How to Invest in Real Estate Without Buying Property
Posted: May 6th, 2008 | Author: Joe | Filed under: Investing, Real Estate | Tags: Investing, Real Estate, REITs | 1 Comment »
Since the housing bubble burst and the subprime lending mess hit the headlines, it seems like I can’t take a virtual stroll down the information suburbs of personal finance blogs without tripping over posts about why people shouldn’t buy homes, or real estate.
My Two Dollars, for instance, has a very good post about why people should wait to buy a house until they can really afford to AND actually need a home.
To be fair, that post is really more about buying a house for housing with investment as a secondary goal. It’s not what this post is about, but it is an important distinction that often times people forget to make. All too often we hear what a great investment real estate is as if that alone were justification for buying a home. (HINT:) It’s not.
Free Money Finance wrote about his take on a Money Magazine article comparing the performance of real estate assets vs. equities in his post “Investment Smackdown: Are Stocks or Real Estate a Better Investment?”
But sometimes people don’t really need (or want) a home. Sometimes renting makes more sense, but they still want to diversify and own real estate as well as stocks. It isn’t always an either/or proposition.
For those who want some real estate exposure without the hassle of finding, maintaining and selling the physical piece of property, they should investigate REITs.
Just last month, The Dividend Guy was Considering REITs In a Dividend Portfolio. He does a fine job of highlighting why dividend or income investors are drawn to REITs.
What the hell is a REIT?
OK, sounds good so far, but what exactly is a REIT?
A REIT (Real Estate Investment Trust) is a type of security much like a stock, that invests only in real estate. REITs were created in 1960 when congress ratified the Real Estate Investment Trust Act. This act allowed small investors to invest in large scale real estate. A REIT is traded on the major exchanges, just like common stock.
It is because they are traded publicly that REITs offer investors the ability to diversify their portfolios with real estate without actually owning the underlying property. Often times, REITs are used to provide stable income in a portfolio, much like bonds. Unlike bonds however, REITs are not eroded as much by inflation. This is because REITs often generate their income from commercial properties with long lease periods and they can pass along the cost of inflation in rent increases.
REITs can either hold real estate property directly, or hold the mortgages to those properties. There are three general classification of REITs: Equity, Mortgage and Hybrid.
Equity REITs invest directly in properties. They derive their name from the fact that they are responsible for the equity (value) of their real estate assets. The majority of an Equity REIT’s revenue comes from the rent collected on the property. An Equity REIT might hold commercial or residential property, or a mix of both.
Mortgage REITs invest purely in mortgages by either lending the money to borrowers directly, or buying existing mortgages or mortgage-backed securities. A Mortgage REIT’s revenue comes from the interest earned on the mortgage loan.
Hybrid REITs are just as the name suggests, a mix of Equity and Mortgage REIT qualities. They generate revenue from Mortgages and physical properties.
These are important distinctions as I write this post, because the subprime fiasco has so panicked many investors that some REITs are down considerably from their highs in many cases simply because they are too tightly coupled to real estate. The reality is that Equity REITs shouldn’t really be affected as much as Mortgage REITs, because the physical property held by Equity REITs is still worth something while a defaulted mortgage is probably worthless.
REITs can invest in residential or commercial properties and mortgages. For example, a REIT might invest in private rental properties or in public shopping malls and business rentals. They may even be focused on specific geographical or demographical segments, retirement communities in Florida, for example.
REITs and Taxes
REITs were created to allow investors to invest in real estate in the same way an investor could invest in stocks through a mutual fund. Because a REIT is an investment entity, and not a business, it receives special tax benefits limiting its corporate tax liability. This means that REITs are required to pay out 90% of their income in the form of dividends to the investor that holds them. So you have an asset that trades like a stock, has significant real estate exposure and often carries a high yield – and you don’t have to shovel out a cranky tenant or repair leaky toilets!
REITs are not without disadvantage however. In 2003, Congress enacted legislation that cut the rate of taxation on dividends to 15% regardless of the recipient’s income tax bracket. This does not affect REITs dividends however – they are exempt and investors will most likely have to pay taxes on any dividends received from a REIT at their ordinary income tax level.
There are times when REITs pay out distributions that are considered “Nontaxable” distributions that are considered capital gains for the recipient and taxed accordingly. See Things to look out for when buying a REIT below for more detail.
The Inner Workings of a REIT.
Publicly traded REITs begin life on the exchange just like common stock – an initial public offering (IPO). The REIT accumulates capital from investors purchasing shares of the IPO, and uses these funds to buy, develop and manage real estate. The investor receives partial ownership in the pool of realestate assets owned and managed by the REIT. The REIT then passes along any income generated by the renting, leasing or interest on a mortgage to the share holders in the form of dividends.
Investing in REITs.
NAREIT (The National Association of Real Estate Investment Trusts) categorizes REITs into 3 types: private, publicly traded and non-exchange traded.
REITs that are classified as private or non-exchange traded are not registered with the Securities and Exchange Commission, and raise capital from individuals, trusts and other entities. These are for a privileged few, and will not be part of the remainder of this discussion.
But do not despair – even after eliminating these types, we’re left with almost 200 publicly traded REITs! These REITs are listed on the New York Stock Exchange (NYSE), NASDAQ, and American Stock Exchange (AMEX) and are open for trading like any other common stock.
Buying REITs is as easy as buying stocks. Shares in REITs can be purchased individually on the open exchange through your brokerage firm, or through mutual funds that focus on real estate. Another key factor here is that they are just as easy to sell. They carry some more risk that traditional real estate holdings, but they are much more liquid and provide a positive cash flow without the overhead of being a landlord.
Things to look out for when buying a REIT.
While past performance is no guarantee of future return, investors should pay special attention to the history of a REIT’s dividend payments. If they seem unduly high (in relation to other REITs) then there is something to be concerned about. It may mean the REIT is paying out more than its income, and that means decreasing capital or equity over time. Sometimes an increase in capital gain distribution can be a sign of non-recurring events (maybe the REIT has sold a property that it had been renting out for income). While such events are not necessarily a warning sign, they do cause the yield to increase for the short term and are not likely to continue. However, if an equity REIT is selling off large portions of its property it relies on for rental income, then it is likely one to avoid.
The most popular method of valuating a REIT is by measuring the funds from operations (FFO). The definition (from NAREIT ):
“FUNDS FROM OPERATIONS means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis.”
FFO is essentially a means to measure a REIT’s cash flow, less administrative and financing costs.
In case you’re wondering where FFO originates, money.howstuffworks.com describes it so:
Under generally accepted accounting principles, net income typically assumes that the value of assets goes down over time — somewhat predictably. Real estate generally retains or even increases in value. On the balance sheet under GAAP, however, land remains at its historical cost and buildings gradually depreciate to zero. Since a REIT’s primary business involves real estate, the depreciation charges negatively skewed the company’s true profitability. FFO was adopted to address that problem by excluding depreciation costs from the net income figure.
Beware - not all REITs calculate FFO using the NAREIT recommendation. Sometimes items such as maintenance, and repairs can skew the figure. Be sure to read the company’s full report for supplemental disclosures!
While a REIT must distribute at least 90% of its income to shareholders in the form of dividends, a REIT can sometimes distribute MORE than its income. This is termed a “return of capital” and if it reduces the basis cost of the REIT to zero, then the remainder of the return is taxed as a capital gain. Even with FFO it is sometimes difficult for investors to predict which category of income (capital gains or dividends) a REIT will distribute in any given year. The good news is that NAREIT has reported that each year since 1998 the proportion of distributions qualifying for the lower tax rate has risen.
REITs are typically considered an income producing asset, but they may at times produce growth (stock price appreciation) when certain conditions are favorable, such as an appreciation in the underlying market (property appreciation for equity REITs, or changes in interest rates for a mortgage REIT for example).
REIT ETFs and Index Funds.
Remember – REITs trade like stocks, and that means they come in ETFs and Index Funds just like stocks. These can make convenient alternatives to buying individual REITs. ETFs are a basket of REITs and so offer instant diversification within the REIT class of investment instruments.
Barclay’s offers two REIT index ETFs: one based on the Dow Jones U.S. Real Estate Index (IYR), and one based on Cohen & Steers Realty Majors Index (ICF). ICF has an expense ratio of 0.35% and IYR is 0.60%. A third alternative is the Vanguard REIT ETF (VNQ) with an expense ratio of 0.12%. Oh, and here’s one more for a round 4 ETFs to choose from: the Dow Jones Wilshire REIT index (RWR) with an expense ratio of 0.25%.
The performance of these ETFs track very closely together, which is not surprising since they each hold the same underlying REITs, albeit in differing proportions.
As I write this, the ICF yields 4.16%, IYR 4.55%, RWR 5.01% and VNQ yields 5.03%. All things being (mostly) equal, except the expense ration, I would probably lean heavily toward the VNQ. But that’s just me.
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Photo ©: James White
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