Investing in REIT stock allows average investors to gain affordable exposure to alternative investments in real estate. For most people, these investments are out of reach since physical properties have large capital requirements. By contrast, REITs offer shares of properties, in the form of a security, that are more affordable to retail investors. Also, REITs will usually invest in a diverse selection of properties in order to greatly reduce your portfolio risk.
You can even split your REIT portfolio into several real estate sectors. As we will see, there are various sectors these trusts can invest in from residential to industrial to commercial. These assets also act as a hedge against inflation and create a steady source of investment income.
Not surprising, then, that their popularity continues to increase. According to Nareit, an incredible 145 million Americans own REITs through investment funds or retirement savings.
Understanding REIT Stocks
REIT (Real Estate Investment Trust) stocks allow investors to gain access to income generated by commercial property. REITs operate in the same fashion as traditional corporations. However, almost all of their assets are held in real estate.
They act similarly to closed-end mutual funds. By pooling together the funds of smaller investors, they can invest the large amounts of capital needed to acquire real estate. The pooling together of capital allows smaller investors to gain access to revenues from the real estate investment space.
One of the greatest features is that publicly quoted REIT stock offers liquidity in a traditionally illiquid asset. These funds issue shares that are traded on exchanges. You can buy their shares in a matter of seconds, but you can also sell them just as easily. As their shares are publicly traded it greatly reduces the liquidity risk compared to selling real estate, which can take months or even years.
A Closer Look at REITS
There are Residential REITs that invest and operate residential condos. However, the more popular for investors and the largest number of REITs invest in and operate commercial property.
These properties range from shopping malls to self-storage spaces, and warehouses or hotels, office spaces, and cell towers. You can even find REITs that invest in timberland, an asset until recently available only to large investors through asset-specific private timberland management companies.
As REITs are quoted in shares this will allow you to diversify your exposure to real estate. Each real estate sector has varying risks. So, having your real estate investment in several different REITs by sector makes all the sense.
What you are doing is diversifying your real estate portfolio. The same as you might when setting up a mutual fund, or stock portfolio. To gain a diversified REIT portfolio you could also invest in an Index REIT.
REITs pay no tax on income at the corporate level, known as pass-through tax status. The special tax status avoids double taxation, as the dividends you receive are net of taxes. To take advantage of these tax breaks the REIT has to comply with two main restrictions. They have to pay at least 90% of taxable income in dividends, and 75% of their income has to come from real estate operations.
Equity, Mortgage, and Hybrid REITs
REITs can invest in direct ownership of real estate property, in mortgages, or a combination of both. REITs that invest at least 75% of their capital in the direct ownership of real estate are considered equity REITs.
When at least 75% of capital is invested in debt they are considered mortgage REITs. While REITs that do not follow the 75% cut-off criteria are considered hybrids. Let’s have a look at the two most common types of REITs, mortgage and equity.
Equity and mortgage REITs give rise to different considerations for each type. Equity REITs operate, renovate and develop properties, in much the same way a traditional company operates its business.
A corporation is usually targeting sales income, whereas a REIT is targeting rental or lease income. Most of the income it generates is through the trust’s rentals or leases, but it can also increase the value of its investments through property revaluation.
Revaluation will depend greatly on the type of property and if it was developed from land or renovated. Having most of their income from lease or rental contracts means that they will also be adjusted over time. The short life of rental contracts leads to the concept that they could act as inflation hedges as rentals are adjusted upwards to compensate for inflation.
The chart below shows the comparison of two indices; the Wilshire US Real Estate Price Index, and the Dow Jones Industrial Average. As we can see with the last crisis in 2020 REITs had a worse performance than stocks. The Wilshire index lost approximately 42.9% compared to a drop of 36.8% in the Dow Jones.
Source: St. Louis Fed
Although equity REITs do not appear to have weathered the pandemic crisis of 2020 as well as its peers of the Dow Jones index, we can see how REIT prices for this index slowly began to pick up again and have surpassed their previous highs of 2020.
Mortgage REITs will perform well with stable to rising property prices and low or declining interest rates. Both factors contribute to property owners being able to make timely payments. It also makes it cheaper and easier to raise fresh capital for growth.
When interest rates are low investors look at REITs for their steady income streams. REITs have little choice but to raise fresh capital if they are looking to make new investments since 90% of income is usually paid in dividends.
Mortgage REITs do not take part in operating properties and they do not have income contracts renewed relatively quickly. Think the average mortgage life is in terms of decades, they rely on regular payments and the smallest percentage possible of failing mortgages.
Why Invest in REITs
If you are looking to invest in real estate you may find that being a landlord is more challenging than it may seem. Many processes have to be drawn up and played out before you find yourself operating a profitable property.
To simplify, you need to first identify a parcel of land and acquire all the permits. Then you need to execute a project, that is to oversee the construction and its completion. Lastly, you need to find the tenants and operate the facility. These three phases may be more than what most people are willing or even have the time or expertise to go through.
Basically, it makes sense to put your capital into the hands of experts in the field of property development and management. You avoid the hassle, not only of running the property but also of acquiring the necessary know-how.
In terms of how it fits into your portfolio, there are various aspects to be considered: alternative income sources, portfolio diversification, and the possibility of protection from inflation. Let’s have a closer look at the concept of portfolio diversification.
Making REITs Work For You
Alternative assets allow you to move away from traditional investments in stocks and bonds. Giving you exposure to a different revenue source. Or, in more colloquial terms, not to have all your eggs in one basket.
We saw above with the last crisis REITs were hit in the same hard way as stocks. However, there may be more than meets the eye initially. Looking at the VIX index for volatility, we see that there may be some protection in REITs against market shocks.
Looking at the chart below comparing the VIX index and the Wilshire US REIT index we see there is a certain resistance in the REIT index in high volatility periods. True that in the crises of 2008 and 2020 REITs had a similar performance to stock and bonds.
However, let’s look at the other various bouts of volatility that have accompanied shocks in the stock market. In the chart below they are outlined by black boxes. We can see that the internet bubble of 2001, which was a full-on crisis, was well-lived by REITs.
The subsequent volatility spikes in 2003, 2010, 2012, and 2016 also show resistance to stock market volatility. The Wilshire index manages to maintain most of the previous increases, with only moderate declines.
Source: St. Louis Fed
It may be that REITs possess enough resilience from small market shocks but not enough to ride out of a full-blown crisis as a winner. From what I see REITs offer some protection from stock market declines when the extra volatility doesn’t turn out into a full crisis.
Choosing the Winning Horse
We are going to have a look now at the considerations you should be making when looking at investing in REIT stock. The objective here is to help you find the best real estate stocks that match your investment criteria.
Choosing the best REIT stocks begins with figuring out which real estate sectors you want to invest in. Let’s take a look at some of the largest funds out there, and the sectors they operate in.
We are going to have a look at 2 of the largest REITs in terms of assets under management, as you can see in the bar chart below. American Tower Corporation, for its investments in modern infrastructure, and Simon Property Group for its investments in classical commercial real estate.
We are simply going to view their characteristics and their past performance. Basically, to get an idea of what we should be looking at when identifying a REIT stock or considering a REIT stock price.
Largest REITs worldwide as of January 2020 by market cap.
American Tower International
American Tower Corporation (AMT), operates and develops multitenant communications real estate. They currently operate a portfolio of around 181,000 communication sites worldwide. From their press release for the second and first quarters of 2021, you can see the following interesting figures.
Most notably AMT saw its total property revenue grow by 7.9% for Q1 and by 17.9% for Q2. They also entered agreements with Telxius Telecom S.A. with which they expect to buy 31,000 communications sites across Latin America and Spain.
AMT also has a low beta of 0.28 according to Yahoo Finance. Beta is the correlation of AMT with the broader stock market. The lower beta is the smaller the moves up or down for AMT as the stock market experiences volatility.
AMT: More Details
AMT operates a sector of real estate that is vital to today’s society where just about everyone and everything is connected to the net. It also has a strong presence in Latin America which may offer higher growth opportunities.
We should always make a comparison between the individual stock and a broader REIT market index. We need to know not only if the REIT has performed well, but if it has outperformed or underperformed compared to its peers.
For example, comparing AMT and the Wilshire US REIT Index shows AMT as a winner of that race. The graph below shows how AMT racked up steeper gains over the 10-year period than the broader Wilshire index. AMT had a solid run of 420.95% compared to the increase of the Wilshire index of 115.65% over the same period.
Simon Property Group
Simon Property Group (SPG) makes its money by owning and running properties that include entertainment, such as premier shopping malls or dining locations. The trust operates properties throughout the USA, Europe, and Asia, and is part of the S&P 100 index.
The beta for SPG is quite high for a quoted stock, Yahoo Finance rates it at 1.52. So, any volatility the broader market experiences will be multiplied if holding this REIT stock.
The chart compares SPG to the Wilshire US REIT Index over a 10-year period. We can see that SPG had a better performance than the broader market index until 2017. After that, SPG starts underperforming badly. From 2020 the trust takes a nosedive as restrictions from the pandemic take effect.
The sudden price drop in 2020 seems to make sense. Consider all the limitations in place due to the pandemic, including extended periods of lockdowns all over the world. SPG operates places where people meet and hang out, or go to do some shopping. All that took a big knock due to the Covid-19 pandemic.
The immediate future for this stock probably depends on how quickly society can go back to normality. Restaurants, shopping malls, etc. many countries are still not operating under normal conditions. Still, this REIT may have more room for growth in the future as the economy begins to pick up again, and people go back to life as usual.
You may not necessarily find REIT stock prices performing better than the general stock market index or a particular stock you hold. The matter is not so much on bagging a hot stock, rather more on portfolio protection and diversification.
Protection comes mainly from diversification of risk, diversifying among assets instead of holding just stocks and bonds, as well as diversification among real estate sectors by investing in various funds operating across the spectrum. You can learn more about portfolio diversification in this portfolio diversification guide
REITs give you access to a different source of income and are very liquid assets. The biggest flaw of investing directly in real estate is possibly the illiquid nature of these holdings. REITs allow you to acquire exposure and adjust timely and promptly for your portfolio. REIT stocks also allow you to reap the potential rewards of real estate in sectors like infrastructure or retail shopping malls, whereas for most individual investors direct investments in these sectors would be impossible.
Although REIT stocks undoubtedly pose massive diversification benefits for the average investor’s portfolio, for true protection you need to take your diversification strategy a step further. For deep portfolio protection, consider adding other alternative assets such as precious metals retirement investments or cryptocurrencies to your IRA.