REIT Investing: An Inexpensive Way to Build a Diversified Real Estate Portfolio

Real estate investing is a popular way to diversify your portfolio and your income streams. But buying rental property can require significant capital and hands-on effort to manage tenants. Owning a small number of properties in a certain area could also put you at risk if the real estate market declines.

A real estate investment trust (REIT) could help to solve these issues with a single investment. Investing in a REIT is generally a less expensive, more hands-off approach to real estate investing. Plus, it can offer immediate diversification, which could offer some protection against market downturns.

In this article, we'll share how investing in REITs works, the types of REITs available, and how to invest in REITs.

How does REIT investing work?

Real estate investment trusts (REITs) are the real estate equivalent of a mutual fund, but with a more hands-on approach. Typically, REITs have professional managers that research potential acquisitions, then manage operations and try to increase a property's value and cash flow. REITs offer immediate diversification for your money, even if you've started investing with a small amount.

When you invest in a REIT, you don't own any of the underlying properties directly. Instead, you buy shares in the corporation, LLC, trust, or other entity that owns or manages the properties. Some REITs do not own any properties. Instead, these REITs finance real estate purchases for other investors or manage properties owned by someone else.

REITs don’t pay corporate taxes on their earnings. Instead, they’re pass-through entities like a limited liability company (LLC). This makes them an attractive choice for investors seeking income because they tend to offer high-yield dividend payouts. However, by law, REITs must follow certain rules to receive their tax-advantaged status:

• At least 75% of its assets are invested in real estate
• Generate at least 75% of its gross income from rents or real estate mortgages
• Distribute at least 90% of its taxable income as dividends
• Have at least 100 shareholders
• Be no more than 50% owned by five shareholders

The dividends paid out by REITs are considered ordinary income for investors. Because ordinary income tax rates are typically the highest, best practices suggest holding REITs in a tax-deferred account such as an individual retirement account (IRA), 401(k), or health savings account (HSA).

In reality, that may not be necessary for the average investor. Unless you are investing a significant sum in REITs or are in a high tax bracket, your taxable income will likely be small enough that it won't affect your taxes much.

If you have questions about how taxes work, read our guide to REITs for more in-depth information on how REIT distributions could impact your taxes.

How REIT investments are structured

As with most investments, when you are investing in REITs, there isn't one single investment option to choose from. There are different ownership structures, liquidity, industries, and other features that set one REIT investment apart from the others.

When you invest in REITs, the way that the REIT is set up often determines the terms of your investment. REIT investments are generally structured as follows:

1. Publicly traded REIT stocks

Publicly traded REIT stocks can be found on major stock market exchanges and can be bought and sold at any time. These investments are highly liquid and you can easily determine their value based on current stock prices. As publicly traded stocks, these REITs have financial disclosure requirements and conflict of interest rules to protect investors.

Who they’re right for: REIT stocks could be ideal for investors with some investing experience with a brokerage account.

2. Publicly traded REIT mutual funds and exchange traded funds (ETFs)

Mutual funds and ETF REITs provide further diversification for investors. With this type of investment, you’re generally investing in numerous REITs. Depending on the fund, you could get exposure to a variety of sub-sectors or a specific niche.

Who they’re right for: Funds could be a good choice for beginner investors unsure of how to pick individual REIT stocks and seeking diversification to reduce their risk, though some do have investment minimums.

3. Private REITs

Private REITs don’t trade on public exchanges and are not registered with the U.S. Securities and Exchange Commission (SEC). Because they aren’t publicly traded, they don’t have to disclose the same level of information as a public company does.

Who they’re right for: Private REITs tend to be illiquid and have larger minimum investments, which could make them better suited for institutional and accredited investors.

4. Public non-traded REITs

Public non-traded REITs are registered with the SEC, but they are not publicly traded. Although they do have financial disclosure requirements, they tend to be illiquid and carry high management fees.

Who they’re right for: Non-traded REITs are generally best suited for experienced investors who do not need access to their capital for many years.

5. REIT preferred stock

Preferred stocks often perform like bonds and receive their dividends ahead of other stock investors. The value of REIT preferred stocks generally changes in response to interest rates more than the value of the assets held by the REIT.

Who they’re right for: Because REIT preferred stocks tend to fluctuate in value less than typical REIT shares, they are generally best for investors who want the income of a REIT without the price volatility.

Types of REITs

REITs also typically fall into two categories: equity REITs and mortgage REITs (mREITs.) For instance, you might invest in a mutual fund focused specifically on equity REITs or a publicly traded mREIT stock. Both categories of REITs may also focus on specific types of properties, like office buildings or apartment buildings.

Equity REITs are real estate companies that own or operate income-producing properties. Most REITs operate as equity REITs, so this is generally the default type when someone is talking about how to invest in REITs.

mREITs purchase or originate mortgages and mortgage-backed securities (MBS). An mREIT's income is derived from loan interest, whereas an equity REIT's income is from rental income and capital appreciation. Just like equity REITs, there are several investment options for mREITs, such as stock, fund, and non-traded REITs.

Additionally, certain REITs focus on specific real estate property types. Property types can touch a number of different industries or facets of our daily lives, such as:

• Office REITs
• Industrial REITs
• Retail REITs
• Residential REITs
• Data center REITs
• Self-storage REITs
• Health care REITs
• Senior care housing REITs

Benefits of REIT investing

• Immediate diversification in real estate assets
• Opportunity for high-dividend yields
• Passive real estate investing with professional management
• Potential for long-term capital appreciation

Risks of REIT investing

• REIT distributions are taxed as ordinary income
• No control over the assets within the REIT
• Lack of liquidity in non-traded REITs

Are REITs a good investment?

When people ask "are REITs a good investment?" the answer is, it depends on your goals and tax situation. If you’re interested in real estate but don’t want to purchase or manage individual properties, REITs could be a good option to help you build a diversified portfolio. They also offer some of the highest-yielding investment options available.

However, REITs must distribute at least 90% of their taxable income to avoid paying federal taxes. For investors, this means that their dividends are taxed as ordinary income. Because of this, REITs are usually best held in a retirement account instead of a taxable brokerage account.

Make sure you consider if a REIT aligns with your investing strategy and the tax implications before you invest. Just as you would with another type of investment, taking the time to evaluate a REIT’s financial performance is also a good idea.

How to evaluate REITs

For those interested in investing in REITs, knowing how to analyze a REIT’s financials is key. You want to make sure that its objectives and performance align with your goals. As a REIT investor, you'll need to learn relevant terms, such as funds from operations, interest coverage, and debt-to-EBITDA. Here’s some insight into those terms:

Funds from operations (FFO)

Because of a REITs ability to pass through income to investors, the traditional metrics that you use to evaluate a stock, such as earnings-per-share (EPS) and price-to-earnings (P/E) ratio, are not relevant.

Instead, the industry term to pay attention to is called funds from operations (FFO). This metric is a measure of a REIT's cash flow that excludes one-time events, non-cash items, and distributions to investors.

Interest coverage

Interest coverage is the ratio of a REIT's FFO compared to how much interest it pays on its debts. This metric tells an investor how much cushion a REIT has. The higher the ratio, the more likely a REIT is to be able to make its debt payments in case of financial distress.

Debt to EBITDA

This ratio helps investors understand how much debt a REIT has compared to its pre-tax annual earnings. EBITDA is a company's earnings before interest, depreciation, taxes, and amortization. EBITDA strips out non-cash items, such as depreciation and amortization, and variables that aren't related to operations, such as financing and taxes. This could simplify the process of comparing REIT investments.

When the EBITDA ratio gets too high, it can signify that the REIT is overleveraged. Some investors look for a ratio of 6:1, but this ratio can change depending on the REIT's sub-sector. The best approach is to compare the REIT's debt-to-EBITDA ratio against peers investing in that same niche. This will help you to understand if it has an above- or below-average debt load.

How to invest in REITs

If you want to know how to invest money in REITs, there are several options you can use to make your first investment. REITs are often purchased through a traditional brokerage account or a FinTech crowdsourcing platform.

Once your brokerage account is open, you can choose to invest in REIT stocks, mutual funds, or ETFs. For individual stocks, use the brokerage's tools to research REIT metrics like those discussed above. When investing in REIT mutual funds and ETFs, look at historical performance and expense ratios.

You can also invest directly in REITs through real estate crowdfunding platforms. These platforms allow you to invest in specific properties, funds, or REITs. The REITs on these platforms are generally either private REITs or non-traded REITs. DiversyFund or RealtyMogul are two platforms to consider if you’re interested in this option:

• DiversyFund is a real estate crowdfunding platform where investors can invest in a non-traded REIT. With just $500, you can buy into its crowdfunded Growth REIT and invest in multifamily commercial property. To learn more, read our DiversyFund review.
• RealtyMogul is a real estate crowdfunding platform for investors to invest in private placements and non-traded REITs. The company offers two REITs with a $5,000 minimum investment. One REIT is focused on generating a higher dividend, while the other's goal is long-term capital appreciation. To learn more, read our RealtyMogul review.

FAQs

Bottom line

Investors learning how to invest in real estate might consider investing in REITs. REITs offer diversification, professional management, and passive income. Many investors choose to invest in REITs through their brokerage account or fintech crowdsourcing platforms such as DiversyFund or RealtyMogul.

REIT dividends are taxed as ordinary income, so investors will generally want to hold larger investments in a tax-advantaged account, such as a Roth IRA or 401(k), to avoid high tax bills.