Real Estate Investing Continued: An Intro to REITs (Real Estate Investment Trusts)

My name is “Nixon” and I’m a money addict.  From close to 7 figures invested in equities, to multiple 7 figures invested in all types of real estate, if it makes money you have my attention.  However, these and other investments are currently side hobbies as my day job entails being one of the primary executives at a Real Estate Investment Trust (REIT).

I’ve worked at a few different REITs in my career and have probably done some type of business with the WSPs or their peers.  I’ve probably even rubbed elbows with the WSPs in Midtown and didn’t even know it.  Probably at a property that was owned by a REIT.

Do you want to invest in a Manhattan skyscraper or maybe even a hotel in Beverly Hills?  REITs are your best bet.  Let’s get started.

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What is a REIT?

A REIT is a company that invests in real estate either through owning properties or through providing mortgages, while distributing at least 90% of their income to shareholders (You) in the form of dividends.  

There are considered to be four main “food groups” in real estate investing and this is where most REITs invest:  multifamily, office, retail, and industrial.  Besides the four food groups, there are numerous other types of real estate that REITs invest in:  storage units, hotels, single family houses, hospitals, golf courses, student housing, data centers, timber, etc.  Most REITs like to specialize in a specific area of real estate, but some will invest in as many types as they can.

REITs are basically spread investors, investing at cap rates that are greater than their cost of capital.  The lower their cost of capital, and the higher the *risk-adjusted* return, the more money they are going to make.  Note that REIT earnings are referred to as “Funds from Operations” (FFO) and not “Earnings Per Share” (EPS).  FFO adds back depreciation (massive non-cash expense for REITs) in order to get closer to a true cash flow metric.

Dividends are typically paid to shareholders (You) quarterly, although some, such as Realty Income (NYSE: O), pay dividends monthly.  If you’re gearing up for financial independence (or generating passive income), this is a fantastic way to get part of your income.  Also, REITs typically increase their dividend payouts every year, and some REITs increase their dividend payouts multiple times a year.

Why Invest in REITs?

1) Income/Total Return:  My favorite feature of REITs are the juicy dividends.  The average dividend yield for REITs is in the 4% range (some even pay in the double digits!) while the average dividend for the S&P 500 is in the 2% range.  REIT total returns have also typically exceeded the broader stock market over the long term when looking over various 20 and 30 year periods.

2) Ease:  If you’re still nervous about investing in real estate after reading OwnMyHood’s excellent post , there is no easier way to get started than buying shares of a REIT.  No repair calls, no chasing tenants for rent, no signing on the dotted line for mortgages, etc.

3) Liquidity:  Maybe you need to sell your real estate quickly in order to take advantage of another opportunity, or maybe you’re feeling bad about the real estate market and want to exit.  You can sell REIT stocks in seconds with a couple clicks of a mouse and get your cash out quick and easy.  If you’re investing in physical real estate, you’re probably talking a few weeks to a couple months (maybe more) to get liquid.

4) Diversification:  REITs invest in hundreds or even thousands of different properties in various locations (including outside the U.S.), so if one of their properties goes bust, it’s only a minor blip on the radar.  As mentioned above, some REITs also invest in multiple asset classes, so if one asset class is underperforming, another is likely outperforming.  Also, REITs are a great way to get some personal investment portfolio diversification when added to your bonds and other equities.  Lastly, you’ll get access to properties and areas you wouldn’t otherwise have access to on your own. 

How do I invest in REITs?

There are publicly-traded REITs and private/non-traded REITs.  This post is focused more on publicly-traded REITs, because if you have access to purchase shares in non-traded REITs then you are probably accredited, which means you shouldn’t be reading this post anyway (although I know for a fact there are *numerous* accredited investors that frequent this site!).

Nearly 200 REITs are listed on the NYSE and can be purchased through your brokerage just as you would any other stock.  There are numerous resources out there to help you analyze a REIT, including if you want pinpoint a certain asset class.  Google is your friend.

I personally invest in several individual REITs in which believe in the strategy and long term strength of their portfolio.  No, I will not share which companies, as you’ve read numerous times already that you never give away all your money-making secrets. 

However, for the average investor I’d just recommend DCA investing in the Vanguard REIT Index (NYSE: VNQ).  I also invest here due to the diversification benefit of investing in over 100 REITs (in addition to the other diversification benefits listed above), along with the tremendously low expense ratio of 12 bps. 

Note: potential inefficiency from inflows towards ETF/passive investing has been on my radar and has also been mentioned several times by WSPs.  If you don’t understand that sentence, maybe WSPs will educate with a future post.

Taxes and Dividends for REITs

Because REITs distribute most of their profits through dividends, they are exempt from paying taxes to the IRS.  Instead, the shareholders (You) pay taxes on that income through the dividends you receive from the REIT.  These dividends are generally taxed at your ordinary income tax rate vs. the qualified dividend tax rate.  This means the IRS takes a larger chunk in taxes of the dividends paid from REITs than dividends paid from other companies.  

However, because REITs distribute most of their income, dividend yields are typically higher for REIT stocks, as are the net after-tax yields.  For example, SPY (the S&P 500 index with mostly qualified dividends) currently has a yield around 1.9%, whereas VNQ currently has a yield around 4.4%.  After tax yields for VNQ (depending on your tax rate) are roughly 3%, whereas SPY is closer to 1.5% even taking into consideration the lower qualified dividend tax rate.

Note that because of the higher tax rates on dividends, REITs may be an excellent option to invest in within a tax-advantaged account like an IRA or 401K.

REIT Investing vs. Do It Yourself Real Estate Investing?

The short answer is both, however DIY may not be an option depending on your situation.  If you’re looking for easier, or more liquid/diversified, real estate investing then REITs are probably for you.  But if you’re willing to work hard, you can *absolutely*build more long term wealth through DIY.  If you’re not willing to work hard you’re probably a normal person (looking for a magic pill) that stumbled onto this site by accident and won’t last too long. 

That’s the high-level overview of REITs according to Nixon.  Thanks to the WSP for handing over the keys for another real estate post (terrible pun intended)!

As always, I’ve gotta run, the money’s calling!

– Nixon

(Full disclosure: long VNQ)

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WSPs Note: Similar to the prior guest post from ownmyhood, after vetting their credentials we’re allowing Nixon, RE Guy and Ownmyhood to post on Real Estate if they feel like giving blogging a try here and there with their free time. We would love to highlight that Nixon sent us this article during the “Final Four” because as he’s mentioned in the past he cares more about making $$ than watching dudes run around with a basketball. Since there is a recommendation by Nixon in the post regarding VNQ we are providing an overview of VNQ below.

Vanguard REIT ETF (Ticker: VNQ):  The Vanguard REIT ETF is set up to 1) track the performance of the MSCI US REIT Index (which covers about 2/3 of the US REIT market, 2) build positions in REITS with a minimum requirement of $100M in market cap and 3) own and manage properties in retail, office, residential apartments & industrial spaces. From a market sub-segment perspective as of this writing the mix of investments is as follows: (Retail REITs 21.6%; Specialized REITs 16.5%; Residential REITs 15.7%; Office REITs 13.9%; Health Care REITs 12.3%; Diversified REITs 7.8%; Hotel & Resort REITs 6.1%; Industrial REITs 6.1%)

From a ETf Overview Perspective: 1) Dividend Yield of 4.4% today, 2) 0.12% expense ratio, 3) ~$65B in net assets, 4) 158 holdings, 5) Turnover rate of 6.70%

Comments

  1. WR says

    Question for Nixon. Difference in investing $80k in REITs vs. buying a $400k property with 20% down? Why buy physical property if you can invest in REITs?

    • WR says

      Looking for a more extended / detailed discussion that the “REIT Investing vs. Do It Yourself Real Estate Investing?” section above.

    • Wall Street Playboys says

      We’ll answer for him. Leverage.

      7 year arm 20% down, low interest rate, leverage on upside as you improve the property = bigger potential return than the REIT

      $80K down on a $400K property example. If it goes to $600K then you sell, you get $280K back vs. the $80K put in or a 2.5x return (200/80). To make this even simpler, the chances a REIT sees a 50% upside is pretty low, even in that case you’re not gonna get 5x buying power (20% down) so your returns are capped lower versus a physical property.

      Downside: The flip of this is that you’re stuck with a higher risk property. A reit exposes you to tons of properties. If you buy the wrong one (same example) $80K down and the value goes to $300K you’re crushed because you now owe $320K on a property worth $300 or -$20K in value.

      In broad terms, single property with leverage = higher risk higher return.

      • OwnMyHood says

        Great post. Thanks for sharing this.

        Both Nixon and WSPs responses are right on the money as far as this question goes.

        Though I’m guessing Nixon would include this in the “control” portion of his breakdown, I’ll expand just a bit:

        One of the biggest differences between DIY and investing passively in a REIT is that while REIT returns are generally driven by the market (though competent management makes a difference) in DIY *you* have the power to increase returns relative to the market through strategic improvement of your properties.

        Though, you could always try investing in VNQ and then calling Jack Bogle and giving him some pointers on how to run his REIT ETF…

  2. OwnMyHood says

    How do REITs find RE to buy? Do they mostly deal in stuff listed publicly, or do they reach out to owners and ask them to sell?

    Do owners ever approach the REIT looking to sell to them?

    • Nixon says

      Great question. REITs are looking at deals from all angles.

      I’ve primarily focused on large class A office and luxury hotels in major metros (NY, SF, LA, Miami, etc.). Most of this stuff trades back and forth amongst REITs, Private Equity firms, insurance companies, and other institutional investors like pension funds. Maybe 7-10 year hold periods depending on the strategy and where we are in the cycle.

      Most of the time a broker/investment bank is engaged to ensure price maximization, and the brokers will reach out to as many potential buyers as possible. Other times deals are off market and shopped to a handful of parties. Most REITs have sizable investment teams also proactively trying to source deals.

      A great way to make serious money right now is to be a developer that takes advantage of the pricing arbitrage between developing a property at cost and selling in the open market to REITs or other firms upon stabilization. For example, developing a new property may cost $100M between land/labor/materials, etc., but since commercial properties sell in the open market based on the income generated, that same $100M property could be worth $150M after leasing up a property for a year.

      By the way, a lot of foreign money entering the US as of late buying up high end real estate!

      • OwnMyHood says

        Thanks for the detailed answer.

        As far as the foreign money goes, I’ve heard the same thing from my contacts in higher end markets. A lot of $ coming from countries that have had some destabilizing events recently. It seems those buyers don’t care what they pay as long as they know their investments will retain some value, making it even tougher to make a buck in those markets.

  3. JP says

    How much of the outperformance of REIT’s has been attributable to lower rates over the last few decades? Moreover, seems tough to advocate currently getting long REIT’s ahead of rates grinding higher.

    • Wall Street Playboys says

      This is one we struggle with, we are not heavily involved with REITs right now (own a minimal amount just for exposure). Would be interested in how interest rates will impact performance since in theory it should be a negative if rates go up.

  4. Wolfinsheepsclothing says

    Does real estate tend to lag behind the real economy? (Source PM in REITs during internship) and what stage of the cycle are we in? Has interest rates skewed performance?

  5. Bromani Jones says

    What’s the best real estate book that I can buy that will build upon my knowledge which I’ve learned upon these last couple of posts?

    P.S. Don’t worry WSPBs, I’m still going to buy your book.

      • Eggplantzzz says

        Is there any planned release date for your book? I can’t wait to get my hands on it!

      • Bromani Jones says

        Also- I bet WSPB didn’t believe there would be a day where a “Bromani Jones” and “Eggplantzzz” would be commenting on their blog. As Don King would say, “Only in America!”

  6. says

    Can you guys do a post about gambling in the crypto currency market? Been wanting to buy Ripple(XRP, Bitcoin(BTC) and Ethereum(ETH) lately and would loive to hear your thoughts since they seem to be gaining popularity.

  7. Imran says

    Nice article but return isnt as promising as it sounds like tho. You’ll get $240/month to pay your cell and internet bill for say 100K investment in VNQ? Whats the fun in that? With little knowledge of tech trends and whats coming people can do much better I guess.

  8. says

    ” If you’re not willing to work hard you’re probably a normal person (looking for a magic pill) that stumbled onto this site by accident and won’t last too long. ”

    Dammit! I guess I’m a normie.

    I’m willing to invest in real estate DIY but how much time do I have to spend with actual manual labor? I suck at fixing things is it realistic to figure stuff out on the fly if I get into real estate?

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