Real estate is one of the oldest forms of investing known to man. It’s still one of the most common paths to wealth and one of the most reliable ways to put our money to work. You already know that I don’t consider the home we live in the greatest of financial investments (still a worthwhile purchase for other reasons, though!), but there are a myriad of other ways to invest in real estate. Here are just a few that come to mind:
- Buying and holding land to sell after values appreciate. (Like cheap land outside a growing city.)
- Leasing commercial buildings out to businesses.
- Buying cheap/foreclosed homes, fixing them up and flipping for a profit.
- Residential rental properties, like houses, apartments, duplexes, AirBnB, etc.
- Building skyscrapers. (Just ask The Donald)
Real Downsides to Real Estate
According to Bloomberg, nearly 80% of US millionaires own real estate and say that it is a top non-stocks investment. But as great as real estate investing can be, there are some real downsides. Here are just a few:
- Liquidity – In most cases, it’s difficult to get our cash out of real estate investments. You can’t exactly withdraw cash to pay the bills from a piece of land.
- Cash Flow – Things like long-term rentals can generate steady, regular cash flow but many other types of real estate investments offer no regular income. Buying and holding land, for example, throws off no cash and all of the earnings come through appreciation.
- Capital Requirements – Most of these types of real estate investments require a lot of money to get started–either through cash we have on hand or through borrowed money (i.e. loans and mortgages). It’s difficult to start building or investing in apartment complexes with just $1000.
- Diversification – Real estate as an asset can be difficult for diversification purposes. Even $1 million in real estate investments probably isn’t going to get you more than a handful of properties. Having all our investments tied up in even two or three properties is a lot of eggs in one basket.
I think this is the point where most people declare, “That’s why only the rich get richer!” Indeed, it certainly looks like us little guys with our measly crumbs have no hope of getting into the real estate investing game.
Or is there actually a way?
Real Estate Investment Trusts or REITs (pronounced “REETs”) are a type of investment asset that can help provide a means for smaller investors to get into real estate. REITs are companies that own, operate, manage, finance, and/or otherwise are involved in real estate. They can be purchased just like a stock and many are traded publicly on the stock exchanges. As a result, you can purchase shares in these companies in small quantities just like any publicly traded company. One of the interesting things about REITs is that they get special corporate tax treatment if they pay out 90% or more of their earnings (whether through the sale of appreciated properties or rental income) to investors as dividends each year. Due to this fact, many of them have higher-than-usual dividend yields. (Some VERY high.)
So REITs mitigate nearly all of the downsides of owning actual, physical real estate and include a few additional benefits. Let’s run through them quickly:
- Liquidity – REITs are very liquid. As liquid as any stock. You can sell at any time during trading hours.
- Cash Flow – Quarterly, above-average dividends provide regular income. Because of the requirements to pay out 90% of income, REITs can have very high dividend yields. (Yields even far in excess of 8% is not unheard of.)
- Capital Requirements – Requires very little capital to get in. As long as you have enough to buy one share, you’re good to go.
- Diversification – REITs innately are diversified vehicles because one REIT will own many more properties than one person is likely to be able to own by themselves. It’s also much easier to diversify across multiple REITs because of the lower capital requirements. You can also own REITs through mutual funds, which even further increases your options for diversification.
- Retirement Account Eligible – While it’s technically possible to own physical real estate in tax-advantaged retirement accounts, REITs are super easy to own in a tax-advantaged manner. Just buy them in your IRA/Roth IRA/HSA and you’ll collect your quarterly dividends without threat from the tax man.
- Costs – REITs are subjected to the regular trading costs as any other stock, however, when compared with the expense of buying, selling, maintaining, and operating actual real estate, it’s probably still a lot cheaper. REITs also don’t carry ongoing expense ratios like mutual funds either.
- Automated Compounding – When automatic dividend reinvestment is turned on, REITs can automatically compound earnings by using each dividend payment toward purchasing more shares. So in theory, each dividend check should be bigger than the last. In traditional real estate investing, like collecting rent, that income doesn’t get compounded unless we manually reinvest it. And even then it’s not compounding within the same property. In other words, collecting rent is like getting paid in simple interest while REITs give the option for compounding interest.
However, along with the benefits they also introduce some new downsides that need to be taken into account:
- Risk – REITs are stocks so they come with all the risks associated with stocks. Market risk, management issues at the company, and economic pressures can all impact the investment that otherwise may not be as significant issues if you were directly owning the real estate yourself.
- Stock Correlation – Related to the previous point, real estate is usually touted as a “non-correlated” asset to stocks in investor portfolios. This means that real estate prices don’t tend to follow the trend of what’s happening to stocks in the market, aiding in the purpose of diversification—steadying the up and downs of your portfolio. However, with REITs being essentially stocks of real estate companies traded on the major exchanges, there would likely be a much closer correlation between the two assets (although some still think that there’s not much correlation).
- Taxes – In owning a REIT, the investor doesn’t actually own the real estate and so none of the tax benefits related to owning property outright applies. Moreover, dividends and capital gains paid out get taxed like regular investment income when held in taxable accounts. So as far as possible, REITs are best held in tax-advantaged accounts (like IRAs and HSAs).
- Growth – REITs as stocks typically have low growth potential, so an investor would own it pretty much only for the dividend income.
Types of REITs
Broadly, REITs can be classified into two types: Equity REITs and Mortgage REITs.
Equity REITs generally specialize in certain niches of the real estate market. For example, some focus on healthcare facilities, while others own office complexes, whereas others operate shopping malls and the like. Equity REITs are usually what’s referred to when the term REIT is used. Here are some equity REITs that you may have seen or heard of before:
(Note: I don’t own any of these stocks, and this is not an endorsement that you should buy these stocks. Just examples to illustrate what REITs are.)
- Tanger Factory Outlet Centers, Inc. (SKT) – Shopping centers, outlet malls.
- Public Storage, Inc (PSA) – Self-storage units.
- Healthcare Realty Trust Inc (HR) – Healthcare facilities, medical offices.
- Host Hotels & Resorts (HST) – Owner and operator of luxury hotels and resorts, owner of many brands that you probably recognize. A company that was split off from Marriott.
- Weyerhaeuser (WY) – Largest publicly-traded owner of timberland.
Mortgage REITs (mREITs for short) on the other hand make money, as their name suggests, through mortgage-based investments (like mortgage-backed securities) rather than physical properties. They typically have higher dividend yields than equity REITs but they also are much more susceptible to interest rate pressure and are riskier in general. (In full disclosure, I was lured by the high interest rate and bought a few shares in an mREIT a few years ago. Soon after I bought, its share price completely cratered and its dividends were cut many times, which goes to show the riskiness of this asset. However, I’ve held on to it and kept reinvesting the dividends and my investment is now finally back to break-even.)
For more information on the precise definition of REITs, check out this Investopedia article.
And here’s a link to a full directory of publicly available REITs in the US that you can sift through.
How Are the Returns?
All of this sounds nice and all, but does it actually offer a reasonable rate of return? Naturally, not all REITs are created equal, so not all of them will perform the same, and that means it would behoove you to do your due diligence if you do decide to invest in any single REIT.
So while it’s doesn’t do any good for me to look at a single REIT’s return, I CAN compare REITs as a class against the S&P 500 to get an idea of how it stacks up against the stock market as a whole. As my proxy for the US-based REITs, I’m going to use the Vanguard REIT Index Fund (VGSIX). This table breaks down the annual total returns (which INCLUDES dividend reinvestments) between VGSIX and the S&P 500 over varying time periods (VGSIX was started in May of 1996 so no data is available before then):
Vanguard REIT Index Fund
|5 Years (Jan 2011-Dec 2015)|
|10 Years (Jan 2006-Dec 2015)|
|15 Years (Jan 2001-Dec 2015)|
|20 Years (May 1996-Dec 2015)|
*These are the compounded annual growth rates (CAGR) as calculated from this site.
As you can see, over the long-term, REITs as an asset class has more than kept up with the S&P 500. That’s not to say that this performance will hold true for every timespan and it certainly says nothing about how it will do in the future. But it DOES indicate that REITs have the potential of meeting the 8% returns threshold and beating inflation.
So How Do I Buy?
Since REITs are basically a type of stock, you can purchase them through just about any brokerage. You might even already be able to buy them through your IRA. You can purchase shares of each REIT individually like any other stock, or you can buy them through an index fund like the Vanguard REIT Index Fund mentioned earlier. Buying through an index fund allows you broad diversification across many REITs in one fell swoop.
Of course, if you own a broad total market index fund that owns every company in the US, you will already have exposure to all the REITs too.
But SHOULD I Buy?
Now perhaps the bigger question isn’t “How?” but “Should I buy REITs?”
That’s not a question that I can answer for you, but REITs certainly look like an attractive asset type that is relatively easy to understand, has potential for reliable long-term returns that beat inflation, offers diversification from other asset types, and allows for low-capital investors to dip their toes into real estate. If these fit your investing profile, it might be worth looking into.
Also, REITs could be helpful for those who are concerned about investing in mutual funds or index funds that may contain companies they have ethical concerns against. I know there are conscientious investors out there who are sensitive to these things, and REITs may offer one solution to this dilemma.
Real Estate. Real Opportunities.
REITs are certainly a fascinating and efficient way of investing in real estate, but I believe change is afoot that will soon open up even more ways of investing in real estate that we haven’t dreamed of before. Many of the methods of buying and selling real estate are rather antiquated in our technological age, and I believe this area is ripe for disruption. (If any of you have gone through the process of buying a home, you know what I mean!)
I’m already seeing various innovative ideas (like real estate crowdfunding, for instance) gaining steam that promises to leverage technology to make it easier for people to put their money to work in real estate investments. It will be very interesting to see how it all develops and who knows, maybe coming up with that radical innovation might be the best real estate investment of all?
Have any of you invested in REITs before? How was your experience? Please share with us in the comments!