Real Estate Investment Trusts (REITs) make a perfect portfolio diversifier, thanks to their competitively high returns and lower overall risks as compared to other assets. Investing in REITs can increase income flow and grow your portfolio without attracting too much risk. Fortunately, most REITs are traded on major stock exchanges around the world, making it possible for investors to sell or buy them throughout the trading hours. But, what are REITs, how do they work, and why should you invest in REITs? This guide has everything you need to know about Real Estate Investment Trusts.
What are Real Estate Investment Trusts?
REITs are companies that own, finance, and typically operate income-generating real estate and correlated assets. Real estate, in this case, may include properties like apartments, commercial houses, office buildings, warehouses, resorts, hotels, and shopping malls. Alternatively, a REIT may be an asset associated with real estate, including mortgages and loans. With REITs, investors can earn returns from real estate without financing, managing, or buying properties themselves. Generally, REITs are highly regulated, and companies must comply with specific investment guidelines as stipulated by the responsible bodies. For instance, the Securities Exchange Commission (SEC) regulates companies that qualify to be REITs in the United States.
Types of Real Estate Investment Trusts
REITs fall under three broad categories, including the following;
Private REITs are exempted from any regulation by such authorities as the SEC. They are also not traded on major stock exchanges. Private Placement REITs, as they are commonly known, can only be sold to institutional investors, such as Accredited Investors and Large Pension Funds.
These are a category of REITs regulated by an exchange regulatory authority like SEC and are listed on major stock exchanges. This means that Publicly-held REITs can be purchased and sold by individual investors.
Public Non-Traded REITs
Unlike the publicly-traded REITs, this category of REITs does not trade on a stock exchange. They are only listed or registered with a capital market regulatory authority but cannot be traded publicly.
Benefits of REITs
You can invest in REITs by buying shares of a publicly-traded real estate investment trust. As with any other publicly-traded securities, you can purchase shares from a REIT through a licensed broker. But before you invest in REITs, here are some notable benefits that you should know.
The greatest appeal to investing in REITs is the high dividend yield that they attract. Since real estate companies qualify to be REITs by distributing not less than 90% of their annual taxable income as shareholder dividends, their yields tend to go above average. This explains why many REITs can outperform market indexes, making them an investors’ favorite income-generating investment. Long-term leases can help stabilize rents from real estate, making REIT dividends and yield more secure.
Buying and selling properties directly may not only prove to be burdensome, but the process may cost you more money, time, and other resources than your budget can facilitate. However, when it comes to REIT shares, the case is entirely different. REIT shares are easy to buy and sell, and you can do so any time you want at a click of a button.
Apparently, real estate investment trusts offer some of the highest dividend returns in the share market. This is obviously because of the 90% annual income that REITs are mandated to pay their shareholders as dividends.
Investment experts recommend portfolio diversification as one of the ideal ways to achieve long-term financial goals. With REITs, investors can access the real estate market, which is historically known to provide low correlation with other securities like bonds and stocks. The unique nature of REITs and their steady, predictable income validates real estate investment trusts as a considerable component for portfolio diversification. Again, real estate has a record of withstanding tough economic cycles better than any other equity market.
Access to Commercial Real Estate
Not every investor is in a position to go out and buy a commercial property all by themselves. However, with a REIT, anyone can acquire commercial real estate and generate passive income. Thanks to REITs, you can own a proportion of multiple commercial complexes, apartments, shopping malls, and storage facilities.
Types of Metrics for REIT Investing
There is a significant variation in the valuation of REITs compared to other securities, such as stocks and bonds. Some of the metrics used when investing in stocks do not translate well when establishing the value of a REIT. Here is an overview of the most common valuation metrics for REIT investing.
Funds from Operations – This is probably the most fundamental metric to understand before investing in REITs. The National Association of Real Estate Investment Trusts (NAREIT), Funds from Operations is a metric equivalent to a REIT’s net come, excluding depreciation, amortization, gains, or loses arising from the sale of a real estate asset, then adding back depreciation. Basically, Funds from Operations (FFO) compares to the traditional earnings per share (EPS) or net income metrics. The primary role of FFO is to establish the amount of money made by a REIT over a specified period of time. The difference between EPS and FFO is that the real estate depreciation is added back in FFO, while that is not the case for EPS or Net Income.
Price-to-FFO Ratio – In the share market, the Price-to-Earnings Ratio is used to determine the value of a given stock. In REITs, the Price-to-FFO (P/FFO) ratio is used to establish the value of a REIT in relation to other REITs.
Adjusted Funds From Operations (AFFO) – AFFO is used as an alternative metric for FFO. However, AFFO is considered more superior as the metric takes into account the costs incurred to maintain the quality of an underlying real estate asset. These costs include straight-lining rent payments and capital expenditures. Therefore, when calculating AFFO, the FFO must be established first. All the amortized and capitalized recurring expenses are then deducted from the value of FFO. Generally, investors rely on AFFO to evaluate the financial performance of a REIT.
Debt-to-EBITDA Ratio – The Debt-to-Earnings Before Interest, Taxes, Depreciation, and Amortization (Debt/EBITDA) ratio is the measure of a REIT’s capacity to pay off its debt. Keeping in mind that REITs require debt to expand their operations, then the Debt/EBITDA metric is critical for investors to assess the risk of investing in a specified REIT. If a REIT has a good standing to cover its debts guarantees more growth opportunities. To calculate the Debt/EBITDA ratio, take the total debt obligations of a REIT (long-term and short-term) and divide the value by the REIT’s EBITDA.
Payout Ratio – The Payout Ratio is a fundamental metric for establishing the ability of a REIT to sustain its dividend payments. The ratio indicates the value of dividends paid out to shareholders by a REIT, expressed as a percentage of its profits or total earnings. Typically, REIT payout ratios tend to go as high as 70% or even 80%. As the thumb rule goes, as long as the payout ratio is consistently below 100%, then the dividend yield of a REIT can be said to be commendably sustainable.
Disadvantages of Investing In REITs
While REITs may be a safe haven for most investors, there are still risks and drawbacks of these investment vehicles. Some of the disadvantages of investing in REITs include the following;
Lack of Liquidity – Publicly-held REITs are very easy to buy and sell at any given time. However, when it comes to private and public non-traded REITs, the level of liquidity is exceptionally minimal. Investors would have to hold their REITs for multiple years for their investments to yield potential returns. This is because there may never be enough sellers or buyers in the market any time you wish to trade.
Tax Burden – Considerably, REITs do not pay taxes. However, the disadvantage of this is that taxes are due on the dividends paid by REITs, a burden investors are forced to shell out for. Unfortunately, the tax cut-offs on REIT dividends are way higher than tax rates associated with other dividends in the securities market.
Low Capital Appreciation – REITs are required to pay out at least 90% of their total earnings as dividends. As a result, these companies are forced to issue new shares to raise funds for their growth and capital appreciation. However, investors do not always show interest in new REIT stocks, especially when there is an economic crisis. Consequently, their growth rate is derailed for a relatively long time.
Interest Rate Risk – When the interest rates increase, the demand for REITs tends to decline. And as history dictates, a rise in interest rates lowers the performance of REITs.
Sites and Apps Where REITs Can Be Traded
REIT trading and investing have been made easier and faster, thanks to robust internet growth and modern technological advancement. Today, you can buy or sell REITs at the comfort of your home or office at a click of a button. All you need is a smartphone and either of the following REIT investing Apps.
Fundrise is one of the oldest and most widely used REIT investing apps in the US. The app allows you to invest and manage your REIT portfolio online, as well as track the performance of your real estate assets. With as little as $500, you can join hundreds of thousands of other investors using Fundrise and enjoy high yields with minimal risks and at low rates.
Rooftsock is a Forbes-recognized smart solution to REIT investors. The app focuses on single-family rental properties, pooling together buyers, sellers, and owners of rental homes. Through Roofstock, you can start generating passive income by buying a proportion of a single-family rental home. The app also allows you to sell or purchase residential investment properties. The good thing about Roofstock with Roofstock is that you can access extensive amounts of information about a property before making an investment decision. The app also features investment tools and calculators to make your trading experience better.
If you are interested in investing in companies that own large parcels of land, then Acre Trader is the ideal trading platform. Types of farms featured in the app include orchards and crop farms. Acre Trader is also known for featuring multiple offerings, which you can choose based on your investment preferences. Investors are also allowed to sell their REIT shares through the app, provided they have reached the stated terminal date.
Streitwise is a great alternative for REIT investing, especially for investors interested in commercial real estate assets. The app allows you to invest in low-risk commercial properties and earn passive income at lower rates. The good news is that you can invest in REITs using Streitwise whether you accredited or non-accredited. Again, all the available offerings are featured on the app in appealing graphics and detail, making it easy for you to know what is in for your investment. The minimum investment at Streitwise is 100 shares, an equivalent of $1021.
Crowdstreet is a perfect platform for investment diversification. The app allows you to add commercial properties to your real estate portfolio easily. With Crowdstreet, you can compare, review, and identify commercial projects that suit your investment needs. The minimum requirements of investing REITs at Crowdstreet may vary with projects. However, the standard minimum investment falls at $25,000. The app also features a Demo account to allow beginners to review the current investment deals before creating an income-generating account.
Real Estate Investment Trusts can be a great addition to your investment portfolio. By creating a trading account, you can buy or sell REITs at any time with a click of a button. Apps like Fundrise, Roofstock, and Acre Trader, allow you to invest in real estate assets without necessarily buying properties. By investing in REITs, you can enjoy a wide range of benefits, including high yields, steady dividends, and portfolio diversification. However, investors must be prepared to face the drawbacks that come with investing in REITs. Such concerns include tax burden, lack of liquidity, and low capital appreciation. Again, measuring the performance and capabilities of a REIT using the necessary metrics is fundamental to your investment success.