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5 Types Of REITs And How To Invest In Them

Real estate investment trusts (REITs) are a key consideration when constructing any equity or fixed-income portfolio. They provide greater diversification, potentially higher total returns and/or lower overall risk. In short, their ability to generate dividend income along with capital appreciation make them an excellent counterbalance to stocks, bonds and cash. REITs generally own and/or manage income-producing commercial real estate, whether it's the properties themselves or the mortgages on those properties. You can invest in the companies individually or through an exchange-traded fund or mutual fund. There are many types of REITs available. Here we look at a few of the main ones and their historical returns. By the end of this article you should have a better idea when and what to buy. (For a primer on buying real estate, take a look at Simple Ways To Invest In Real Estate.) Historical Returns
Real estate investment trusts are historically one of the best-performing asset classes available. The FTSE NAREIT Equity REIT Index is what most investors use to gauge the performance of the U.S. real estate market. Between 1990 and 2010, the index's average annual return was 9.9%, second only to mid-cap stocks, which averaged 10.3% per year over the same period. In comparison, fixed income assets managed 7% annual returns and commodities just 4.5% a year. Real estate was the worst performer of eight asset classes in just two years out of 20. Fixed income, on the other hand, was the worst performer six times in the same 20-year period. Historically, investors looking for yield have done better investing in real estate than fixed income, the traditional asset class for this purpose. A carefully constructed portfolio should consider both. (Learn more in How To Assess A Real Estate Investment Trust.)
Once you've made your industry assessment, your focus should turn to the REITs themselves. Like any investment, it's important that they have good profits, strong balance sheets and as little debt as possible, especially the short-term kind. In a poor economy, retail REITs with significant cash positions will be presented with opportunities to buy good real estate at distressed prices. The best-run companies will take advantage of this. (For more insight on commercial real estate, check out 7 Steps To A Hot Commercial Real Estate Deal and Find Fortune In Commercial Real Estate.)Residential REITs These are REITs that own and operate multi-family rental apartment buildings as well as manufactured housing. When looking to invest in this type of REIT, one should consider several factors before jumping in. For instance, the best apartment markets tend to be where home affordability is low relative to the rest of the country. In places like New York and Los Angeles, the high cost of single homes forces more people to rent, which drives up the price landlords can charge each month. As a result, the biggest residential REITs tend to focus on large urban centers.Within each specific market, investors should look for population and job growth. Generally, when there is a net inflow of people to a city, it's because jobs are readily available and the economy is growing. A falling vacancy rate coupled with rising rents is a sign that demand is improving. As long as the apartment supply in a particular market remains low and demand continues to rise, residential REITs should do well. As with all companies, those with the strongest balance sheets and the most available capital normally do the best. (Learn more about residential real estate in Making Money In Residential Real Estate.)

The current foreclosure crisis calls for a new funding vehicle to finance the transition of real estate owned (REO) properties into the rental market. The Federal Reserve, in its recent letter to Congress, identified the need for Congress to adopt policies for overcoming obstacles inhibiting the conversion of REO properties to rentals. The Fed writes:

Reducing some of the barriers to converting foreclosed properties to rental units will help redeploy the existing stock of houses in a more efficient way. Such conversions might also increase lenders’ eventual recoveries on foreclosed and surrendered properties.

In case you are interested in the size of the market, the Fed quantifies the potential opportunity:

While the total stock of REO properties is difficult to measure precisely, perhaps one-fourth of the two million vacant homes for sale in the second quarter of 2011 were REO properties. The combination of weak demand and elevated supply has put substantial downward pressure on house prices, and the continued flow of new REO properties — perhaps as high as one million properties per year in 2012 and 2013 — will continue to weigh on house prices for some time. To the extent that REO holders discount properties in order to sell them quickly, the near-term pressure on home prices might be even greater.

One of the obstacles is the lack of large scale, professionally managed, well-financed organizations in the single-family rental space. The business has traditionally been run by small-scale, local investors. These current operators lack the resources to absorb the large number of REO properties entering the market. If financial institutions are forced to sell into a market of this structure, it will significantly increase the losses they are likely to incur.

That is why a new vehicle like a single-family real estate investment trust (SF-REIT) should be considered. REITs, with their access to public capital and highly skilled talent, represent a possible solution for the current crisis. A REIT entity tailored to the unique characteristics of single-family rentals could provide:

  • ability to raise debt and equity financing in public markets to support higher bid prices for REO properties,

  • professional management to implement the technology required to manage geographically disbursed and physically heterogeneous properties,

  • ability to rapidly absorb large portfolios of REOs out of financial institutions in exchange for cash and REIT units and

  • enable widespread public participation in this expanding industry while giving investors liquidity for their investment

SF-REITs will face much different operating needs than multifamily REITs. Therefore it will be necessary to tailor new legislation to accommodate these needs. But the benefits are clear and opportunities large.

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Healthcare REITs Healthcare REITs will be an interesting sub sector to watch as Americans age and healthcare costs continue to climb. Healthcare REITs invest in the real estate of hospitals, medical centers, nursing facilities and retirement homes. The success of this real estate is directly tied to the healthcare system. A majority of the operators of these facilities rely on occupancy fees, Medicare and Medicaid reimbursements as well as private pay. As long as the funding of healthcare is a question mark, so are healthcare REITs.

Things you should look for in a healthcare REIT include a diversified group of customers as well as investments in a number of different property types. Focus is good to an extent but so is spreading your risk. Generally, an increase in the demand for healthcare services (which should happen with an aging population) is good for healthcare real estate. Therefore, in addition to customer and property-type diversification, look for companies whose healthcare experience is significant, whose balance sheets are strong and whose access to low-cost capital is high. (For related reading, see Investing In The Healthcare Sector.)

Office REITs Office REITs invest in office buildings. They receive rental income from tenants who have usually signed long-term leases. Four questions come to mind for anyone interested in investing in an office REIT

  1. What is the state of the economy and how high is the unemployment rate?

  2. What are vacancy rates like?

  3. How is the area in which the REIT invests doing economically?

  4. How much capital does it have for acquisitions?

Try to find REITs that invest in economic strongholds. It's better to own a bunch of average buildings in Washington, D.C., than it is to own prime office space in Detroit, for example. (For more on commercial real estate, see Find Fortune In Commerical Real Estate.)

Mortgage REITs Approximately 10% of REIT investments are in mortgages as opposed to the real estate itself. The best known but not necessarily the greatest investments are Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages on the secondary market. But just because this type of REIT invests in mortgages instead of equity doesn't mean it comes without risks. An increase in interest rates would translate into a decrease in mortgage REIT book values, driving stock prices lower. In addition, mortgage REITs get a considerable amount of their capital through secured and unsecured debt offerings. Should interest rates rise, future financing will be more expensive, reducing the value of a portfolio of loans. In a low-interest rate environment with the prospect of rising rates, most mortgage REITs trade at a discount to net asset value per share. The trick is finding the right one. (Learn more about the effects of interest rates in The Impact Of Interest Rates On Real Estate Investment Trusts.) The Keys to Assessing Any REIT I've talked about specific types of REITs as well as what to look for when investing in them. However, there are a few things to keep in mind when assessing any REIT. They include the following:
  1. REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
  2. Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides without being locked in long term. Liquidity matters.
  3. Depreciation tends to overstate an investment's decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess an REIT, look at its funds from operations (FFO) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide by the FFO per share. The higher the yield the better.
  4. Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
  5. Quality counts. Only invest in REITs with great properties and tenants.
  6. Consider buying a mutual fund or ETF that invests in REITs, and leave the research and buying to the pros.
The Bottom Line The federal government made it possible for investors to buy into large-scale commercial real estate projects as far back as 1960. However, only in the last decade have individual investors embraced REITs. Reasons for this include low interest rates, which forced investors to look beyond bonds for income-producing investments, the advent of exchange-traded and mutual funds focusing on real estate and, until the 2007-08 real estate meltdown, an insatiable appetite on the part of Americans to own real estate and other tangible assets. REITs, like every other investment in 2008, suffered greatly. But despite this, they continue to be an excellent addition to any diversified portfolio.

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