For the average small real estate investor, outright ownership of an office building, a local shopping center, a warehouse, or even an apartment complex is a dream that will go unrealized.
However, there is an investment vehicle that does allow smaller investors to participate in the commercial marketplace by buying an interest in those property types, without the hassle of daily management responsibilities, while providing great potential for a passive income.
Those vehicles are known as real estate investment trusts (or REITs). Created by Congress in 1960, REITs allow anyone to invest in a variety of commercial real estate, depending on the type of property a particular REIT specializes in.
“While the Internet has made it easier for investors to find and buy commercial real estate, these transactions are still more complex and certainly more expensive than a typical residential property purchase,” says Rick Sharga, executive vice president at Auction.com, an online real estate marketplace.
“Real estate investment trusts may be a viable option for investors who’d like to diversify their portfolios by adding commercial real estate, but aren’t comfortable with the complexity or can’t meet the capital requirements that buying commercial properties involve,” he says.
From hotels to apartments to assisted living facilities, office buildings, industrial space, retail space and more worldwide, REITs are mandated by law to be widely held and to distribute most of their income as dividends to shareholders. And because investors can purchase shares on the stock market, REITs are considered to be a very liquid asset.
“REITs provide mom-and-pop investors with instant liquidity. By owning REITs they have the ability to enter and exit on a daily basis,” says Samuel Sahn, a portfolio manager in the New York office of Timbercreek Asset Management, who currently manages $800 million in REIT stocks.
Additionally, Sahn says REITs are a good risk mitigator that provides diversification to a household’s portfolio.
“Mom-and-pop investors have the ability to purchase REITs. It provides them with real estate exposure they can’t get on their own, plus access to the best assets in the world,” he says. “It’s tough to buy a storage unit or a hotel along with having the expertise and time to manage those assets.”
Equity versus mortgage REITs. According to the National Association of Real Estate Investment Trusts (NAREIT), 90 percent of all market capitalization in the REIT industry is focused on equity REITs. Their business model is that of a real estate company that buys specific types of commercial properties. Investors’ capital gets pooled together and then the REIT’s management team purchases the type of properties the REIT specializes in.
After expenses are paid, the bulk of the REIT’s annual income is distributed to investors/shareholders as dividends. Any capital appreciation from the sale of properties is also distributed in the dividends.
On the other side are mortgage REITs . In this scenario, investors are putting their money into the debt financing side of the business. The business model for mortgage REITs is to invest in real estate mortgages (mostly single-family home loans) or mortgage-backed securities. Investors in turn earn income from the interest paid on those investments and the sale of mortgages.
Long-term returns. Whether the investor chooses to go with equity REITs or mortgage REITs is an individual decision that should be based on the investor’s long-term investment goals and strategy.
Unlike the quick double-digit rates of return veteran investors are accustomed to as either owners of rental units or as flippers, buying shares of REITs is a more conservative play that has the proven potential for a more sustainable rate of return, albeit over a long period of time.
According to data compiled by NAREIT, over the past 25 years equity REITs based in the U.S. have outperformed the Standard & Poor’s 500 index in terms of income and total returns combined.
“Looking at the current dividend yield is not enough,” said Brad Case, senior vice president of research and industry information for NAREIT. “You want something that will give you a strong dividend yield and appreciation in value. It needs to be supported by a long track record.”
NAREIT data shows that listed equity REITs had an average total return of 12.14 percent per year for the last 20 years without the reinvestment of dividends, while reinvesting dividends yielded an average total return of 17.60 percent per year.
Long-term yields are an important factor, particularly for investors who are looking for a stable income stream to assure they have funds when they are ready to retire.
“As an investor, you should be looking for investments that will pay the bills and also grow your wealth so you’re not running out of money,” Case says. “That’s one of the greatest things most retirees are worried about.”
Economic factors are important to valuation. Like any other investment vehicle, the value of REITs — and their return on investment — are tied in large part to economic factors such as interest rates (which are of particular concern to investors in mortgage REITs), unemployment, inflation and many others.
Although he can’t predict whether REITs will continue to outperform the stock market over any particular time period, Case notes that the average real estate cycle is much longer than the average stock market cycle (18 years for real estate versus four years for the stock market).
Given those numbers, Case believes that the current real estate market cycle is a bull market that is not even halfway along and has several years of strong returns to go. So while the nation’s overall economy does have an impact on the market for REITs, Case recommends that investors have a well-diversified exposure to the real estate cycle and that REITs be a part of every portfolio.
“My basic recommendation is that you should always have a significant piece of your portfolio in REITs. It you don’t currently have it, there’s no reason to think it’s a bad time,” he says. “I can’t tell you that the returns between now and the end of the year will be good, but I can say that in the next eight years it is more likely to be good than bad.” Plus the investor can start off small because a lot of REITs have no minimum buy-in, Case says.
While there are some global markets performing well, Sahn believes the U.S. has the strongest economic fundamentals to support today’s REIT market, which will translate into the strongest earnings growth of any of the developed markets in the world.
Options for selecting REITs. For investors who like to be actively involved in selecting assets and managing their own portfolio, there is nothing stopping them from selecting and buying shares of REITs individually through a stock broker, financial advisor or financial planner.
Whether their interest lies in storage units, retail malls, multi-family apartments, or any other type of commercial property, for investors who understand where they are putting their money, REITs offer an opportunity to actively manage a diverse portfolio.
However, for those who are not so confident in selecting particular REITs or property types, there is the option to buy as many or as few shares as they want through either a mutual fund or an exchange-traded fund, such as those available through Vanguard, Fidelity or JPMorgan Chase & Co., along with many other providers.
Then there are actively managed funds that research the REIT market and strive to build portfolios of REITs that will outperform the market, Sahn says.
“They pick the market and the property type based on where they find the best underlying fundamentals,” he says. “You can have the same property type, but depending on the geographic location you can have different fundamentals.”
No matter which way an investor decides to go when it comes to choosing REITs for investment potential, as always it is good to get a financial advisor involved to address any concerns before putting up the money.