What are REITs?
Real estate investment trusts, or REITs, are special purpose entities with special tax status, that own real estate and pass along most of the income from that real estate (rents or mortgage payments) to shareholders. They can own any type of real estate, and many specialize in one type, like apartment buildings, malls, office buildings, self-storage facilities or hotels. Investing in REITs is a good way to diversify your holdings.
A REIT that owns property directly and gets most of its income from its tenants’ rents is called an equity REIT. A mortgage REIT, on the other hand, is a REIT that doesn’t own property directly. Instead, it owns property mortgages and mortgage-backed securities. Its income comes from the interest it’s paid on the mortgages. Mortgage REITs are sometimes called mREITs.
There are also hybrid REITs that own a mix of assets, including both mortgages and equity.
There are a lot of reasons for investors to like REITS. They offer benefits like:
- High income—As long as you choose a fundamentally strong REIT with a history of consistent payouts, you can generally count on some hefty dividends, with a wide range from 1.5% to 15%. That kind of income is nothing to sneeze at.
- Portfolio protection—REITs in your portfolio can help protect your returns if the stock market corrects, as they often follow the housing market and trade independently of the stock market.
- Diversification of assets—Pooling your funds with thousands of other investors allows you to participate in a selection of real estate properties that you probably wouldn’t be able to purchase—or afford to maintain—on your own.
- Liquidity—It’s a lot easier to sell shares of your REIT than it would be to sell a home.
Those advantages to buying REITs hold true, no matter what stage the economy or markets are cycling through. But you do need to keep a few potential drawbacks in mind.
The (small) downside of investing in REITs
On average, about 70% of REIT distributions are taxable as ordinary income. Furthermore, REITs are negatively impacted by rising interest rates —their borrowing costs go up, and they may become less important to investors.
There are simple ways to counteract those factors, though. Holding any REITs you own in a tax-advantaged account like an IRA will limit your tax burden. As for interest rates, history has shown that REITs tend to outperform in times of rising rates for one simple reason:
Interest rates only increase when the economy is expanding, and when economic growth is strong, REITs see demand for their properties increase, and they can raise rents. Beyond that, rising rates are never worth a panic, because increases are usually moderate, occur over time, and rarely go as far as most people expect.
In short, a high quality company that earns reliable income and passes it on to investors is always going to be a good investment, regardless of interest rates.
What questions do you have about investing in REITs? Let us know in the comments below.