Investing in REITs for Income and Growth
An Income-Oriented Equity
Real estate investment trusts, or REITs, are securities that sell on the major exchanges like shares of common stock. They can rise and fall in value like stocks, but typically they pay a higher dividend. In addition to being influenced by trends in the economy, the stock market and interest rates, REITs reflect changes in the real estate market.
REITs and Income
A REIT is a real estate company that offers common shares to the public. Most are in the business of managing income-producing properties – anything from apartment complexes to shopping malls to hospital complexes. A primary difference between REITs and common stocks is that the REIT must distribute most of its income to share owners in order to qualify as a REIT with the IRS. By having REIT status, the company avoids corporate income tax, although the income paid to shareholders is fully taxable. Investors who want to shelter their income from income taxes use REITs that offer “dividend reinvestment plans” (DRIPs) to fund tax-deferred accounts like Individual Retirement Accounts (IRAs). Income in these accounts is not taxable until investors retire and start to draw on it.
REITs and Appreciation
There are three basic types of REITs. Equity REITs invest in physical property and derive most of their income from rents. Mortgage REITs, which account for less than 10% of the market, own a portfolio of mortgages that provide income. A few hybrid REITs own both real estate operations and mortgages. The appreciation potential of stocks and equity REITs is a major part of their attraction for long-term investors interested in a combination of reinvested income and capital appreciation. Since REITs generally have a much higher yield than Treasury securities, with less price fluctuation than common stocks, REIT investors get some of the advantages of both worlds. Moreover, most income-oriented securities tend to be less volatile in price than those that pay little or no income, so REITs are considered more conservative than most growth-oriented investments.
REITs and diversification
In the past, REITs were expected to move independently of the stock market, offering investors extra diversification. However, as recently as 2008, the stock, bond and REIT markets – and real estate values – all fell over one another on the way down, and in 2009 all three began to struggle upward more or less simultaneously. Investing in different investment media usually provides diversification, but not 100% of the time.
REITs and relative safety
A rule of thumb for REIT investors is to buy the company, not the yield. If properties held in a REIT are poorly chosen, not well diversified or fall into foreclosure for any reason, both the value of the REIT and the amount of income it pays may decline precipitously. For this reason, conservative REIT investors focus on the property and the manager, and try to avoid being distracted by a high yield.
One way to hedge your bets is to invest in a REIT mutual fund that offers a portfolio of different REITs, although mutual funds face expenses like trading, administrative and management fees. There are also many REIT exchange traded funds (ETFs) that combine diversification with potentially lower operating costs than a mutual fund. Or you can build your own REIT portfolio. You can learn more from the National Association of Real Estate Investment Trusts (or NAREIT), an organization created by Congress in 1960 to make REIT investments more accessible to individual investors. NAREIT publishes an Investors Guide that can be downloaded in PDF format free of charge.