Real-estate may provide investors with a high-yield and low risk investment combination for greater total return potential to a diversified long-term portfolio. For most people, investing in real estate begins and ends with the purchase of a home and any prospects of investing in office buildings, hotels, and shopping centers seems nearly impossible. However, these investments are more attainable than you may think thanks to real estate investment trusts (REITs).
A REITs sole purpose is to invest in groups of professionally managed properties such as office buildings, apartment complexes, medical complexes, industrial buildings, and so on. REIT performance has varied over the years, but the total annual return for the past 10 years has been 10.5%.
REITs trade like close-end mutual funds. There are a fixed number of shares outstanding and they offer those shares via a price per share model similar to close-end mutual funds. However, unlike close-end mutual funds, REITs gauge performance under different metrics. Rather than measuring performance by net asset value, REITs use a tool called funds from operations. Fund from operations is defined as net income plus depreciations and amortization, excluding gains or losses from debt restructurings and sales of properties. A REITs growth benchmark is a byproduct of funds of operations growth.
Appeal of REITs
REITs offer an array of advantages to investors, including:
Diversification – Investors turn to REITs and their good dividend paying potential for diversification against future market downturns because REITs are uncorrelated with equity markets.
Built-in management – Each REIT and its property investments are overseen with their own management team, saving investors tremendous time from researching each property’s management team.
Tax advantages – REITs don’t pay federal corporate income taxes and are required by law to distribute at least 90% of their annual taxable income as dividends, eliminating double taxation of income. Investors can also have a portion of REIT dividend income be treated as a return of capital.
Inflation protection – Since landlords are inclined to raise rents more quickly when inflation picks up, equity REITs – which obtain most of their income from rents – can be an inflation hedge.
Weighing out some risks
Just like all investments, REITs carry with them specific risks that you should consider and discuss with your financial advisor before adding them to your portfolio. Above all is the lack of industry diversification because all REIT investments include only property investments. Some REITs may be even less diversified when they choose to specialize in specific property developments such as medical buildings, or golf courses. Because of their focus, a REIT investment should be used as part of a diversified portfolio to provide greater diversification.
You should also be aware that REITs are subject to changes in the value of their underlying portfolios, and their prices may fluctuate with changes in their real estate holdings. REITs are also interest-rate sensitive – particularly mortgage REITs. If rates and borrowing costs rise, construction projects with marginal funding may be shelved, potentially driving down prices across the REIT industry.
There are some unique factors to consider when selecting a REIT
Yield and debt – High-yields are tempting, but REIT yields above certain levels may mean that there’s not enough being reinvested for acquisitions, which could affect long-term growth. Too much debt or leverage can also influence prospects for growth. Your Isakov Planning Group Financial Advisor can help you define what a high REIT yield and a high debt load could be in a given market scenario.
Management potential – Management should have a substantial personal stake in the REIT, which should be listed in the latest proxy statement. If the REIT is new, refer to the prospectus for the management’s track record (if any) in similar enterprises. For insight into management’s effectiveness at cutting costs and increasing rents and occupancy, refer to same-space revenue growth in the annual report’s financial analysis.
Demographic trends – In the case of apartment REITs, for example, ask about the area’s direction of vacancy rates and rents, the amount of new apartment construction, and the affordability of home ownership. The higher the cost of home ownership, the more attractive an apartment REIT might be.
Perhaps investing in a REIT mutual fund is one way to manage risks or real estate investing, and to spare investors from investing time into researching all the avenues that should be carefully considered when investing in a diversified real estate portfolio on their own. A real estate mutual fund may invest in several different properties across different sectors of the real estate industry in several different geographic regions, giving you diversification and a way to manage your risks.