Would you like to have real estate in your portfolio, but you don’t have hundreds of thousands for property? I am going to show you how is that possible with this beginner’s guide to REITs.
Before we start here is a list of all the Metrics in case there is something you don’t know.
Table Of Contents
- What is a REIT?
- Why Should You Invest in REITs?
- Why Shoud You Not Invest in REITs?
- Different Kinds of REITs
- How to Pick a Good REIT?
- REITs and Taxes
- Dividends Tax From US REITs
- Closing Thoughts
What is a REIT?
REIT stands for real estate investment trust. It is working on the same principle like equity trusts, but those are investing solely in real estate. In order for a company to be considered a REIT there are a couple of things that need to happen :
- 90% of the taxable income must be distributed to shareholders in the form of a dividend.
- At least 75% of it’s assets must be in real estate.
- At least 75% of the income must be from rents, interest from mortgages or from sales of real estate.
- Have a minimum of 100 shareholders
- Have no more than 50% of the shares held by 5 or less shareholders.
As you can see there is something very interesting in the structure of the REITs. That is the fact that they are required by law to pay out 90% of their taxable income back to shareholders via dividends. That is why REITs have much higher dividends than the average company. Also that is why they are so different to evaluate than your regular company, but more on that in a minute.
Why Should You Invest in REITs?
Here are a couple of reasons if you are thinking about REITs:
1. High Average Return
Up to date they are the best investment vehicle in the last 20 years with average returns of 11.8%. They are outperforming both the S&P500 (8.6%) and commercial real estate (9.5%)
2. Diversification
In order to reduce the overall risk in your portfolio it is a good idea to be diversified with some real estate and REITs are a great tool to do that.
The good part is that REITs usually have hundreds if not thousands of properties making you instantly diversified within the sector.
3. Increase your dividend income
Usually REITs are knows for providing high dividends because of their structure. It is not unusual for them to have yields of 7,8,9 or even 10%. If you want to boost the dividend income in your portfolio REITs are a great way to do that.
Why Shoud You Not Invest in REITs?
There are of course some reasons, where investing in REITs might not be the best thing to do.
1. If You Have Enough Exposure
If you have a large part of your portfolio already in real estate you might consider investing in something else. While having some real estate is great having all of your portfolio in it might be risky.
2. Interest Rates Enviroment
Ok this is a bit tricky as it is not always true, but usually real estate is very sensitive to interest rates. REITs usually need a lot of debt in order to operate and increasing the cost to borrow might be very crippling for the bussines. As I said that is not always true, but you need to be careful and make some extra due diligence when interest rates are rising.
3. If You Are a Total Beginner
In my opinion REITs are a bit more complex and require more understanding of macroeconomics, central bank policies etc. Of course there is always a way to simplify your investing and you can invest in REITs by ETFs. There are a number of broadly diversified REIT ETFs that are going to make things much easier for you. For more information about ETFs you can check this ETFs Overview.
Different Kinds of REITs
As you know there a lot of diffent kinds of real estates and naturally there are different kinds of REITs aswell.
1. Retail REITs
By the name you can probably say that those are REITs that operate retail stores, shopping centres, outlets etc. This is a very broad category as in retail you can see things from your local grocery store to a huge bank in the city centre. That is why you need to make a good research about the individual REIT portfolios as the performance may vary a lot depending on the sorts of retail stores they operate.
2. Residential REITs
This kind operates familiy homes, apartment buildings etc. Again the performance might vary depending on different cities, countries, building types, demographics etc. A good thing about those REITs is that they are quite recession- proof as people need to live somewhere no matter what.
3. Healthcare REITs
This can be hospitals, care centers, retirement homes etc. This REITs are also very resistant to recession as they provide services that is a necessity to people. Again we can expect different returns depending on the locations, the allocation, the country etc. so make sure you make your research beforehand.
4. Office REITs
They operate office buildings and they are dealing with bussineses. They can vary depending on the town, the country, the clients they are working with and others. They are very tied to the economy so make sure you do your research around the economy is in the area.
5. Mortgage REITs
As you can say by the name these REITs are providing finance for real estate by buying mortgages or mortgage- backed securities. Here the income comes from interest payments instead of loans. If you remember the 2008 financial crisis you might know that mortgage- backed securities carry a lot of risks. Here you can find some very high dividends, but the risk is very high aswell. I absolutely do not recommend this kind of stocks for beginner investors. Here you really need to know what you are doing in order to make good returns.
6. Tech REITs
This is an interesting sector, because a big part of it started developing in the last couple of years. You have cell tower operators, which have been around for a while now. But you also have data center managers, document managers and different new industries which are coming up along the cloud computing industry. Here the dividend yields are genuinely a bit lower, but they have more growth, which means stronger dividend growth aswell.
How to Pick a Good REIT?
First you need to know that most of the metrics that we use to research companies do not work with REITs. Here are the the things that I like to go through when evaluating real estate companies.
1. Debt Management
This is crucial for the real estate bussines- if the debt is not managed well it can snowball and fail the entire company. A good metric I like to use for REITs is debt to equity ratio. Usually REITs use a bit more leverage than other companies, keep that in mind.
2. Cash flow growth
To evaluate the cash flow I like to use funds from operations. It is obviously important to have a positive cash flow growth year over year, otherwise there is probably a problem somewhere in the company. Remember that net income does not work very well for eveluating REITs due to the structure of their bussines models. That is why metrics like P/E and EPS does not work so well. Use P/FFO instead.
3. Location
For real estate the single most important thing is the location. Before you invest in a REIT make sure you get to know their portfolio and where are their properties located. After that do a good research of the area- how is the bussines doing there, what are the demographics etc.
4. Occupancy rate
A high occupancy rate is a sign of a healthy REIT. That is where all of their money comes from. A low occupancy rate is usually a red flag that something is wrong with the bussines. Either the locations are not good, maybe the quality of the buildings is not good or the have been targeting the wrong demographics.
REITs and Taxes
Here is where the REITs are quite different than other stocks. They have a different tax structure and their dividends are considered PID (property income dividend). They are taxed at a mininum of 20% and can go up to 45% depending on the income. The initial 20% are deducted from the company with the issuance of the dividend. If you get a £100 PID dividend you are going to receive £80 in your account. That is because the company has already paid the 20% tax on your behalf before sending you the dividend.
If you are in a higher bracket and are making more than £31,785 in property income you need to fill a self- assesment form for the higher rate tax.
Bear in mind that your dividend can be PID or normal depending on the company. Best thing to do is check how the company is issuing their dividend- you can do that from their investor relations page.
Dividends Tax From US REITs
The dividends received from US REITs can be considered ordinary dividends in the current conditions:
Under the American Jobs Creation Act of 2004, REITs capital gains dividends can be considered as ordinary dividends and reported as such under the following conditions:
- The distribution is received in respect of a class of stock that is regularly traded on an established securities market located in the U.S.A.; and
- The beneficial owner did not, in the aggregate, own more than 10% of the outstanding shares of the class of stock at any time during the taxable year; and
- The beneficial owner is a non-U.S. person.
In case you are not living in the US and you do not own more than 10% of a company that is traded on a major stock exchange you are going to receive your dividends as ordinary.
Closing Thoughts
To sum it up REITs can be a very good driver of income for your portfolio. They are the perfect solution for people that want to own real estate, but don’t have the capital to invest in properties. Also they have shown the highest annual return mainly driven by their strong dividends.
Still REITs can be risky and you should do a thorough research before investing in them. If you manage to do so you can see some fantastic returns on your investment.
Hope you had a good read and you can now pick some goo REITs for your portfolio. Don’t forget to subscribe if you want to be notified for new articles.
