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Are REITs Worth Investing In?

Published: 08-09-23 Category: Investing

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You may want to invest in commercial property but don't have the time or resources to deal with everything that comes with direct property ownership. Between acquiring loans, negotiating sales, and closing transactions, investing in commercial real estate will demand a fair share of your time—time you could spend investing elsewhere.

That's where real estate investment trusts, or REITs, come in. REITs give investors exposure to real estate without the time requirements and hassles that come with direct property ownership.

Here, we'll discuss what REITs are, how they work, and whether buying REITs is worth it. Let's get started.

What Are Real Estate Investment Trusts (REITs)?

Real estate investment trusts are companies that buy, finance, and operate income-generating properties. REITs pool investor capital and use those funds to handle the acquisition and management of said income-generating properties so that others can invest in real estate without having to buy, finance, or manage the real estate themselves.

REITs own and manage all kinds of properties, including but not limited to:

Office buildings;
Retail space;
Hotels;
Resorts;
Self-storage;
Warehouses; and,
Malls.

A major difference between REITs and other types of real estate investment companies is that REITs don't buy properties to resell. Instead, they buy properties as part of an investment portfolio.

How Do REITs Work?

The basic idea of a REIT is similar to a mutual fund: Investors invest in the company so it can use those funds to buy commercial property. The company then pays investors dividends from any income those properties generate. Investors can buy REIT shares on the stock market, just like other stocks and securities.

REITs first came about in the 60s after Congress amended the Cigar Tax Extension to allow investors to buy shares in commercial real estate portfolios. To legally qualify as a REIT, a company must:

Be a taxable corporation;
Have at least 75% of its assets in real estate, treasuries, or cash;
Generate at least 75% of income from rental income, mortgage interest, or real estate financing;
Distribute at least 90% of taxable income as dividends;
Have at least 100 shareholders;
Have a board of trustees; and,
Have no more than 50% of its shares owned by five or fewer people.

Investors can generally divide REITs into three main types:

Mortgage: Generates income from mortgage interest;
Equity: Generates income from operating property; and,
Hybrid: Generates income from mortgage interest and operating property.

For example, self-storage REITs that rent individual units would probably be an equity REIT. Most REITs are public and traded on the stock market, but there are also public, non-traded REITs and private REITs that are not registered with the SEC.

Specialty REITs

Most REITs focus on a specific property sector but typically have diversified assets to hedge against losses. Specialty REITs own and operate ‘unique' properties that are not normally part of larger, more mainstream REITs.

Below are some of our favorite examples of unconventional REITs that show promise.

#1 – Data Center REITs

Data center REITs focus on buying properties that house and store servers and other computing equipment. The International Data Corporation (IDC) predicts that global data usage will double by 2026, so data center REITs will have room to grow. The market cap for the top-three largest data center REITs was over $123 billion in 2022.

#2 – Self Storage REITs

Self-storage REITs invest in storage facilities and individual units. Self-storage REITs generate excellent growth and steady income thanks to regular rent and growing demand. Experts predict that the total market cap for self-storage REITs will grow to over $67 billion by 2026.

#3 – Tower REITS

Tower REITs are an interesting alternative investment that focus on buying microwave and communications towers.

Tower REITs can generate steady income because of reliable leases from telecommunications companies. Tower REITs currently have a market cap of over $180 billion.

Can You Really Make Money from REITs?

Yes, you really can make significant money from buying REITs. According to the National Association of Real Estate Investment Trusts (Nareit), REITs as a whole have outperformed the S&P 500 across most timeframes since 1972. In 2021, average REIT returns were 39.9% while average S&P 500 returns were 28.7%.

The real money-maker from REITs is dividends. Since the law requires REITs to distribute at least 90% of their income to investors, REIT dividend yield ratios tend to be high.

According to Nareit's historical dividends records, REITs have overall managed a 4.37% dividend yield over the first six months of 2023, compared to the S&P 500's average dividend yield of 1.66% over the same time period.

The best REITs can have dividend yields as high as 10%, though higher dividend yields indicate more risk.

Are REITs a Good Investment?

Below are just a handful of the reasons why buying REITs can be a good investment.

#1 – Low Barrier to Entry

One of the best features of buying REITs is they have a low barrier to entry. In the past, investing in real estate required large amounts of capital and industry connections. REITs let virtually anyone invest in real estate. Most REITs have minimum investment amounts between $1,000 and $2,500, but some allow investments as low as $100.

#2 – Excellent Returns

Buying REITs can provide incredible returns for investors in the form of dividends and capital appreciation. REITs get special tax exemptions for income that it pays to shareholders, so they can put more of their money to paying investors.

#3 – Flexible and Diverse

As long as the REIT abides by SEC structure and disbursement rules, they can basically buy whatever kind of properties they want.

This flexibility means REITs are a useful tool to diversify assets. Investing in companies that buy non-traditional properties, like data center REITs, self-storage REITs, or cell phone tower REITs can serve as a hedge during market downturns.

#4 – Liquidity

Traditional direct real estate purchases are highly illiquid because it takes time to buy and sell property. REITs are far more liquid as they're traded in the same way that stocks or derivatives are.

What Are the Downsides to Investing in REITs?

Like any kind of investment, buying REITs has its disadvantages.

#1 – Sensitive to Interest Rates and Trends

Given their reliance on commercial properties and mortgages, REITs are particularly sensitive to interest rates. When interest rates go up, REITs have to spend more money covering their debts, which means investors get less money.

#2 – Dividend Taxes

The SEC defines REIT dividends as ordinary income, so they are taxed at a higher rate than capital gains. An investor that has invested significant sums in REITs may have to pay a lot of taxes at the end of the year.

#3 – High Fees

REITs take a lot of work to manage, so management fees can be higher than other kinds of investments, particularly with non-traded REITs. The SEC warns that fees on non-traded REITs can total as high as 9% to 10% of the total investment amount.