Many people dream of investing in large apartment buildings, shopping malls, and commercial office space – yet few have the necessary funds and expertise for such investments. Real Estate Investment Trusts (REITs) are one way the average person can invest in large and expensive real estate properties.
An REIT invests in properties that produce income; these properties may be condominiums, commercial real estate, strips malls, hospitals, apartments, and more. From a practical standpoint, an REIT is comparable to a mutual fund; the investments are pooled and the REIT buys and operates income-producing properties.
How Do You Make Money From REITs?
REITs are essentially landlords. The revenue consists of all the rents collected from the tenants. The expenses include property management, property tax, utilities, mortgage payments, and more. The profit is what’s left over after all the bills are paid.
This profit is given back to investors in the form of dividends. The great news is that REITs have a powerful incentive to distribute a minimum of 90% of the taxable income to investors; REITs do not have to pay corporate income tax if they meet the 90% minimum payout.
There are 3 main types of REITs:
- Equity REIT. The most common type is an equity REIT. These companies invest in income producing property that the REIT will also manage. When REIT’s are considered as investments, this is the type that is typically being referred to.
- Mortgage REIT. These REITs invest in outstanding mortgages and also make loans backed by real estate. While the underlying property values are important for both equity and mortgage REITs, mortgage REITs values are also very dependent on interest rates. This type of REIT accounts for less than 10% of all REITs operating in the United States.
- Hybrid REIT. The hybrid REIT is a combination of an equity REIT and mortgage REIT. So this type invests in both mortgages and actual real estate assets. The hybrid REIT potentially has the greatest diversification.
Some equity and hybrid REITs will invest in numerous properties of varying size and function. This diversification should provide some stability relative to the change in value of the individual properties. What can affect values? Vacancies, non-payment of rent, general downturn of the local market, and interest rates are a few of the things that can affect the values.
How Do You Evaluate an REIT as an Investment?
As an investor, you can buy and sell your shares in an REIT just as you could with any other stock. Be sure you educate yourself in the proper way to evaluate an REIT. It is not in the business of manufacturing anything and it is not providing a service. The common methods of evaluating stocks may not apply in the same way.
Most REITs specialize in a single type of property, like apartments, retail space, or commercial office space. Many REITs limit themselves to a geographical area as well; this can be an important consideration when attempting to determine which REIT is best for you.
A great REIT will manage its properties to get the best possible income growth and then reinvest that money in properties that generate an even greater return than the existing properties. Those are the two things an equity REIT must do to excel.
A good measure for evaluating REITs is “funds from operations” (FFO). This discounts gains and losses from the sale of assets and adds back depreciation. A long-term FFO growth is generally a good indicator of the financial health of an REIT.
While FFO gives an indication of the strength of an REIT, it is not the only predictor of a REIT’s value. REITs own a lot of assets, and the value of those assets has the largest impact on the current asking price of an REIT’s shares.
An REIT might be the investment vehicle you’ve been looking for to expand your portfolio. As always, be sure to educate yourself or seek out the advice of a financial expert before investing any of your hard-earned money in any new investment.