portfolio, but there are some common mistakes that can hurt your returns or expose you to unnecessary risks. Being aware of these pitfalls can help you invest more confidently and effectively.

Not Diversifying Your Investments

For example, say you’ve put all of your money into one type of fund or REIT category, such as office buildings. If any of those takes a hit, your REIT investment can as well.

You can reduce some of that risk by spreading your investment across different REIT categories.

Ignoring Dividend Yields

A high yield can signal great growth, but this can be somewhat deceiving, too. Some REITs borrow money or sell properties so that they can keep providing dividends, but that isn’t the best practice. You should compare the dividend yields across many different REITs and see which ones are derived from real profits.

How to Evaluate a REIT’s Profits

Review its quarterly earnings releases and information found on finance sites such as Yahoo Finance. Metrics to look for include:

• Funds from operations (FFO): FFO shows how much of the REIT’s cash flow comes from operations, so it’s a useful way to measure net income, or profit
• Adjusted funds from operations (AFFO): AFFO makes certain adjustments to FFO to produce a more specific picture of cash flow
• Net asset value (NAV): This is the equivalent of market capitalization, equal to a REIT’s assets less its liabilities

Failing to Understand Market Trends

A REIT’s performance is based on factors, including interest rates, the current supply and demand for real estate and even how the economy is doing overall. It’s good to keep an eye on any trends in the market; otherwise, you could be investing in a REIT at a higher share price or in a struggling fund.

The Bottom Line

It’s important to keep your investing goals and your risk tolerance in mind as you develop a strategy for investing in REITs.

If your goal is to minimize tax liability, you might use a tax-deferred retirement account, such as an individual retirement account, to invest in REITs. That way, your dividends and capital gains are tax-deferred.

If you’re risk-averse, you might spread your investment dollars across several REITs to incorporate different types of investment property and perhaps add mortgage REITs into your equity REIT mix. Alternatively, you might invest in a mutual fund or exchange-traded fund that invests in many different REITs or that tracks a REIT index instead of picking and choosing REITs on your own.

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