Explaining the Different Kinds of REITs
You probably have learned by now that I’m all about diversification as you get closer to retirement but gung-ho on stocks at a young age. REITs or Real Estate Investment Trusts give you a sort of hybrid security that should be appealing to both the middle aged and young investor.
They provide substantial fixed income returns with lower overall risk when compared to equities. REITs typically pay out large dividends to investors annually making them a great high-reward counterweight to stocks.
So what is a REIT?
REITs own and/or manage real estate. Duh, right? Let’s look to Investopedia for a semi-official definition:
“A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.”
So that being said, REITs come in many different forms. Some use mortgages, some use equity, some invest in medical homes, some invest in strip malls, etc. You get the idea, I think. REITs are very wide reaching and cover just about every single form of real estate that creates income.
History of REITs
REITs actually became part of US law in 1960 when Eisenhower signed the REIT Act into law. The goal of the law was to give investors the ability to invest in diversified real estate portfolios the same way they did stocks and bonds.
REITs have spread worldwide since then and over 20 countries have some form of REIT law to date. As of 2013, over $650 billion was invested via some form of REIT compared to just over $1.4 billion in 1971.
People don’t often think of high yielding investments to be high performing. Between 1990 and 2010, the FTSE NAREIT Equity REIT Index (wordy, eh?) yielded, on average, 9.9%! That beat the general stock market over that span. Only mid-cap stocks averaged more per year, averaging 10.3% over the period. Traditional fixed income assets averaged 7% per year as a benchmark.
Even since 2009 when the markets hit their bottom, REITs have still outperformed the broader stock market as seen in the chart below.
These REITs may be one of the most intriguing forms out there as Obamacare, skyrocketing healthcare costs, and the aging US population should only help them. These REITs invest in hospitals, medical buildings, nursing facilities and retirement homes. Obviously as the name implies, the success of these REITs are directly tied to the healthcare system which pay the real estate owners via Medicare, Medicaid and out of pocket payment/occupancy fees.
Typically you want your REIT to be diversified across the country with very little exposure to one market. For instance, you probably don’t want 50% exposure to California or another state that teetered on the brink during the financial crisis.
As the US population continues to age, namely baby boomers, the demand for Healthcare facilities will increase. It is unknown if the construction of new facilities will keep up with demand at this time. Typically you want to find Healthcare REITs that have exposure not only to different regions but also to different forms of healthcare real estate.
Retail REITS make up approximately a quarter of all REIT investments. These REITs are typically invested in strip malls, freestanding retail and shopping malls. These can be tricky as malls have seen decreases in traffic with the rise of internet shopping and sites like Amazon. To understand these investments, one must have a firm understanding of the retail industry and where it’s going.
These REITs make money from rent predominately. If retailers suffer through another recession as they did a few years ago then rent collection could be an issue. If a retailer closes, then the property manager must find a new tenant which will take time and result in months of lost rent. Anchor tenants provide stability in this area. If large grocery stores and retailers are in a mall or strip mall then they’ll attract traffic and in turn, attract tenants.
These REITs invest using debt rather than equity which can decrease risk in a stable environment (and also returns). Keep in mind that if interest rates increase then the value of mortgage REITs would decrease on a book basis and the share prices would decrease. Also to compound issues, if interest rates rise then debt becomes more pricey and it becomes more expensive for these REITs to raise capital reducing the potential spread (difference between interest income and interest expense rates) the REIT can earn.
These REITs are fairly self-explanatory. They own everything from mobile homes, duplexes to apartment buildings. Residential REITs tend to be focused in large cities where home ownership is very expensive compared to renting. Cities such as San Francisco, New York, and Washington, DC face expensive home markets and thus provide strong rental markets which allow REITs to charge higher than normal rent.
When investing in Residential REITS, be sure to examine which cities the REIT is heavily exposed to. Make sure these cities are growing and, more importantly, make sure jobs are growing in the cities. The two metrics typically will go hand in hand but not always! As long as land is scarce, then it’s harder to build new units to provide for the increased population. San Francisco over the last two years is a perfect example. Rent prices are skyrocketing!
How to Assess Other REITs
Let’s discuss factors that apply to all REITs now. The main attraction to REITs is the high dividend yield. Look for REITs that consistently grow their yield similar to the Dividend Aristocrats when it comes to stocks.
Funds From Operations is a key metric when looking at REITs. Depreciation can quickly add up and the thus book value of a REIT can quickly decline if they’re not purchasing new units. FFO is defined as net income minus any sales of property and depreciation. Then take dividend per share divided by the FFO per share which provides a yield.
Remember that you don’t have to pick and choose your REIT. There are mutual funds and ETFs that invest solely in REITs which take out the guess work on your part. Why research if you don’t have to? I, for one, would be happy to earn the market return!
The Bottom Line
REITs provide high yield investments with the liquidity of stocks. They’ve historically over performed in the last 20 years or so compared to the broader market. As an investor ages they may sprinkle in more and more fixed income products and REITs provide a great alternative to avoid sacrificing return. Their risk profile is typically somewhere between stocks and bonds. All in all, REITs are a great tool for diversification as an investor should have real estate (not counting their home) as part of their portfolio!
As always, look forward to hearing your thoughts. Did I miss something? See any errors? Discussion in general is always welcome!