Real Estate Investment Trusts (REITS)

Summary - For investors who are looking to get the benefits of investing in real estate without owning property, a real estate investment trust (REIT) is an attractive option. And by combining the popularity of exchange-traded funds (ETFs) with an investment in REIT stocks, investors can get the benefits of REIT stocks with much lower risk. With a REIT ETF, investors can own a diverse group of properties inside of a fund that is traded in the same way that they would buy and sell shares on a stock exchange. REIT ETF investors also benefit from the high dividend yields that REIT ETFs generate.

For a company to be considered a REIT, they have to meet many specific requirements. These requirements, which were established by Congress when they created the concept of a REIT in 1960, help ensure that investors can maximize the income generating aspect of a REIT.

Like any ETF investors should pay close attention to the ETF’s prospectus for information regarding who manages the fund, the fees, and expenses associated with the fund, whether the fund is actively or passively managed, and the overall investment philosophy of the fund before deciding whether to invest. A REIT ETF carries the same risks, although perhaps moderated, as other real estate investments. The most notable threat to the profitability of an ETF is rising interest rates.

Introduction

Part of the grown-up humor in the children’s classic A Charlie Brown Christmas is when Lucy tells Charlie Brown that she never gets what she really wants for Christmas. When Charlie Brown asks Lucy what that something is, she replies “real estate”.

Investors have long understood the value of real estate as an investment vehicle. However, property ownership was, and in some cases still is, a barrier of entry for all but institutional investors. That was one of the reasons Congress established the concept of a real estate investment trust (REIT) that would give individual investors an opportunity to invest in real estate without owning residential or commercial real estate. Just like the housing market, a REIT can be subject to the volatility of the stock market. However, REITs have several rules in place that make them an attractive investment option. When you combine those rules with the benefits of an exchange-traded fund (ETF), REITs can be an attractive alternative for income-oriented investors in any market.

In this article, we’ll look at REIT ETFs as an investment decision. For those investors who are unfamiliar with what REITs are, we’ll define what a REIT is as well as look at give a basic overview of what an ETF is. As the article goes on, we’ll put the two together to show why a REIT ETF can give investors the advantages of investing in real estate with less risk.

What is a Real Estate Investment Trust (REIT)?

In 1960, Congress established a financial product that would allow individual investors to invest in real estate without having to buy or finance property. A Real Estate Investment Trust (or REIT) is made up of a number of real estate companies that own a portfolio of income-producing real estate assets. Investing in a REIT allows these investors to earn a share of the income that these assets produce.

Real estate investment trusts are divided into two categories: equity REITs and mortgage REITs.

• Equity REITs invest in a variety of commercial properties such as offices, shopping malls, apartments, and hotels. The primary income source for these REITs comes through the income they receive from rent. Equity REITs currently make up the majority of the REIT market with more than $2 trillion of assets under management. Avalon Bay Communities (NYSE: AVB) is an example of an equity REIT.
• Mortgage REITs, by contrast, are composed of more residential than commercial properties and most of their income is derived from mortgages and mortgage-backed securities. Mortgage REITs (or mREITs) profit from the spread between the interest rates they earn from their mortgage loans and the rates they are changed for their short-term borrowing. For example, let's look at a mortgage REIT that purchases a 15-year mortgage that pays them 3% interest per year. If their short-term borrowing cost is 2% per year than they will have a difference or spread of 1% that represents their profit. New York Mortgage Trust (NASDAQ: NYMT) is an example of a mortgage REIT.

REITs can be publicly listed and publicly traded in the stock market, publicly listed (but not publicly traded), or privately listed. REITs must follow specific rules that make them an attractive investment. To begin with, REITs are modeled after mutual funds in the sense that every REIT contains a “basket” of properties. The Internal Revenue Service (IRS) treats a REIT like a corporation. Shares in a REIT must be widely held by shareholders and the REIT itself must primarily own or finance real estate. In addition, their real estate holding must have a long-term investment outlook.

Some additional rules that govern REITs include:

• At least 75% of their income must be earned from real estate as rent, interest, or the sale of real estate assets.
• At least 75% of their assets must be in real estate.
• At least 95% of their income must be passive.
• At least 90% of their taxable income must be distributed to shareholders as dividends (a REIT has no retained earnings). All dividends are taxed at ordinary rates.

What are the benefits of investing in REITs?

Dividend income– Because of the rules that govern REITs, investors are assured of a dividend payout that is higher in proportion to other stocks. Financial advisors will often recommend a REIT to their income-oriented clients because the dividend yields have historically been higher than stocks on the S&P 500 index. 

Diversification – REITs have a historically low correlation with other asset classes like stocks and bonds. This means that when stocks and bonds are undergoing a correction, REITs generally may do well. However, to maximize the benefits of diversification, investors should look to invest in a variety of REITs so as to get diversification not only between asset classes but also within an asset class.

Inflation Hedging– Equity REITs, in particular, have demonstrated an ability to generate increased revenue – from rent for example – even during periods when inflation is on the rise. This means that investors who are looking for an income that will provide reliable income that can help sustain a longer retirement timeline.

Total Return Performance– In addition to issuing regular dividends, REITs have a proven history of long-term capital appreciation. In fact, over the past half-century, REITs have outperformed the broader stock market as well as other assets.

Liquidity and Transparency– Because they are traded on stock exchanges, REITs offer the same liquidity as other stocks. And because those that are publicly traded are registered and regulated by the SEC, investors are assured that the companies are subject to the SEC standards for corporate governance, financial reporting, and information disclosure. 

What is an exchange-traded fund (ETF)?

An exchange-traded fund (ETF) is one of many financial products that serve as a vehicle for investing in REITs. In contrast to a mutual fund which reconciles share price once a day based on the fund’s closing price, shares of an ETF trade like a common stock on an exchange, meaning the market price will go up or down throughout a trading session as shares are bought and sold. An ETF generally trades with a higher daily volume than a mutual fund and has lower fees and expenses which can make them more attractive for investors. Like a publicly traded company that sells shares on a stock exchange, a company that manages an ETF is required to disclose information about the fund to the public.

Putting it all together, the REIT ETF

A REIT ETF is an exchange-traded fund that is exclusive to REIT stocks. As an investor, REIT funds are an ideal vehicle to use a low-cost investment vehicle to gain exposure to a diverse range of properties. As with any investment, investors should take care to perform their due diligence before deciding to invest money in a REIT ETF.

• Know who manages the ETF– in many cases, REIT ETFs are issued by well-known investment firms that have earned the trust of investors. However, as ETFs have become increasingly popular, there are more companies that are ETFs being created. Just because a company is not well-known does not make it a bad investment, it just means that investors may have to perform more research before making an investment.
• Know the fee structure– Although most ETFs charge lower fees and expenses than a mutual fund there are exceptions. The best way to compare the fees and expenses of an ETF is similar to how you would compare any asset class. Look at the prospectus of the REIT you are considering along with the prospectus of REIT ETFs that share a similar portfolio of assets.
• Know your risk tolerance– REIT ETFs help manage the risk that can come from owning real estate. They cannot, however, eliminate all risk. As should be expected, REIT ETFs are subject to the same market forces that affect the real estate market. They are extremely sensitive to interest rates as well as employment rates.

How to have success with a REIT ETF

There are currently more than 200 REIT ETFs for investors to choose from. REIT ETFs are beginning to figure prominently in the 401(k) plans. However, like other investment vehicles, not all ETFs are the same. To have success, investors should understand what the investment philosophy of the ETF is and match that to their personal risk tolerance. Like any mutual fund, portfolio managers can get very niche driven which can add more risk to the ETF that investors are comfortable with. You should also be sure to know if the fund is actively managed or passively managed. In an actively managed ETF, a portfolio manager selects the REIT stocks that make up the fund and will actively buy and sell stocks to generate a higher total return. In a passively managed fund, the portfolio manager seeks stocks that track an index. The Financial Times Stock Exchange (FTSE) Nareit Index tracks the performance of the U.S. REIT industry and the Global REIT market.

Finally, investors should look for diversification. This means looking at U.S. REIT ETFs as well as the global REIT ETF market.

The bottom line on REIT ETFs

One of the most important strategies for investment success is the ability to profit in any market condition. For income investors, a REIT EFT can help produce regular and predictable income even in times of low-interest rates. A REIT ETF provides the ability for investors to gain exposure to and profit in the real estate market without owning property. Owning shares of a REIT ETF is similar to buying shares of a REIT stock with the exception that investors have more diversification because they are purchasing a basket of companies rather than tying their investment to a specific REIT stock.

One of the most important benefits of a REIT ETF is regular dividend distributions along with some capital appreciation that can lead to a total return that, while not as high as if the investor owned the underlying properties comes with significantly lower risk. Like the real estate market in general, REIT ETFs can be sensitive to fluctuations in interest rates.