Real estate is nearly always a good investment, even when the housing market is shaky as it is now. While a lot of investors have shied away from investing in real estate after the housing crash – and the revelation of the games played by many investment brokers to make worthless paper look like AAA stock investments – recent developments are enticing many back into the real estate investment market. Among the most popular new investments are REITs – real estate investment trusts. REITs offer a way for smaller investors to invest in large, professionally managed real estate projects and reap the benefits they offer.
Why REITs Now?
There are a number of reasons that REITs are gaining in popularity now as opposed to five years ago.
- Interest rates are low. That means that the effective yields on stocks and bonds are also low. In fact, they’re at rock bottom, and will continue to be poor earners until interest rates start to rise again.
- Tax laws have just changed, raising the tax rate on dividend income from 15% to 20%, and corporate income tax rates back up to 39.6%.
- REITs are taxed differently than other corporations. They don’t pay taxes at the corporate level, so investors avoid the bind of double taxation. Instead, profits and capital gains flow through to the investor’s individual tax return and are taxed as normal income.
- Bonds and traditional funds are paying out returns in the 3-4% range. REITs have paid out an annualized return of about 12% for the past decade.
What Are REITs?
Real estate investment trusts are like mutual funds that invest in real estate projects. There are a number of different types of REITs. Some invest in pools of mortgages, while others own properties or companies that own properties. In addition to investing directly in REITs, you can also buy mutual funds that buy nothing but REITs if investing directly in real estate investment trusts feels too risky. There are a number of subsectors in the REIT market. They include residential REITs that invest in new home developments, condos and apartment buildings, office REITs that invest in commercial development and management and retail REITs that invest in shopping malls and plazas.
Where residential REITs are concerned, it’s important to consider the strategy of the trust. With the housing market still a bit rocky, trusts that focus on building new housing developments are going through some rocky times. By contrast, those that own and/or manage rental properties often do quite well when the housing market stagnates.
On the commercial end of things, REITs may develop, own or manage office buildings, which are expected to become hot properties as the economy recovers, regional and neighborhood retail malls, hospitals, healthcare facilities and senior housing.
Prospects with REITs
Are REITs a good investment? As real estate investment vehicles, they tend to do well. In 17 of the last 23 years, dividend growth in REITs has outpaced inflation, even in 2008 and 2009. That, however, only refers to the overall performance of this type of investment. The results realized obviously vary depending upon the trust and its specialties. For example, some general trends in demographics and the economy suggest that:
- REITs that invest in large regional malls are likely to do well, while those that develop and own smaller neighborhood retail malls may struggle for profits
- As baby boomers enter peak years for health care consumption, expect REITs that specialize in hospitals, senior living and health care facilities to do well.
- Location is always a major factor in real estate investment, and REITs are no exception. Well-managed real estate investment trusts will be investing in office and industrial space as the economy recovers.
Publicly Traded vs. Non-Listed REITS
Real estate investment trusts may be publicly traded or non-listed, with attendant benefits and risks. Publicly traded REITs provide far more transparency than those that are privately held and non-listed, which makes it far easier to make informed decisions about where to invest your money. Since the profitability of the REIT depends so greatly on the quality and reliability of the trust’s management, transparency is vital to reducing risks in your investing. Non-traded REITs are more opaque, and it can be difficult to sell your shares in a non-traded trust if you want to sell your position. Despite that, however, some non-listed REITs post consistently high profits that make them very attractive to those who are willing to withstand a higher degree of risk.
Benefits of REITs
In a nutshell, the benefits of real estate investments using REITs include:
- High Yields are the major attraction of REITs. The average dividend yield for REITs was better than 4% in September 2012, which was considerably higher than the S&P 500 Index. It was also considerably below the typical 7%-8% historical yields.
- Simple Tax Treatment is another major benefit of real estate investment trusts. For tax purposes, dividends are allocated as ordinary income, capital gains and return of capital. REITs don’t pay taxes at the corporate level, which reduces overall taxes paid by the REIT and the tax treatment simplifies taxes for shareholders.
- Liquidity is higher for REIT shares which are bought and sold on a stock exchange. It’s far simpler and less expensive than buying and selling real estate directly.
- Diversification is an important goal for nearly any investor. Those who add REITs to an investment portfolio increase yields and reduce risks because REITs have little correlation with the S&P 500.
- Income production is a major benefit to REITs, which are required to pay out 90% or more of their profits in the form of dividends each year.
- Inflation protection is another feature that draws some investors to investing in real estate, which generally rises in value along with inflation.
- Professional managers run the actual business, select properties, handle maintenance and leases, so investors get the benefit of expertise.
- Easy to buy REIT shares are popular with investors who can buy shares in real estate without the hassles of evaluating properties, dealing with real estate agents and mortgages or maintaining the properties.
- The low price of admission makes real estate investment trusts popular with investors of all types and sizes. They were devised by Congress in the 1960s to allow “little guys” access to the commercial real estate market and have remained remarkably focused on that. Where the typical real estate deal would require an investment of $25,000 to $500,000, you can buy into an REIT for a few hundred dollars or less.
Drawbacks of REITs
REITs aren’t all sunshine and ponies, of course. There are downsides and risks to investing in real estate investment trusts as well as benefits.
- Little capital appreciation. If you’re looking for capital appreciation, REITs are not your investment vehicle. Because they are required to pay out the bulk of gross profits every years, the shares tend to remain at a stable price.
- Taxable income. While REITs provide a steady stream of income, that income is taxed as ordinary income, which is typically considerably higher than capital gains or investment dividend income. On the other hand, you can mitigate the tax drawbacks to some extent by holding the shares in your IRA or retirement account.
- Liquidity. While buying and selling shares of REITs is considerably easier than buying and selling real estate directly, it can sometimes be difficult to find buyers for shares of some non-listed REITs if you want to divest yourself of them.
- Market-dependent. The value of shares and the amount of dividend you’ll receive is dependent on the real estate market. In a bad real estate market, the value of shares may decline. In a bad commercial market, rental income could decline, which would affect your dividends.
Like any other investment, REITs carry benefits and risks. Researching investments in advance will help investors make informed decisions about whether or not real estate investing in REITs is for you.