Deidre Woollard: You've probably heard the term REIT, but may not know what it is.
Real estate investment trusts, or REITs, can be a fantastic way to add growth and income to
your overall portfolio while adding diversification at the same time. I'm Deidre Woollard,
editor at Millionacres, the real estate investing website created by The Motley Fool. We exist
to make you smarter, happier, and richer through real estate investing. In this video,
we're going to talk about all things REIT. A real estate investment trust, or REIT,
is a unique type of company that allows investors to pool their money to invest in real estate assets.
This is a bit of an oversimplification, but you can think of a REIT like a mutual
fund for real estate. Hundreds or thousands of investors buy shares and contribute money
to a pool, and professional managers decide how to invest it. Some REITs simply buy properties
and rent them to tenants. Others develop properties
from the ground up. Some don't even own properties at all,
choosing to focus on the mortgage and financial side of real estate. The purpose
of REITs is to allow everyday investors to be able to invest in real estate assets that
they otherwise wouldn't be able to. Not all companies that have real estate portfolios
are REITs, so let's look at the some of the things that make a REIT a REIT. One thing
that's important to know about REITs is that that they aren't the same as most other dividend stocks.
A company simply can't buy some real estate and call itself a real estate investment trust.
There are some specific requirements that must be met. REITs must invest at least
three-fourths of their assets in real estate or related assets, and must derive three-fourths
of their income or more from these assets. In other words, more than 75% of a REIT's
income needs to be from sources like rental income, mortgage payments, third-party management
fees, or other real-estate-derived sources. REITs also must be structured as corporations,
and they must have at least 100 shareholders. Because of the 100-shareholder requirement,
many REITs start out as real estate partnerships, and then they become REITs later on. No more
than 50% of a REIT's shares can be owned by five or fewer shareholders. In general,
REITs limit the ownership of any single investor to 10% in order to ensure compliance with
this rule. Most importantly to you as an investor, REITs are required to pay out at
least 90% of their taxable income. This is why REITs typically pay above-average dividend yields.
You're probably wondering, why would a company
want to be classified as a REIT? As you can see, there are some pretty strict requirements
that must be met in order for a company to be classified as a REIT. Why would any real estate
company want to go through the trouble? There's a very big motivating factor that
encourages companies to pursue REIT status, and it has to do with taxes. Specifically,
REITs are not treated as ordinary corporations for tax purposes. If a company qualifies as
a REIT, it will pay no corporate tax whatsoever, no matter how much profit it earns.
That's where the 90% payout requirement comes in. Because REITs are required to pay most of
their income, they're treated as pass-through entities that are only taxable at the individual level.
With most dividend-paying companies, profits are effectively taxed twice.
When a company earns a profit, it has to pay corporate income tax, which is currently at the flat
rate of 21%. Then, when the profits are paid out as dividends to shareholders,
they're subject to dividend taxes at the individual level. So, only being taxed once is a huge
advantage for REITs. There are some unique elements as to how REITs
are taxed for individuals. We'll tackle that in a bit. But first, aside from the tax benefit,
there's several other good reasons why REITs are a good addition to a long-term investor's portfolio.
REITs can a source of reliable, growing income. Who doesn't like that?
Besides, most property-owning REITs lease their properties on a long-term basis. REITs can be nicely
set up for steady income, quarter after quarter. There's definitely far less variance in the
quarter-to-quarter profits of well-run REITs than there is for most other companies,
including those that are generally thought of as stable. If you're looking to add some variety to your
portfolio, REITs can be a smart way to diversify easily. They're technically stocks, but they
represent real estate assets, and real estate is generally considered a separate asset class
that isn't closely coordinated with the stock market. In fact, when the overall market is down,
REITs may remain strong. The two main types of REITs.
Before we go any further, let's take a minute to discuss two different classifications of REITs.
There are REITs that specify in a wide variety of asset types, but all REITs can
be dropped in one of two buckets: mortgage REITs and equity REITs. First, equity REITs
are the type of real estate investment trusts that own properties as their primary business.
For example, a shopping mall REIT or senior housing REIT would be considered an equity rate.
In general, you can assume the term REIT refers to equity REIT unless specified otherwise.
Second, mortgage REITs invest in mortgages, mortgage-backed securities,
and other mortgage-related assets. This means they aren't usually invested in physical assets,
but in the loans surrounding those assets. Mortgage REITs, which are also called MREITs,
are companies which borrow large amounts of money at lower short-term interest rates and
use this money to purchase 15-year or 30-year mortgages that pay higher rates.
Mortgage REITs are considered to be financial stocks, just like banks and insurance companies.
There are a few REITs that own both property and mortgage assets. These are known as hybrid REITs.
However, the overwhelming majority of REITs invest in either one type of
real estate asset or the other. There are many different types of equity REITs.
A little earlier, we talked about diversification with REITs. One of the reasons that REITs
are so interesting is that you can invest in just about any type of commercial property
you can imagine. Here's a rundown of some of the different specializations of REITs
you can invest in, besides mortgage REITs, which we just discussed. If you want to invest
in education properties, entertainment properties, farmland, timberland or prisons, there's likely
a REIT for that. Some of the most popular REIT types include residential REITs,
which can specialize in apartment, multifamily, and single-family properties, and office REITs,
which invest in a wide variety of properties, and self-storage REITs. Industrial REITs,
which own properties such as distribution centers, factories and warehouses, have been
growing as e-commerce giants like Amazon continue to expand. Healthcare REITs own hospitals
as well as medical offices, wellness centers, and senior housing. There are also hospitality
and retail REITs, which invest in malls and hotels.
Now that we know a little bit more about types of REITs, let's discuss how you evaluate a
potential REIT investment. There are two very important metrics for real estate investors
to know. To be perfectly clear, there are certainly more than two metrics that REIT
investors use. However, traditional valuation metrics and methods of calculating earnings
per share don't necessarily translate well to REITs. Two most important metrics to know
are funds from operation and company-specific varieties of the same metric. Funds from operation,
or FFO, express a company's profits in a way that makes more sense for REITs than traditional
metrics like net income or earnings per share. When you invest in real estate, you can write off
or deduct a certain portion of the purchase price each year. This is known as depreciation,
and it's something that rental property investors are probably familiar with. Although this
decreases taxable income, it also distorts a REIT's profit. After all, depreciation doesn't
actually cost the REIT anything. FFO adds back in this depreciation expense,
makes a few other adjustments, and creates a real-estate-friendly
expression of the company's profits.
The price to FFO ratio is a way to assess whether a REIT is expensive or cheap relative to its peers.
REIT risks to be aware of.
No discussion of any investment would be complete without mentioning risks. There are certainly
a few that REIT investors should know about. Just to name a few of the most significant:
• “Interest rate risk.” In a nutshell, rising interest rates are bad for REITs. Specifically,
when long-term interest rates paid by risk-free assets like Treasury securities rise, REIT
share prices tend to experience downward pressure. • “Oversupply risk.” There is a risk factor
in all areas of real estate, but this especially comes into play with property types
expected to grow significantly in the coming years, or with property types that have
a relatively low barrier to entry. For example, self-storage properties are generally quick
and easy to build, so they're vulnerable to oversupply problems in strong economies.
• “Tenant risk.” Any REIT's cash flows are only as reliable as its tenants.
This can be somewhat mitigated if a REIT's tenants are mostly of a high credit quality,
or if there's a diverse tenant base, but it's still a risk to keep in mind.
• “Economic risk.” In recessions, many REITs see their vacancies spike and their
pricing power fall. To be clear, there's a wide variety of cyclicality, economic sensitivity
among REITs. For example, healthcare is a pretty recession-proof business, so healthcare
REITs tend to hold up nicely. On the other hand, hotels are very sensitive to recessions,
so hotel REITs often get crushed during tough times, but tend to do particularly well during
prosperous economic times. In addition to these, there are a wide variety
of companies-specific risk factors. For example, most REITs use at least some level of debt
to finance their growth. Too much debt can be a big problem.
Tax implications of REIT investing. Earlier in this video, we noted that REITs
have a special taxing structure. Although the lack of corporate taxation is certainly
a benefit for REITs and their investors, the caveat is that the tax structure of REITs
can be complicated if you own them in a taxable brokerage account. First off, most REIT dividends
don't meet the IRS definition of qualified dividends, which would entitle them to lower
tax rates. For example, someone in the 22% tax bracket typically pays 15% on qualified dividends,
but REIT dividends generally don't qualify for this favorable treatment. However,
because REITs are pass-through businesses, REIT dividends that aren't considered qualified
dividends typically qualify for the 20% qualified business income, QBI, deduction. In other words,
if you receive $1,000 in ordinary dividends from a REIT, as little as $800 of that may
be taxable. Plus, REIT dividends often have several different components. The majority
of each distribution you receive from a REIT is typically considered to be ordinary income,
but some portion might meet a qualified dividend definition, and some portion of REIT distributions
can also be considered a return of capital, which isn't taxable at all, but reduces your
cost basis in the REIT and can have future tax implications.
Confused yet? Good news is, you don't have to keep track of any of this. When you receive
your year-end tax forms from your brokerage, the dividend classification will be broken
down for you automatically, which makes it a lot easier to deal with at tax time.
If you want to invest in real estate, REITs can be an easy way to get started.
REITs can be great additions to your portfolio as they produce steady income as well as growth,
which can translate into some pretty impressive long-term total returns. Just be sure to have
a good understanding of how these companies work as well as the risks involved before
you get started. If you want to do some more learning on REITs,
please check out the REITs hub on millionacres.com. You can catch the link to that in the video description.
We've got breakdowns of all the major REIT categories and articles on specific
REITs that we are keeping our eye on. If you like this video, let us know by giving us a
thumbs up and subscribing. If you have any questions we didn't answer, drop it in
the comments section below.