4 Real Estate Investing Strategies: REITs
There are 4 main strategies investors can use to build their real estate portfolio. In these blog posts, I will break them down from what they are, what it takes to invest in them, the level of risk associated with each strategy, and how each strategy can benefit you financially. This is the first part of a 4 part series.
Real Estate Investment Trusts (REITs):
What is a Real Estate Investment Trust and how does it work?
A Real Estate Investment Trust, or REIT for short, “is a company that owns, operates, or finances income-generating real estate” (Great Investopedia article about REITs). An REIT will accumulate capital from numerous investors in order to generate funds for investing in real estate in certain geographical locations that vary form local, state, and national levels. This is a great way to invest part of your income and be able to gain exposure to different types of asset classes in real estate. This asset class contains properties that vary from residential communities, commercial properties, to even industrial buildings. A great benefit to investing in REITs is gaining exposure to the broad market of real estate. You are able to invest in companies that follow market trends and allow you to simply put money into these trusts without actually having to physically invest in these types of real estate yourself. You are able to buy shares of commercial real estate portfolios all from the convenience of your at-home device, such as a phone or computer. Investors like REITs because the portfolio consists of many different property types which can help reduce the investors risk. There are many REITs out there, each with exposure to different real estate sectors. Finding a trusted investment advisor who is well informed of market trends can help you identify which REIT is right for you. (Click here to see if your personal investment professional is registered with the SEC.)
What does it take to Invest in an REIT?
These days, many security transactions can happen at the click of a button. Thanks to technology, investing is easier and more accessible than it has ever been. If the average person wants to invest in an REIT, they have a couple of options. Most REITs are publicly tradeable, like stocks, and can be traded on exchange markets such as the NYSE and the NASDAQ. Since many REITs are traded on the large exchange markets, making them the most liquid form of real estate investing. You do not need a 20% down payment, nor do you need to be approved for a loan by a lender or bank. If you want to sell, you do not need to hire an agent and market your real estate. You can just click a button and boom, your investment is now on its way to cash. You can easily download an online brokerage service and start investing in REITs. Some REITs are not publicly traded, so you cannot sell your shares any time you would like. This will make your investment horizon longer term and this is something to keep in mind when you consider investing into a non-publicly traded REIT. Beware of scams when investing into an REIT. Make sure it is registered with the SEC to prevent being subject to fraud. (This website can check if the REIT is registered with the SEC.)
What is the risk associated with investing in an REIT?
Like I mentioned before, it is important to understand which REIT is right for you. With that being said, publicly traded REITs compared to their counterparts, non-exchange traded REITs (or NXREIT), are more liquid to the investor. You can sell your shares of a public REIT and get out of your position if you believe in doing so. It is important to keep in mind that there is no guarantee with REIT investments and you should not invest more than you are willing to lose. It is vital you do your own research before investing in an REIT or consult a licensed investment professional to understand what you are investing in. The risks for NXREITs are higher than their counterparts for a number of reasons and it is important you know why before investing in them. The first reason is they are considered to be illiquid investments. If you need to sell quickly, you might not be able to do so because there might be requirements for how long you have to hold your funds in the account and they cannot be sold on the open market. Another risk is the share value transparency. When public shares are traded on the open market, you can see in real time what the value of your investment is. It can be years before you know the value of your investment in an NXREIT. However, there are quarterly and annual statements SEC registered REITs are required to file. These statements can provide you with financial information about the company, including the NAV, or net asset value. This is calculated by estimating the market value of the assets the REIT holds, minus its liabilities. Divide this calculation by the number of common shares outstanding and you will find a good estimate of the net asset value per share. The most common rule for any investment abides by “the higher the risk, the higher the return.” You might ask yourself, “why invest in an NXREIT?” Typically, NXREITs attract investors with their high dividend yields. In order to maintain a high dividend yield, NXREITs can pay their investors from offering proceeds and borrowings. This is not typically used by public REITs, and can reduce the share value and sometimes even the cash on hand a NXREIT company has. This can affect their buying power when it comes to purchasing additional assets. The reason this is a risk to an investor is because in the short run, you may receive your promised dividend yield every year. However, if the company has to reach into its own pockets to pay back investors, this practice can hurt the company in the long run. Another potential downside to NXREITs are the conflicts of interest these companies can have. These companies can typically hire an outside manager to handle the property acquisition and assets under management. When a company hires a third party source instead of their own employee, the external manager must be incentivized by fees, and this can conflict with the interests of shareholders. It is important to note that not every fee to an external manager is a bad fee. For instance, if the fee is a performance based fee, where the external manager is only compensated based on the performance of the assets under management, then this fee can incentivize the manager to make better decisions. If the fee is based on the number of transactions, regardless of the performance of the transaction, this may not incentivize the manager to make sound investments. The manager now has more of an incentive to take on risk because the number of transactions is what matters, not the manager maximizing the performance of the assets of the company. This is not always the case for each REIT. Each REIT is different and there are exceptions to the rules. But it is important to understand how an external manager may be incentivized in the form of fees.
How can an REIT benefit me financially?
Strong, stable, and relatively high dividend yield that is paid annually to investors is an excellent reason to consider if you are thinking of adding a Real Estate Trust to your portfolio. Real estate appreciation is real thanks to scarcity and consistent demand. As a shareholder, you can be compensated by the REIT at years end when the company sells their assets for a profit. This is known as capital gains and is only realized when the asset is sold. Appreciation plays a large role in capital gains. Appreciation causes the value of an asset to increase over time and real estate is notorious for appreciating assets. In the past, REITs have performed well compared to other investments. This can be due to their low correlation to other assets and their performance. Another reason REITs can perform well for investors is because the goal of a public REIT is to maximize its shareholder value by producing income. There are 3 main ways REIT companies can earn income. One way can be through rents from real property where they must attract tenants to their properties in order to earn a rental income. If a company owns a piece of real property, and this property produces income through rent, this is called an Equity REIT. An equity REIT is the most common form of REIT. As I mentioned previously, if this asset appreciates over time and the company sells the asset for a profit, you as a shareholder will receive part of the earned profit from the sale of real estate the REIT owns in the form of capital gains. The second way an REIT can be set up to make money is through lending, both directly and indirectly. If an REIT loans money directly, they are lending directly to landlords, real estate owners, or real estate operators. If an REIT loans money indirectly, they will swap money for mortgage backed securities, or MBS for short. (What is a mortgage back security?) Both direct and indirect lending practices earn income through the net interest margin. The net interest margin is the difference between the interest earned on these loans and the cost of issuing the loan to the borrower. The last way REIT companies earn an income is creating a Hybrid REIT. This is the combination of an Equity REIT and a Mortgage REIT. At years end, the REIT will issue a 1099-DIV form that states where the income is generated. Income, capital gains, and return on capital all go towards the dividends shareholders receive. It is important to consult a tax professional because each is treated differently when it comes time for an investor to pay taxes. It is also important to keep in mind that certain REIT dividends are subject to tax breaks under the Tax Cuts and Jobs Act of 2018 and consulting with a professional tax advisor will help you take advantage of these new tax laws. The way an REIT is set up requires at least 90% of the taxable income an REIT makes to be redistributed to its shareholders in the form of dividends each year. At least 75% of the investments an REIT makes must be in real estate, and at least 75% of the gross income an REIT earns must be from the specified sources mentioned above. Because of this, REITs are not subject to corporate income tax and can pay dividends that create attractive income streams for investors, especially since the dividends from REITs are typically higher than other investments. REITs do offer great diversification for any portfolio because of their risk adjusted returns and stable cashflow. In order to continue its operation, the business plan of an REIT is reliant on consistent investment from outside sources and making sure those shareholders have their returns maximized. This means it is vital for an REIT to make sound investment decisions in order to keep operating in the future even if their taxable income they keep is less than 10% of their gross income. Keeping their shareholders willing to invest is very beneficial to the shareholder, so why not become a shareholder yourself? There are ways to research REITs before investing in them. Forms like the balance sheets, income statements, and the statement of shareholder’s equity can all allow you to see the inside financials of both publicly traded and non-publicly traded REIT company. Analyzing these can empower you to make smart investment decisions for your personal journey to financial freedom.
I hope you enjoyed the first part of my Real Estate Investing Series. If you are curious about how I analyze REITs, be on the lookout for a video where I teach you how to do this! Quick disclosure: anything I have mentioned is not investment advice and is intended for educational and entertainment purposes only. I will always link articles and sources for your benefit and you can explore more on the topics I post about. Leave a comment down below letting me know what you liked, disliked, or have questions on! The second part of the Real Estate Investing Series will be on my website and make sure you check it out. So excited to educate you all about the endless possibilities of real estate investing. Let’s talk soon.