Real Estate Investment Trusts, or REITs, are best described as a form of mutual fund in which the underlying assets are various forms of real estate. REITs use a pool of money collected from investors to generate income through leasing, renting or selling properties.
There are three basic types of REIT:
- Equity REIT – Properties are generally owned and held for investment, and revenue is generated from rent.
- Mortgage REIT – These funds own the mortgage debts on properties instead of the properties themselves. They generate income through interest on the loans.
- Hybrid REIT– They combine property- and mortgage-ownership, thus generating revenue from both rent and interest proportionate to the ratio of the holdings.
REITs can be purchased directly through open exchanges or indirectly through real-estate specific mutual funds. They may be targeted to a particular type of real estate (shopping malls, for example), a geographic area, or some other niche; or they may be intentionally diversified to provide added safety, along with income.
A major benefit of REITs is their requirement to distribute at least 90% of the annual taxable income to shareholders in the form of dividends. Thanks to timing issues, they have been known to distribute more than 100% of earnings.
REITs are generally less volatile than stocks, and also have unique tax advantages that generally translate to higher yields compared to other fixed-income vehicles. The downside is that they are not a particularly liquid investment. Real estate transactions take time.
How do REIT's do in the market? Pretty well, in general. As of May 2014, the average return on REITs is 8.6%, in contrast to the S&P 500's 1.8% return.
In fairness, that reflects the change in a relative beating REITs absorbed through the housing crisis in comparison to stocks. However, according to data on publicly traded REITs produced by the National Association of Real Estate Investment Trusts (NAREIT), REITs compare favorably with five-year and greater historical returns, with equity REITs frequently beating the Dow, NASDAQ, S&P 500 and Russell 2000.
Before investing in an REIT, make sure you have clearly defined your goals. Are you looking for a relatively stable source of income? Are you trying to balance the volatility of your market holdings with something less volatile and less coordinating with your holdings? Are you looking for inflation protection?
Answer those questions, and then assess the nature of the REIT's holdings to verify that it matches your goals. For example, if reducing the correlation to your stocks is important to you, you probably do not want a publicly traded REIT. If income is important to you, you will want something with a proven, steady track record of dividends – not necessarily the highest-yielding one.
Just as with stocks, it is better to assess a REIT's value through cash flow rather than yields – specifically for REITs, use the AFFO (Adjusted Funds from Operations), as it is the true residual cash flow that is available to shareholders.
REITs have a cyclic nature like most investments, but different holdings will be affected by different indicators. For example, hotel holdings are going to be more volatile and dependent on the economy in general, while holdings in places like health care facilities and data centers are more stable and less prone to short-term economic influences.
Do your research and you, too, can be a successful investor in real estate just like Donald Trump – albeit on a lesser scale, and without the flamboyant comb-over.