What You Need to Know Before Investing in REITs

What You Need to Know Before Investing in REITs

When considering the best investments for the future, people often look to real estate. Unfortunately, the high costs often associated with purchasing property can pose a barrier to entry into this market, especially for everyday investors. However, you do have options. A real estate investment trust (REIT) remains one of the best ones. A REIT is an organization that owns and/or manages commercial real estate that produces income. Individuals can invest directly in these companies or through an exchange-traded fund, similar to a stock.

On the surface, REITs are a great way to enter the real estate market without the responsibility or expense associated with purchasing property. At the same time, they offer a number of other benefits, ranging from diversification to the potential for very high returns. Plus, REITs are set to enjoy substantial gains this year, according to some analysts. Some of the primary advantages of investing in REITs include:

real estate1. High dividends: Nearly all REIT profits are paid out through dividends, so these payments tend to be significantly higher than those associated with other asset classes. The current average dividend yield on stocks in the S&P 500 is about 2 percent, while returns from the biggest REITs are approaching 5 percent. Such high yields are not unusual, and some companies have achieved even higher rates, up to 12.4 percent.

2. Unique behavior: Since REITs are tied to the real estate market, they behave differently than stocks and bonds. The bottom line is that REITs make portfolios more stable. Since they do not rise or fall with stocks and bonds, they can significantly reduce volatility. Investors should also consider the fact that prices tend to increase over time, so payouts from REITs generally rise. Moreover, the income is fairly reliable.

3. Superior liquidity: One of the biggest challenges of investing in real estate is the lack of liquidity. Selling assets requires a great deal of time and money, which makes it nearly impossible to get capital out of the investments quickly. Since REIT investments are similar to stocks, they have much more liquidity and can be sold without much of an investment in time or other resources.

4. Tax benefits: The majority of payouts from REITs do not count as qualified dividends, so they do not receive a favorable tax rate. At the same time, these payouts are not exposed to the double taxation of other investment profits. Provided that REITs disburse more than 90 percent of taxable income, they do not face corporate taxation and can thus pay out higher dividends.

5. Interest rates: In general, interest rates are slowly increasing. For REIT investors, this is good news. Higher interest rates mean a stronger economy, which in turn results in an increase in occupancy levels and a rise in rents. In the end, REITs end up making more money as the economy improves.

Of course, just as with any other type of investment, not all REITs are created equal. A number of REITs focus on particular parts of the market, such as retail, residential, or healthcare properties. Individuals need to perform due diligence before investing to ensure that they are making a wise decision for the future. Each category of REIT has inherent benefits and drawbacks, and investors should understand them thoroughly before purchasing shares. Some other helpful hints for investing in REITS include:

real estate1. Focus on publicly traded REITs:  Research by Morningstar has shown that publicly traded commercial equity REITs outperform nontraded ones over time and that they recover faster from dips in the market. In addition, publicly traded options tend to have lower fees and stronger performances during market upswings. According to FINRA, untraded options often lack transparency and are sometimes required to be held for eight years or more, which negates the liquidity benefit.

2. Look at REIT track records:  The chief tool that investors have for predicting future returns is by looking at past performance. Typically, investors should avoid newly issued REITs until they have a sufficient track record to understand how they operate. Those who create a REIT may not necessarily have the skills and background to operate the company successfully. Ideally, REITs have a relatively stable payout over time, which means that their leadership understands how to handle unstable markets.

3. Equity REITs have greater stability:  Mortgage REITs invest in real estate debt and tend to be very highly leveraged. When REITs use borrowed capital, they may face serious consequences as interest rates start to rise, since borrowing costs will skyrocket. Equity REITs—those that own property—are not as sensitive to interest rates and can even benefit from rising rates.

4. REITs are one part of diversification:  Since REITs tend to have relatively high dividends, investors may be tempted to put all of their eggs in one basket and ignore the most stable investments, such as bonds. In reality, this is a rather aggressive approach that could cause you to lose a lot of money in the long run. As with most investments, REITs have risks, so it is always smart to balance out that risk with bonds.