Deidre Woollard: You’ve probably heard the
term REIT, but may not know what it is. Real estate investment trusts, or REITs, can be
a fantastic way to add growth and income to your overall portfolio while adding diversification
at the same time. I’m Deidre Woollard, editor at Millionacres, the real estate investing
website created by The Motley Fool. We exist to make you smarter, happier, and richer
through real estate investing. In this video, we’re going to talk about all things REIT.
A real estate investment trust, or REIT, is a unique type of company that allows investors
to pool their money to invest in real estate assets. This is a bit of an oversimplification,
but you can think of a REIT like a mutual fund for real estate. Hundreds or thousands
of investors buy shares and contribute money to a pool, and professional managers decide
how to invest it. Some REITs simply buy properties and rent them to tenants.
Others develop properties from the ground up.
Some don’t even own properties at all, choosing to focus on the mortgage
and financial side of real estate. The purpose of REITs is to allow everyday investors to
be able to invest in real estate assets that they otherwise wouldn’t be able to.
Not all companies that have real estate portfolios are REITs, so let’s look at the some of the
things that make a REIT a REIT. One thing that’s important to know about REITs is that
that they aren’t the same as most other dividend stocks. A company simply can’t buy some real estate and
call itself a real estate investment trust. There are some specific requirements
that must be met. REITs must invest at least three-fourths of their assets in real estate
or related assets, and must derive three-fourths of their income or more from these assets.
In other words, more than 75% of a REIT’s income needs to be from sources like rental income,
mortgage payments, third-party management fees, or other real-estate-derived sources.
REITs also must be structured as corporations, and they must have at least 100 shareholders.
Because of the 100-shareholder requirement, many REITs start out as real estate partnerships,
and then they become REITs later on. No more than 50% of a REIT’s shares can be owned by
five or fewer shareholders. In general, REITs limit the ownership of any single investor
to 10% in order to ensure compliance with this rule. Most importantly to you as
an investor, REITs are required to pay out at least 90% of their taxable income. This is why
REITs typically pay above-average dividend yields. You’re probably wondering,
why would a company want to be classified as a REIT? As you can
see, there are some pretty strict requirements that must be met in order for a company to
be classified as a REIT. Why would any real estate company want to go through the trouble?
There’s a very big motivating factor that encourages companies to pursue REIT status,
and it has to do with taxes. Specifically, REITs are not treated as ordinary corporations
for tax purposes. If a company qualifies as a REIT, it will pay no corporate tax whatsoever,
no matter how much profit it earns. That’s where the 90% payout requirement comes in.
Because REITs are required to pay most of their income, they’re treated as pass-through
entities that are only taxable at the individual level. With most dividend-paying companies,
profits are effectively taxed twice. When a company earns a profit, it has to pay
corporate income tax, which is currently at the flat rate of 21%. Then, when the profits are
paid out as dividends to shareholders, they’re subject to dividend taxes at the
individual level. So, only being taxed once is a huge advantage for REITs.
There are some unique elements as to how REITs are taxed for individuals. We’ll tackle that
in a bit. But first, aside from the tax benefit, there’s several other good reasons why REITs are
a good addition to a long-term investor’s portfolio. REITs can a source of reliable,
growing income. Who doesn’t like that? Besides, most property-owning REITs lease their
properties on a long-term basis. REITs can be nicely set up for steady income, quarter after quarter.
There’s definitely far less variance in the quarter-to-quarter profits of well-run REITs
than there is for most other companies, including those that are generally thought of as stable.
If you’re looking to add some variety to your portfolio, REITs can be a smart way to diversify
easily. They’re technically stocks, but they represent real estate assets, and real estate
is generally considered a separate asset class that isn’t closely coordinated with the stock market.
In fact, when the overall market is down, REITs may remain strong.
The two main types of REITs. Before we go any further, let’s take a minute
to discuss two different classifications of REITs. There are REITs that specify in a wide
variety of asset types, but all REITs can be dropped in one of two buckets: mortgage
REITs and equity REITs. First, equity REITs are the type of real estate investment trusts
that own properties as their primary business. For example, a shopping mall REIT or senior
housing REIT would be considered an equity rate. In general, you can assume the term
REIT refers to equity REIT unless specified otherwise. Second, mortgage REITs invest in
mortgages, mortgage-backed securities, and other mortgage-related assets. This means
they aren’t usually invested in physical assets, but in the loans surrounding those assets.
Mortgage REITs, which are also called MREITs, are companies which borrow large amounts of
money at lower short-term interest rates and use this money to purchase 15-year or
30-year mortgages that pay higher rates. Mortgage REITs are considered to be financial stocks,
just like banks and insurance companies. There are a few REITs that own both property and
mortgage assets. These are known as hybrid REITs. However, the overwhelming majority
of REITs invest in either one type of real estate asset or the other.
There are many different types of equity REITs. A little earlier, we talked about diversification
with REITs. One of the reasons that REITs are so interesting is that you can invest
in just about any type of commercial property you can imagine. Here’s a rundown of some
of the different specializations of REITs you can invest in, besides mortgage REITs,
which we just discussed. If you want to invest in education properties, entertainment properties,
farmland, timberland or prisons, there’s likely a REIT for that. Some of the most popular
REIT types include residential REITs, which can specialize in apartment, multifamily,
and single-family properties, and office REITs, which invest in a wide variety of properties,
and self-storage REITs. Industrial REITs, which own properties such as distribution
centers, factories and warehouses, have been growing as e-commerce giants like Amazon
continue to expand. Healthcare REITs own hospitals as well as medical offices, wellness centers,
and senior housing. There are also hospitality and retail REITs,
which invest in malls and hotels. Now that we know a little bit more about types
of REITs, let’s discuss how you evaluate a potential REIT investment. There are two very
important metrics for real estate investors to know. To be perfectly clear, there are
certainly more than two metrics that REIT investors use. However, traditional valuation
metrics and methods of calculating earnings per share don’t necessarily translate well
to REITs. Two most important metrics to know are funds from operation and company-specific
varieties of the same metric. Funds from operation, or FFO, express a company’s profits in a way
that makes more sense for REITs than traditional metrics like net income or earnings per share.
When you invest in real estate, you can write off or deduct a certain portion of the purchase
price each year. This is known as depreciation, and it’s something that rental property investors
are probably familiar with. Although this decreases taxable income, it also distorts
a REIT’s profit. After all, depreciation doesn’t actually cost the REIT anything.
FFO adds back in this depreciation expense, makes a few other adjustments,
and creates a real-estate-friendly expression of the company’s profits. The price to FFO ratio is a way to assess whether
a REIT is expensive or cheap relative to its peers. REIT risks to be aware of. No discussion of any investment would be complete
without mentioning risks. There are certainly a few that REIT investors should know about.
Just to name a few of the most significant: • “Interest rate risk.” In a nutshell,
rising interest rates are bad for REITs. Specifically, when long-term interest rates paid by risk-free
assets like Treasury securities rise, REIT share prices tend to experience downward pressure.
• “Oversupply risk.” There is a risk factor in all areas of real estate, but this
especially comes into play with property types expected to grow significantly in the
coming years, or with property types that have a relatively low barrier to entry. For example,
self-storage properties are generally quick and easy to build, so they’re vulnerable to
oversupply problems in strong economies. • “Tenant risk.” Any REIT’s cash flows
are only as reliable as its tenants. This can be somewhat mitigated if a REIT’s
tenants are mostly of a high credit quality, or if there’s a diverse tenant base,
but it’s still a risk to keep in mind. • “Economic risk.” In recessions,
many REITs see their vacancies spike and their pricing power fall. To be clear, there’s
a wide variety of cyclicality, economic sensitivity among REITs. For example, healthcare is a
pretty recession-proof business, so healthcare REITs tend to hold up nicely. On the other
hand, hotels are very sensitive to recessions, so hotel REITs often get crushed during tough
times, but tend to do particularly well during prosperous economic times.
In addition to these, there are a wide variety of companies-specific risk factors. For example,
most REITs use at least some level of debt to finance their growth.
Too much debt can be a big problem. Tax implications of REIT investing.
Earlier in this video, we noted that REITs have a special taxing structure.
Although the lack of corporate taxation is certainly a benefit for REITs and their investors,
the caveat is that the tax structure of REITs can be complicated if you own them in a taxable
brokerage account. First off, most REIT dividends don’t meet the IRS definition of qualified
dividends, which would entitle them to lower tax rates. For example, someone in the 22% tax
bracket typically pays 15% on qualified dividends, but REIT dividends generally don’t
qualify for this favorable treatment. However, because REITs are pass-through businesses,
REIT dividends that aren’t considered qualified dividends typically qualify for the 20% qualified
business income, QBI, deduction. In other words, if you receive $1,000 in ordinary dividends
from a REIT, as little as $800 of that may be taxable. Plus, REIT dividends often have
several different components. The majority of each distribution you receive from a REIT
is typically considered to be ordinary income, but some portion might meet a qualified dividend
definition, and some portion of REIT distributions can also be considered a return of capital,
which isn’t taxable at all, but reduces your cost basis in the REIT and
can have future tax implications. Confused yet? Good news is, you don’t have
to keep track of any of this. When you receive your year-end tax forms from your brokerage,
the dividend classification will be broken down for you automatically,
which makes it a lot easier to deal with at tax time. If you want to invest in real estate,
REITs can be an easy way to get started. REITs can be great additions to your portfolio as
they produce steady income as well as growth, which can translate into some pretty impressive
long-term total returns. Just be sure to have a good understanding of how these companies
work as well as the risks involved before you get started. If you want
to do some more learning on REITs, please check out the REITs hub on millionacres.com.
You can catch the link to that in the video description. We’ve got breakdowns of all the major
REIT categories and articles on specific REITs that we are keeping our eye on.
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any questions we didn’t answer, drop it in the comments section below.