What Is a REIT?

Compare Different Types of REITs, How They Work and What to Watch Out For

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Did you know you could acquire the benefits of owning large-scale, income-producing real estate without maintenance calls and constantly having to find new tenants to fill empty rooms?

Here’s why you might want to research adding real estate to your investment portfolio. Let’s talk about REITs.

Related: Just the Basics: 9 Common Ways to Invest

What Are REITs?

REIT stands for ‘Real Estate Investment Trust’ and essentially is a company that owns income-producing real estate.

They are often compared to mutual funds and ETFs but instead of owning stocks, a REIT owns a portfolio of residential properties or mortgages, which may include office buildings, apartments, hotels, and malls. A REIT is unlike other real estate companies because it does not develop and resell real estate properties. Instead, a REIT buys and develops properties to manage them as a part of its own investment portfolio. REITs allow investors to earn a share of the income produced through commercial real estate without having to buy commercial real estate on their own.

REITs must have at least 100 shareholders, and at least 75% of the REIT’s assets must be invested in real estate.

What Types of REITs Are There?

You can invest in either a publicly traded REIT or a non-traded REIT. Publicly traded REITs are typically considered a safer bet because they are listed and traded on a major stock exchange and have liquidity.

This means that when a public REIT is not performing well, investors may choose to sell the underperforming REIT. That is not always the case with non-traded REITs. Non-traded REITs require shareholders to buy and sell shares from the company that manages the trust and often have high up-front fees, sometimes as high as 12%-15% of the investment.

During the recession in 2008, some real estate investment companies halted their REITs. This left shareholders stuck with their investments as real estate values plummeted.

Related: The Seven Layer Dip of Fees to Avoid When Investing

What Are the Benefits of Investing in a REIT?

REITs are increasingly popular because they include a steady income stream and offer a way to include real estate in one’s investment portfolio. In other words, they are required by law to maintain dividend payout ratios of at least 90%. As of August 2016, REIT's have averaged an 11.1% annual return over the past 20 years, compared to 8.1% for the S&P 500 Index, according to Bloomberg. But as with any investment, there are most certainly some risks and limitations. So it is important to research and understand how the REIT you are considering works and operates before you invest. Let’s get into it.

What Should I Look for When Buying a REIT?

One of the important things to know about a REIT before you invest is the quality and structure of its holdings. In the U.S. there are 3 main kinds of REITs: equity, mortgage and hybrid.

Equity REITs invest in and own commercial properties such as apartment buildings, shopping malls and warehouses, so they are responsible for the value of their real estate assets and their income stream comes primarily from leasing space to tenants.

When looking for an equity REIT, you should look for quality space with long-term tenants, so if the property owns a smoke shop or a place like “Big Al’s Bar” you may want to pass.

Mortgage REITs invest in and own property mortgages. These kinds of REITs loan money for mortgages to real estate owners and purchase existing mortgages. Another important note is that REITs are usually focused on a certain category of real estate such a residential (apartment buildings, hotels), retail (malls, shopping centers) or healthcare (hospitals, medical centers). This is essential to keep in mind when shopping for a REIT because an investor should consider the current state of the chosen sector when evaluating the trust. Often, residential focused REITs bind their investments to specific markets, mostly large cities, so the prospects for those economies should also be factored into an investment decision.

Hybrid REITs are exactly what their name suggests. These REITs invest in both properties and mortgages.

A REIT’s management team should have experience and effectively execute each business role from marketing to maintenance. Look for established trusts with a history of maintaining a decent payout across variations of market turns. Make sure to also keep an eye on a REIT’s debt because trusts that use a significant amount of borrowed capital are often more defenseless when interest rates rise.

REIT’s high annual return and steady income stream may seem like a dream to your investment portfolio but don’t overload on those investments. Here, at Wela, we suggest REITs should compose no more than 5%-10% of your portfolio. Diversification is best so your REIT distribution should be spread across multiple real estate categories. One option is to invest in a REIT ETF, which will add diversification to your portfolio and a basket of REITs that hold different baskets of properties and mortgages.

Related: ETFs VS. Mutual Funds - Which Is Right for You?

The real estate industry is a key component of the U.S. economy and REITs make it possible for individual investors to own and take part in commercial real estate. If you are looking to add REITs to your portfolio contact an advisor at Wela to help with any questions you may have. If you choose wisely and research your options you may find that REITs could be the perfect addition to your portfolio.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Matt Reiner is CEO of Wela. As a founding partner and Portfolio Manager, Matt also coordinates the Investment Committee and translates the decisions into trades and allocation adjustments within the Wela Models. Matt also serves as a Partner for Capital Investment Advisors (CIA). Matt uses his experience and education in Financial Services to craft the digital advisor experience to bring users the same level of personalization they would receive from a traditional financial advisor.