Investing in real estate the old-fashioned way is hard. Not many investors have enough extra money for a down payment just laying around. And even if they did, tying all of that money in a single property might give them pause.
If you’re in this situation, the solution to your problem might just be a Real Estate Investment Trust, also called a “REIT”. A REIT operates like an index fund, but for actual real estate properties. According to Nareit, approximately 145 million American households (44%) are invested in REITs.
It combines the best of both worlds: the potential for high gains in the real estate market, but at a level that anyone can afford. Keep reading to learn more about this real estate investment option.
REITs have the potential for high gains in the real estate market, but at a level that anyone can afford.
How REITs Work
You can think of REITs as a type of index fund for real estate. REITs are funds that invest in real estate and allow people to buy shares. Just like with stock market funds, you’ll earn dividends, and you can buy or sell shares at any time for (hopefully) a profit.
There are some special rules that apply to REITs compared with other types of funds, however. For example, a REIT must have at least 100 shareholders, be managed by a board of directors or trustees, invest at least 75% of the funds in real estate of some sort, and pay at least 90% of its income to shareholders as dividends.
REITs are a hot commodity, too. To see why, it’s helpful to look at the fund FTSE Nareit All REITs, which is a fund-of-REITs that invests in all publicly-traded REITs in the U.S. stock markets. The yield dividend for this fund is 4.3%, as opposed to just 1.8% with the S&P 500. It also has a higher 20-year return of 9.5% vs. 6.3% for the S&P 500, too.
However, the FTSE Nareit All REITs fund is down this year, by a lot: 17%, in fact.
That brings up one of the major downsides of REITs: they’re highly volatile. Although they’re generally a good piece to add to your portfolio in small amounts, you won’t want to invest a lot of money in them, especially if you’re getting close to when you might need that money.
Types of REITs
Currently, there are around 1,100 REITs in the U.S., with about 225 of them available on the publicly-traded markets. That’s a lot of REITs, and as you might expect, there are almost as many types of REITs available as there are ways to invest directly in real estate.
Some of these categories overlap with each other. For example, a REIT that specializes in office buildings and a REIT that specializes in apartments both fall under the same umbrella: equity REITs. Let’s sort out some of these categories next.
Equity REITs are what most people think of when they think of REITs. These are funds that focus on purchasing income-producing properties like retail stores, house rentals, and more. In this way, they’re more akin to people who purchase buy-and-hold real estate, and bank on the value of the rental increasing and steady income from rent each month.
Some REITs focus on the actual lending of money — i.e., the mortgages themselves, rather than the properties they buy. Mortgage REITs might invest in mortgages directly, or focus on mortgage-backed securities (yes, the very same from the famed Great Recession).
Most REITs fall under the umbrella categories of either equity REITs or mortgage REITs. Hybrid REITs, however, invest both: buying actual properties, and funding the mortgages that other people use to buy other properties, too.
Another way to parse out REITs is by certain industries. Each of these REITs also falls under the equity, mortgage, or hybrid umbrellas. For example, a residential REIT can specialize in buying homes and apartments, providing mortgages for other people to buy them, or both.
Here are some of the most common sector-based REITs:
- Data centers
- Office buildings
- Healthcare buildings
- Self-storage properties
- Timberland (forest land for logging)
- Residential (standalone homes, duplexes, apartment complexes, etc.)
The advantage of sector-based REITs is that if you’re savvy, you can key in on trends that affect certain parts of the real estate industry. You might have a hankering that there’s something big going on in the office building vs. residential market, for example, and that might affect your investment decisions.
Pros and Cons of REITs
There’s a reason REITs are considered separate investments from the usual breakdown of stocks vs. bonds. Here are some considerations, before you invest in a REIT.
|REIT Pros||REIT Cons|
|Highly liquidEasy to get started|
Potential for high returns
Easy to diversify your portfolio
Dividends are taxed as ordinary income
There’s a lot to like about REITs. Let’s look at each of these more closely.
If you buy a real estate property, you might find yourself in the unlucky position of not being able to sell it later. And even if it is a hot seller’s market, there’s a lot of time, hassle, and money you have to spend to turn that property into cash in your bank account.
But with REITs, you can just click a few buttons to sell your shares and get done with it. No realtors, no title companies, fewer hassle.
Easy to Get Started
On the other hand, if you were to buy real estate, you’d need a lot of cash up-front. If you bought a home in the Seattle marketplace with an average value of $784,000, for example, you’d need a down payment of $157,000 if you used a conventional mortgage with no PMI.
Not exactly obtainable for the average investor.
Potential for High Returns
REITs offer the potential for some pretty impressive returns. For example, VNQ has shown returns as high as 30% in some years. Imagine earning a 30% APY from your bank account — that’d be quite the cause for celebration.
Easy to Diversify Your Portfolio
Since REITs are so easy to handle, it’s also easy to add them into your portfolio mix and keep them at whatever percentage you want. You can even automate it entirely by buying REITs within a robo-advisor platform.
For example, let’s say you want to keep real estate to just 5% of your portfolio. If we use the same example from Seattle above with an average home value of $784,000, you’d need at least $15.7 million more in your portfolio to keep it to that target 5% mark.
Again, not quite so obtainable for the average bear.
So, why doesn’t everyone invest all in REITs, all the time? They do have some downsides.
It’s true that Vanguard’s VNQ REIT has offered returns as high as 30% in some years. But it’s also true that REITs can go down in value — and sometimes spectacularly so. During the 2008 real estate crash, for example, this same fund offered returns of negative 37%. That’s not exactly something you want to see if you’re right on the verge of retiring, for example.
If you’re a DIY real estate investor, you can control a lot of the costs yourself. You can even get up in the middle of the night to fix a flooding toilet, if you don’t want to spring for property management services, after all.
But if you invest in a REIT, there will be costs in the form of an expense ratio and possibly trading fees. These don’t have to be high (VNQ has an expense ratio of 0.12%), but they’re a cost you’ll have to pay if you’re not a DIY real estate investor.
Dividends Are Taxed As Ordinary Income
Many types of investments pay out qualified dividends, which are taxed at a lower capital gains rate. But REIT dividends aren’t considered “qualified,” and so they’re generally taxed at your marginal tax rate as ordinary income (like from your job), and this can be a lot higher than the capital gains rate.
Are REITs a Good Option for You?
REITs are just like any other investment type. They’re a tool, and whether they’re a good tool for you depends on your situation.
If you’re looking for an easy and affordable way to invest in real estate without jumping in headfirst to the DIY real estate investing world, REITs can be a good option for you. They’re also a good choice if you’re just getting started and you don’t have millions (or even thousands) to invest in real estate just yet.
But if you think you’d enjoy a more hands-on approach and you’re not afraid of devoting a lot of time and money (and headaches) to the cause, investing more directly in real estate might be in the cards for you.
Remember, there’s no wrong answer here. Only what you (and/or your financial advisor) determines is best.