This guest post is from Ben Reynolds and Samuel Smith of Sure Dividend. You may remember Ben from his other guest posts – How I Became a Successful Dividend Growth Investor and Reached Early Retirement by Investing in Dividend Growth. REITs are a topic that comes up a lot with readers of Making Sense of Cents. So I’m glad the Sure Dividend experts are talking about this topic today. Enjoy!
Ben Reynolds with a sure dividend here. Sure Dividend is focused on helping individual investors build high quality dividend growth portfolios.
To that end, I wanted to educate readers of Making Sense of Cents about the possibility for investors to invest in real estate in a variety of ways through Real Estate Investment Trusts (REITs).
We started covering REITs at Sure Dividend back in 2016 as they have unique characteristics that make them a compelling choice for investors looking for up-to-date income and earnings growth.
Our audience at Sure Dividend was interested in learning more about REITs, so we did our research.
I learned how REITs are legally required to pay out at least 90% of their income to their shareholders.
This is a powerful concept, which means that REITs share the vast majority of their earnings with investors.
I’ve learned that REITs have special tax breaks that make them more efficient to pass income on to investors.
And I’ve learned how easy it is to invest in and diversify publicly traded REITs versus traditional real estate.
These characteristics have shown us that we need to cover REITs because of the benefits they offer high income investors. Read on to find out more about this particular asset class.
The term Real Estate Investment Trust was established by the Congress of the United States in 1960 and has since been introduced worldwide to describe a special tax-privileged instrument for collective real estate investment.
We have put one together List of publicly traded REITsas well as key financial metrics such as dividend yields and market capitalization.
Similar to mutual funds with companies, REITs allow investors to invest in a diversified real estate portfolio without having to buy, manage and finance real estate themselves.
F.In addition, most REITs are publicly traded on an exchange, allowing investors to participate in owning large, well-diversified real estate portfolios, just as investors would invest in any other industry.
REITs are structured as corporations, but are unique in that they are exempt from corporation tax as long as they meet certain quality rules for REITs. According to NAREITmust be a REIT:
Invest at least 75% of total assets in real estate.
Derive at least 75% of gross income from property rentals, mortgage interest income, or property sales
Every year shareholders pay at least 90% of their taxable income as dividends.
Have a board of directors or trustee.
At least 100 investors must own shares in the REIT.
Fifty percent or less of its shares may be held by fewer than six people.
These rules are designed to protect shareholders, ensure discipline in allocating capital and reduce conflicts of interest between managers and shareholders.
Why invest in REITs?
In the past, REITs have achieved an average of 15% per year and clearly outperformed all other asset classes:
REITs were hugely lucrative for investors who got in early and knew what they were doing. In addition to providing higher total returns, REITs generally pay higher dividends, are less volatile, and offer valuable inflation protection and diversification benefits.
About 90% of millionaires attribute real estate investments as a significant contributor to their net worth. REITs allow you to invest in real estate, adding the benefits of professional management, diversification, liquidity, low transaction costs and passive income.
How do I invest in REITs?
Investing in real estate is expensive and time consuming.
You need to deal with brokers, contractors, lenders, tenants, and property managers. From due diligence to closing a deal, deals can span months or even years. The transaction costs are usually 5-10% of your purchase price.
REITs make this whole process a lot easier, cheaper, and faster.
All you need is a brokerage account and you can invest in REITs via the public exchange with a few clicks of the mouse, just like you would if you were investing in any other stock. Fees are only a few dollars – if not free – and trades are executed instantly in most cases.
How much good do you want
While REITs have proven to be very attractive long-term investments, it’s important to stay well diversified and not put all your eggs in one basket.
How much you decide to invest in REITs depends heavily on three factors. These are your return goals, your ability to take risks, and your willingness to take those risks.
While there is no one-size-fits-all solution for everyone, it is reasonable to assume that a well-diversified portfolio with REIT exposure can minimize volatility while maximizing long-term returns.
David Swensen, legendary manager of the Yale Endowment Fund, recommends investing ~ 20% of your portfolio in REITs. His track record makes him a superstar among institutional managers, and much of his success has come from real estate investments.
Other financial advisors typically recommend a 15% to 30% real estate investment exposure, and we believe this is a fair proposition.
In the end, it all comes down to your personal investment goals and what you’re comfortable with.
How to choose good REITs
Choosing good REIT investments depends on your personal investment goals and what you are comfortable with.
In short, the ideal REIT investment opportunity would include the following factors:
It has a differentiated strategy that creates value
It generates a stable and steady cash flow.
It has the balance sheet and the pipeline to cyclically maintain and grow its asset base.
A superior yield that is well covered by cycles pays off.
It is trading with a valuation that is well below average.
If the REIT has many of these traits, it should be a big winner in the long run. Obviously, it is very rare to find such cases because if a REIT is this great it is likely to be trading at a premium rating.
No selection process is bulletproof. However, it is important to have some core filters that will help you minimize the loss of investments while maximizing your chances of picking out profitable investments.
The four filters we are looking at are:
Is management geared towards investors in terms of REIT governance structure, compensation, and insider ownership? In general, internally managed REITs with significant inside ownership of common stock and compensation associated with performance outperform REITs that lack one or more of these characteristics.
Are the assets classified as high quality or low quality? The more challenging the sector, the more important it is to insist on quality. NOI in the same deal, lease spreads, and occupancy are good indicators of determining the quality of an asset.
Does the REIT have a strong balance sheet? Looking at credit ratings is an easy way to accomplish this, as is debt to asset ratio, fixed cost recovery, and debt to EBITDA ratio to sector.
Does the REIT offer an attractive valuation? The more certain you are that the REIT will pass the first three filters, the less discount you need to pass, but in general, it’s good to buy REITs that trade at a discount on their historical price-to-FFO and / or price – to NAV ratio (net asset value).
Put everything together
REITs can be great tools for long-term compounding of wealth and passive income generation. However, not all REITs have the same structure.
For more aggressive and adventurous investors, choosing individual REITs can be a fun and rewarding way to invest in real estate.
For those who wish to remain passive and / or who have no confidence in their ability to select successful REITs, investing in ETFs such as Vanguard’s VNQ REIT funds is advisable.
Would you like to learn how to start REITs?