Investing in REITs: All You Need to Know
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The real estate market offers great investment opportunities and impressive growth. However, real estate investing can be an exclusive club. Buying rental properties requires a large amount of money. This is even more true for commercial properties such as malls, office buildings, and hotels. The high barrier to entry prevents many investors from enjoying the great growth of the real estate market, but you can still consider investing in REITs.
With the rise of Real Estate Investment Trusts (REITs), everyone can now invest in the real estate market and start building wealth by earning passive income. This article will teach you how to invest in REITs to boost your real estate investment in 2020.
Real Estate Investment Trusts (REITs) are corporations that pool investor funds to invest in residential and commercial properties. In terms of structure, REITs are similar to Exchange-Traded Funds (ETFs). Instead of holding stocks or bonds, REITs invest in real estate. When you own shares of REITs, you’re entitled to your portion of the rental income the trusts receive.
Professional managers oversee these real estate portfolios. They purchase properties and lease them out to generate rental income. REITs’ large size and economy of scales allow them to negotiate better deals for their shareholders. By law, REITs must distribute at least 90% of the income back to investors every quarter. This makes investing in REITs a great tool to earn regular passive income.
Most REITs trade on public exchanges. You can buy and sell shares of REITs just like regular stocks. There is also no minimum investment requirement for REITs. As long as you can afford one share, you too can invest in the real estate market.
There are two types of REITs: equity REITs and mortgage REITs. Equity REITs (eREITs) invest in properties and lease them out to generate rental income. Mortgage REITs (MREITs) originate mortgages and mortgage-backed securities to earn interest income.
Mortgage and equity REITs are very different in their business models. Equity REITs are similar to landlords, whereas mortgage REITs are more similar to banks.
You can invest in commercial and residential properties with equity REITs. When you own REITs shares, you are entitled to a portion of the rental income from all of their properties.
REITs’ main goal is to maximize rental income from their property portfolios.
You can even invest in specific sectors of the real estate market. Each REIT has its own mandate and investment strategy. For example, some focus on commercial properties such as hospitals and casinos. Based on your view and strategy, REITs can help you invest in different types of properties, as shown below.
Mortgage REITs originate mortgages and mortgage-backed securities. They make money from mortgage interest payments.
Mortgage REITs frequently use financial leverage to boost their returns. They borrow short-term loans and lend this money to property buyers. The difference between the interest rate mREITs pay and the mortgage rate they charge is the source of their income. Consequently, mREITs are similar to banks in their operation and business model.
Compared to equity REITs, mortgage REITs are less intuitive. They can be affected by many economic factors that are often hard to predict. Additionally, mortgage REITs use financial leverage that increases volatility. As a result, we generally recommend new investors be cautious when investing in mREITs.
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Compared to traditional real estate investments, REITs are good alternatives with many great advantages.
Investing in real estate normally requires a large amount of money. Having a diversified property portfolio would require even more capital. In comparison, REITs are much more accessible. There is no minimum investment. You can buy as few as one share. Even with just one share, your investment is still diversified.
Traditional real estate investments have high concentration risk. If you invest in a rental property, you have a portfolio of one. As a landlord, you have no income when the property becomes vacant. On the other hand, REITs have diversified portfolios. When some units become vacant, you will still receive rents from other properties in the REIT’s portfolio. This reduces your concentration risk and makes your income more stable.
Traditional real estate investment restricts most investors to only residential properties. Hospitals, malls, and hotels are unavailable to most individuals. With REITs that focus on commercial properties, you can gain direct exposure to the growth in niche real estate markets. If you are looking to include some commercial properties in your portfolio, REITs are your best options.
Real estate investments have poor illiquidity. It often takes months and even years to sell a house and cash in on your investment. Because REITs trade on exchanges, selling and buying shares of REITs is extremely easy.
The U.S. government requires REITs to distribute at least 90% of its income as dividends every quarter. This makes REITs great sources of passive income. Before investing, research the trust’s historical dividend payment for the past few years. While future performance is not guaranteed, the dividend history can help you estimate the income from your REITs.
Additionally, investors can capture capital gains when investing in REITs. Most REITs trade on public exchanges and their prices change daily. By buying and selling REITs, you could capture capital gains and losses.
Dividends from REITs are taxed in three different ways: ordinary income, returns of capital, and capital gain.
Generally, the dividends paid from your REITs ownership is taxed as ordinary income. The tax rate depends on your income level, ranging from 10% to 37%. Some dividends are returns of capital. Returns of capital reduce your taxable income and defer the taxes to when the REITs are sold by lowering the cost basis of your investment. Lastly, some dividends will be taxed as capital gains.
Like any investment, REITs have risks. First, most REITs trade on public exchanges. As the market price moves, you could potentially lose money if you sell your REITs at the wrong time. Thus, exchange-traded REITs are exposed to market risks.
Additionally, equity and mortgage REITs have different risk factors, due to their different business models.
Real estate market risk
Equity REITs operate investment properties and rely on rental income. Thus, the strength of the rental demand directly affects the return of your investment. Additionally, REITs with special focuses such as retail properties or hospitals also respond to demands in the corresponding sectors.
Management risk
As an equity REIT owner, you can take advantage of the professionally managed portfolios. At the same time, without direct control over the properties, your return will depend on the REIT managers. A good manager makes great deals and generates great profits. A bad one, on the other hand, can hurt your investment. As an investor, you should research the experience of the management team and the trust’s past performance.
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Interest rate risk
Mortgage REITs do not own properties directly. The profit for mREITs depends on their abilities to lend at a higher interest rate than their borrowing rate. This difference in interest rates is the “spread”. Consequently, the interest environment has a direct impact on mREITs. A rise in borrowing rates or a decline in mortgage rates can reduce the spread and lower profitability.
Credit risk
Mortgage REITs’ core business is lending. When you lend someone money, there is always a risk that you might not get it back. This is the credit risk. Most securities held by mREITs are backed by the U.S. government agencies to reduce credit risk. However, some mortgages can still be risky.
Management risk
Similar to equity REITs, mortgage REITs also have management risks. Because the business model of mortgage REITs is riskier and more complex, good management can be critical to your investment returns. It’s crucial to check the REIT’s historical return and its management experience before investing.
Get started today
Start investing in mortgage REITs with DiversyFund.
CEO of Wall Strategies
Kehan is a registered financial representative and investment advisor with over 5 years of experience in trading and investment banking. Kehan started his financial career as a proprietary bond trader on Wall Street. Later, he led Citigroup’s European structured loan program in London, working exclusively with platinum clients.
In 2019, Kehan founded Wall Strategies which offers free investing strategies and videos created by Wall Street professionals. He aims to break the hereditary nature of financial education by making Wall Street investment strategies accessible to everyone. Wall Strategies covers a wide range of topics from investing in cryptocurrencies to saving for retirement.
Wall Strategies | YouTube
This article was re-posted with permission from the author, Kehan Zhou, at Wall Strategies.
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