I’ve talked about how real estate compares to the stock market. Real estate offers sustainable cash flows and valuable tax benefits for investors. Most importantly, real estate is something that should always be in demand because, face it, you have to live somewhere!
Investors have two choices for investing in real estate. First, there are direct investments in investment real estate that you own and manage yourself. Secondly, there are products on Wall Street known as real estate investment trusts, that invest in diversified portfolios of real estate on behalf of all their investors.
What are REITs?
A real estate investment trust is a type of formation that allows many different people to invest in several real estate projects via the stock market. Real estate investment trusts use capital from investors, leverage it with debt issues, and then purchase and hold investment real estate for capital appreciation and rental income.
One of the biggest advantages of a REIT formation is that they are not taxed at the corporate income level. By law, REITs must pay out 90% of their earnings in the form of distributions (dividends) to investors each year. Those dividends are then taxed at the personal income tax rate of the investor.
This is a huge advantage for REITs. If you invest in dividend-paying stocks, for example, the company has to pay 35% corporate taxes on its income, then any income paid out as a dividend is taxed at your dividend income tax rate. After Uncle Sam gets his cut, there isn’t much left for the investor! REITs skip the 35% corporate income tax alltogether.
Upsides to REITs
REITs offer some advantages to the individual investor:
- Small upfront investment – Whereas you might have to invest as much as $20,000 in a down payment to buy a $100,000 home with a bank loan, you can buy shares in a REIT with less than $100.
- Diversification – REITs often own many different properties, from commercial real estate to residential real estate. They also own properties in many different markets, giving them exposure to different cities and economies. Individual investors simply cannot achieve the same diversification with such a small amount of money buying their own properties.
- Liquidity – You can buy and sell shares of a REIT in a matter of minutes. Buying or selling a home, apartment building, or commercial property can take months.
- Income – REITs pay out substantially all their income in the form of distributions, so investors enjoy higher yields with REITs than they do other kinds of investments.
Should you own REITs?
I think REITs should be a part of any truly diversified portfolio. Of course, the total amount invested in REITs should be fairly low – don’t put half your portfolio in REITs, let alone a single real estate investment trust.
Here are a few REITs which own different types of properties (commercial or residential real estate). This isn’t a recommendation to invest in any of these REITs, but rather an introduction and example of the kind of REITs that are available on the market for your to invest in:
- UMH Properties (UMH) – This REIT invests in land which it then rents to manufactured homeowners. Basically, it acquires raw land and then leases that land to people who need a place to slap down a prefabricated home or mobile home. Investors who own this REIT enjoy a very high dividend yield (currently 7%) and exposure only to residential real estate – real estate that people lease to live on, not to do business on.
- Campus Crest Communities (CCG) – This is another kind of residential REIT, but with very different exposure. This REIT owns student housing, which investors generally believe to be a safer investment because students have access to all kinds of financing – eek, student loans! – to pay for their monthly rental payments. Plus, on- or near-campus dwellings usually rent at a premium price because students are willing to pay more to be close to their campus. Investors earn a 4.8% yield with this REIT.
- Realty Income Corporation (O) – This REIT is one of the biggest on the market. Realty Income Corporation is invested mostly in commercial real estate which it then leases on long-term arrangements of 10 to 20 years. Naturally, this has a different risk profile than a residential REIT because its tenants are businesses, not individuals wanting a roof over their head. Owning this REIT will get you a share of an incredible 2,634 different properties, which provides excellent diversification to reduce the risk that a tenant stops paying. The yield of 4.8% is very good in this low interest rate climate.
- General Growth Properties Inc (GGP) – Are you a fan of shopping malls? This REIT is. General Growth invests in and operates more than 130 shopping malls in the United States. Thus, its earnings are as good as mall traffic. I included this one for a very specific reason: this REIT has had some financial trouble and previously slashed its dividend. Sometimes real estate investments don’t go as planned, and investors who owned this REIT got crushed when its shopping malls didn’t prove to be as profitable as investors hoped.
If you’re interested in investing in REITs, start shopping around for a REIT with an investment profile that fits your desired real estate investment. If you’d own near-campus housing as an investment, then you might be more comfortable with a REIT like Campus Crest Communities. If you like commercial real estate, then a REIT like Realty Income Corporation, which only invests in commercial real estate, would be perfect for you.
As always stay diversified and think for the long term. Real estate is an investment that works best when it is bought and held. The same is also true for REITs – these aren’t investments for day traders, but for people who are serious about very long-term, slow-growth wealth creation. Over the long haul, REITs offer excellent income from distributions and capital returns as rents and property values rise over time.