EDUCATION
Real Estate Investment Trusts (REITs) or Real Estate Investment and Management Companies (SIGI) are companies that own, operate or finance income-generating properties. Some of these companies invest directly in property, earning income from rents and management fees. Others invest in property debt, i.e. mortgages and mortgage-backed securities.
REITs tend to focus on a specific property sector, for example shopping centres, retail, hotels and resorts, or healthcare and hospitals. However, diversified and specialised REITs can contain different types of properties in their portfolios, such as a REIT that consists of both office and retail properties.
Like an investment fund, a REIT raises money from several investors to buy property. Thus, REITs are listed on the stock exchange, and investors can buy and sell them like shares, being considered very liquid instruments. In addition, it is possible to invest in them through REIT mutual funds and REIT ETFs.
These make it possible for individual investors to earn dividends from property investments, without having to buy, manage or finance any properties themselves.
Business model
Most REITs have a simple business model: The REIT leases the space and collects rents from the properties, then distributes that income as dividends to shareholders.
Mortgage REITs, on the other hand, don’t own properties, but finance them, i.e. lend money to property owners. These REITs earn income through the spread between the interest they earn on the loans granted and the cost of financing those loans.
This second type of REIT is considered riskier, as there is a risk that the borrower will default on the loan.
In order to qualify as a REIT, companies must fulfil the following requirements:
Invest at least 75% of their assets in real estate, cash or Treasury Bonds.
Obtain at least 75% of their income from rents, interest on loans or the sale of property.
Pay out 90% of its profits in dividends to shareholders.
Have more than 100 shareholders in its constitution after the first year of operations.
Not have more than 50 per cent of its shares held by five individuals or less.
Advantages of investing in REITs
One of the biggest benefits REITs have to offer is their high dividends, as they are obliged to pay out 90 per cent of taxable income to shareholders. These dividend-based yields are often higher than those that can be obtained from other investments.
Their comparatively low correlation with other assets also makes REITs an excellent means of portfolio diversification, which can help reduce your overall risk and increase returns.
As such, REITs are very appealing for an investment portfolio because they offer strong and stable annual dividends over the long term, and can be an excellent counterweight to equities within the portfolio.
In addition, REITs are easy to buy and sell, since most are listed on the stock exchange, and are highly liquid – a feature that mitigates some of the traditional drawbacks of real estate.
A three-year average for REITs between November 2017 and November 2020 found that the average annual return was 11.25 per cent, well above both the S&P 500 and the Russell 2000, which reached 9.07 per cent and 6.45 per cent respectively. Historically, investors looking for fixed income have done better by investing in REITs than in bonds, the traditional asset class for this purpose. A carefully constructed portfolio should consider both, since REITs also carry risks, as we’ll see below.
Disadvantages of investing in REITs
Like all investments, REITs have their disadvantages.
Firstly, they don’t offer much in terms of long-term capital appreciation, since they have to pay out at least 90 per cent of the income to investors. Thus, only 10% of the income can be reinvested back into the REIT, which is not favourable for the company’s growth.
In addition, REITs are subject to the risks of the sector to which they are exposed, which means that they can suffer greatly depending on the macroeconomic situation in the world. As we saw in 2020, when a large number of hotel chains had to close, REITs exposed to this sector fell in value a lot.
Another disadvantage is that taxes are levied on dividends, and tax rates are typically higher than the 15 per cent at which most dividends are currently taxed. This is because a large part of a REIT’s dividends are considered ordinary income, which is usually taxed at a higher rate.
Risks of investing in REITs
Being traded on the stock exchange, REITs have added risks that would be typical of riskier investments. Although the long-term returns on REITs are impressive, there have been periods when they have significantly underperformed.
REITs can produce negative total returns during periods when interest rates are high or rising. When rates are low, investors usually move out of safer assets to seek income in other areas of the market. Conversely, when rates are high or times are uncertain, investors often opt for government bonds or other fixed-income investments.
In 2007, for example, the iShares Dow Jones US Real Estate ETF (IYR) saw a return of -20.35%, followed by an abysmal return of -40.03% during the bursting of the property bubble in late 2007 and early 2008.
Although they are sometimes misclassified as “bond substitutes”, REITs are not bonds, they are like shares. And like all shares, they have a significantly higher measure of risk than government bonds.
How to invest in REITs?
Since they are listed on the stock exchange, you can invest in REITs through a broker, such as DEGIRO, Robinhood etc for example. Of course, to choose where to invest you should look at the numbers, such as the expected growth in earnings per share and current dividends. A particularly useful metric is FFO – Funds from Operations, which describes the cash flow of a property company or property investment fund
REITs are available to investors in various forms, including ETFs. Here are some popular exchange-traded ETFs that focus on REITs:
Vanguard Real Estate (VNQ)
Schwab US REIT (SCHH)
iShares Mortgage Real Estate (REM)
iShares Residential Real Estate (REZ)
iShares European Property Yield UCITS ETF (IPRP)
Amundi ETF FTSE EPRA NAREIT Global UCITS ETF DR (EPRU)
Investors can also buy individual REITs directly. Some of the most popular are:
American Tower (AMT)
Equity LifeStyle Properties (ELS)
Americold (COLD)
Innovative Industrial Properties (IIPR)
Digital Realty (DLR)
CubeSmart (CUBE)
STORE Capital (STOR)
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