What Are Real Estate Investment Trusts (REITs)?
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Investors and financial advisors routinely laud real estate as one of the best places to invest your money. Most people are familiar with real estate. They may own a home and possibly rent out a spare bedroom or basement suite – they understand what it entails, investment-wise.
However, not everyone has the means to own and operate a property to generate rental income and realize gains from price appreciation. An alternative way to participate in the real estate market is by purchasing Real Estate Investment Trusts (REIT).
What is a REIT?
A REIT is a company that operates in the real estate industry. REITs own, manage, or finance real estate with the purpose of generating income. They pool capital together from investors and provide returns in the form of dividends and capital appreciation. While some operate as private investment vehicles, most REITs are publicly traded like stocks.
As an investment opportunity, REITs provide investors with access to the real estate market without directly purchasing a property. You can invest in REITs through a mutual fund or by purchasing them directly on an exchange through a brokerage firm.
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Types of REITs
REITs tend to specialize in a certain sector of properties. Below are some of the most common types of REITs you can invest in.
Residential REITs invest in rental apartments and manufactured housing. To maximize income and generate stable cash flow from rent payments, they tend to purchase properties in urban areas, where demand for rental units is high.
The performance of residential REITs depends on factors such as home affordability and the cost of single-family homes. If home prices decrease and mortgage rates drop, homeownership will become more appealing to people, so the demand for rental properties will decline. Conversely, if the cost of owning a home rises, people will be more inclined to rent. For this reason, you should assess the state of the market before investing in residential REITs to determine whether people are more likely to rent or buy a home.
The level of employment, population growth, and vacancy rates are other aspects you should analyze. An economy with low unemployment, an increasing population, and falling vacancy rates is ideal for residential REITs.
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These REITs invest primarily in shopping malls and freestanding retail stores. Much like residential REITs, they generate income from rent charged to tenants. Hence, investments in retailers with reliable cash flow and locations that attract plenty of shoppers are crucial.
The state of the overall economy greatly impacts retail REITs. In a healthy economy, jobs are plentiful, so people are more apt to visit retail stores and spend money. In contrast, people are less eager to shop in a contracting economy and opt to save their cash.
Also, changes in peoples’ spending habits are important to consider. Consumer shopping trends have increasingly shifted toward online retail, resulting in reduced profits for firms still operating mostly physical outlets. Shopping centres have also seen marked declines in traffic.
The best performing retail REITs invest in properties with strong anchor tenants, such as grocery stores, where demand is consistently high. They also find innovative ways to fill vacant locations that they own, such as converting retail space into an office.
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Mortgage REITs are unique in that they don’t directly own any tangible real estate. Instead, they issue mortgages to real estate owners or purchase mortgage-backed securities. They generate income by the interest they earn on their investments in mortgages and mortgage-related assets.
The model that mortgages REITs utilize makes them susceptible to interest rate increases. Should interest rates rise, the value of their holdings would decrease, which would, in turn, depress their stock price, as well as increase their cost to raise capital. However, a period of falling interest rates would have the opposite effect and result in gains in their mortgage portfolio
Healthcare REITs invest in real estate that operates in the healthcare field, such as hospitals, medical centres, and retirement homes. These REITs are one of the safest to invest in, as demand for medical services typically stays high, irrespective of what’s happening in the broader economy.
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Healthcare REITs’ performance is tied to the healthcare system, so an increase in the demand for health-related services will translate to higher returns. The ideal healthcare REIT should be well-diversified and have steady income streams, including facilities that care for an increasingly ageing population.
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These REITs make investments in office buildings and generate rental income from tenants. As a result, they seek to purchase property in locations where demand is high and likely to grow in the future.
The state of the economy and the unemployment rate impact the performance of office REITs. When businesses are expanding their operations, they hire more people and require new office space, which presents opportunities for office REITs to acquire property that can be readily leased. During an economic contraction, however, these REITs don’t fare so well – they may lose considerable income if their vacancy rates climb.
Good quality office REITs own properties in large economic centres, have plenty of capital for acquisitions, and can pivot by finding unique ways to earn income from unused space they own.
Pros and Cons of Investing in REITs vs Rental Income
Before you decide whether to put some of your money into REITs, you should ensure you’re aware of the pros and cons of this type of investment.
- Higher liquidity: REITs trade on an exchange like stocks, making them easy to sell and quickly convert to cash.
- Higher dividend yields: REITs can have high dividend yields and can provide a better return than bonds. The reason REITs have high dividend yields relative to other investments is that they can generate consistent cash flow.
- Invest in commercial real estate: REITs are a great way to gain exposure to commercial real estate, usually out of reach for ordinary investors.
- Portfolio diversification: Proper diversification is crucial for the long-term performance of your investment portfolio. Investing in real estate through REITs is a great way to expose your portfolio to different asset classes. Real estate retains its value more effectively than stocks, especially during market downturns, and offers a more robust income stream.
- Slow growth: Expect to wait a while to generate a significant return on your REIT. Values of REITs are subject to interest rate fluctuations as well as the health of the economy. They provide little in the way of capital appreciation during periods of tepid economic growth and may lose a considerable amount of value during recessions. REITs function best as long-term investments.
- Property risks: REITs are subject to varying types of risks. Their performance depends heavily on the state of the sector they invest in. Adverse trends in the sector can shrink a REIT’s income streams and severely impair its value. For example, a REIT that invests heavily in the hospitality or retail sector is very sensitive to economic downturns; it can experience tremendous losses should the market enter into a recession.
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Buying Rental Property
While there are benefits to owning REITs as part of a well-diversified investment portfolio, it’s worth examining how they compare with directly owning and operating a rental property.
- Have your property paid for by another person: The most significant advantage of owning a rental property is that your renters will provide you with a regular income stream. You can use the funds to pay for all the expenses associated with the rental property. Ideally, you’ll end up with some profit.
- Income from property value growth: Historically, the value of real estate tends to increase over time. Though prices fluctuate based on a wide array of factors, you stand to earn a significant amount of money should you decide to sell the property in the future.
- Takes effort: Contrary to popular opinion, rental property is not a passive investment – it’s more akin to running a small business. You’ll have to devote time and effort to paperwork, repairs, and maintenance. Also, you’ll have to deal with tenants’ issues and possible lawsuits.
- You tie up your money in illiquid assets: A notable drawback of owning a physical property is that it concentrates a large chunk of your assets into a single investment. The problem with this strategy is that your investment portfolio is not well-diversified and vulnerable to huge losses. Real estate is also an illiquid asset; it can take a long time for you to sell it and receive the cash proceeds.
- Cash flow problems: If your tenant fails to pay you, you’ll have no choice but to cover the costs yourself. The longer you operate the property without a tenant, the more money you’ll lose over the long run.
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REITs are an ideal investment for those wishing to add some diversity to their portfolios and those looking to invest in real estate without having to purchase it directly. As with stocks, their value can erode during a recessionary environment. But a proper mix of REITs can provide adequate income and growth for many years and may even outperform other asset classes. As with any investment, ensure you do your research to determine whether they’re the right option for you.
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