This guest contribution is by 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 Reaching Early Retirement Through Dividend Growth Investing. REITs are a topic that come up often with Making Sense of Cents readers, so I’m glad the experts at Sure Dividend are talking about this subject today. Enjoy!
Ben Reynolds with Sure Dividend here. Sure Dividend is focused on helping individual investors build high quality dividend growth portfolios.
And to that end I wanted to inform Making Sense of Cents readers about the opportunity for investors to invest in real estate in a diversified manner through Real Estate Investment Trusts (REITs).
We started covering REITs in detail at Sure Dividend back in 2016 because they have unique characteristics that make them a compelling choice for investors looking for current income and income growth.
Our audience at Sure Dividend was interested in learning more about REITs, so we did our research.
I learned how REITs are required by law to pay out at least 90% of their income to their shareholders.
That’s a powerful concept that means REITs share the vast majority of what they make with investors.
I learned that REITs have special tax advantages that make them more efficient vehicles to pass income to investors.
And I learned how easy it is to both invest in and diversify with publicly traded REITs versus traditional real estate.
These characteristics showed us we need to cover REITs because of the benefits they offer to income investors. Keep reading to learn more about this special category of investment.
The term Real Estate Investment Trust was originated in 1960 by the United States Congress and has since been adopted worldwide to describe a special tax-advantaged vehicle for collective real estate investments.
We have compiled a list of publicly-traded REITs, along with important financial metrics such as dividend yields and market capitalization.
Similar to what mutual funds do with companies, REITs allow investors to invest in a diversified real estate portfolio without actually having to buy, manage, and finance properties themselves.
Furthermore, most REITs are publicly traded on a stock exchange and allow investors to participate in the ownership of large scale, well-diversified real estate portfolios in the same way as investors would invest in any other industry.
REITs are structured as corporations, but are unique in that they are exempt from corporate income taxes as long as they comply with specific rules to quality as a REITs. According to NAREIT, a REIT must:
- Invest at least 75% of its total assets in real estate.
- Derive at least 75% of its gross income real property rents, mortgage interest income, or from real estate sales
- Each year pay at least 90% of its taxable income to shareholders in dividends.
- Have a board of directors or trustees.
- A minimum of 100 investors must own shares in the REIT.
- 50% or less of its shares may be held by fewer than six individuals.
These rules are there to protect shareholders, assure discipline in capital allocation and reduce conflicts of interest between the manager and shareholder.
Why invest in REITs?
Historically, REITs have returned 15% per year on average and outperformed all other asset classes by a large margin:
REITs have been enormously lucrative to investors who got in early and knew what they were doing. In addition to the greater total returns, REITs generally pay higher dividends, are less volatile, and provide valuable inflation protection and diversification benefits.
About 90% of millionaires credit real estate investments as a major contributor to their net worth, and REITs allow you to invest in real estate with the added benefits of professional management, diversification, liquidity, low transaction cost, and passive income.
How to invest in REITs?
Investing in real estate is costly and time consuming.
You need to deal with brokers, contractors, lenders, tenants, and property managers. From due diligence till completion of a deal deals can extend for months or even years and transaction costs are generally 5-10% of your purchase price.
REITs make this entire process much easier, cheaper, and faster.
All you need is a brokerage account and in a few clicks of mouse, you can start investing in REITs through the public stock exchange just like you would when you invest in any other stock. Fees are just a few dollars – if not free – and trades are executed instantly in most cases.
How much of a good thing do you want?
While REITs have proven to be very attractive long-term investments, it is important to remain well-diversified and not put all your eggs in one basket.
How much you decide to invest in REITs depends greatly on three factors. These are your return objectives, your ability to take risks, and your willingness to take these risks.
While there is no one-size-fits-all solution for every individual, it is reasonable to suggest that a well-diversified portfolio containing exposure to REITs can minimize volatility while maximizing long-term returns.
David Swensen, legendary manager of the Yale endowment fund, recommends to invest ~20% of your portfolio in REITs. His track record makes him a superstar among institutional managers and much of his success came from real estate investing.
Other financial advisors commonly recommend 15-30% exposure to real estate investments, and we believe that this is a fair suggestion.
In the end, it comes down to your personal investment objectives and what you feel comfortable with.
How to pick good REITs
Picking good REIT investments comes down to your personal investment objectives and what you feel comfortable with.
In a nutshell, the ideal REIT investment opportunity would include the following factors:
- It has a differentiated strategy that creates value
- It generates resilient and steady cash flow.
- It has the balance sheet and pipeline to sustain and grow its asset base through cycles.
- It pays a superior yield that is well-covered through cycles.
- It trades at a valuation that is significantly below average.
If the REIT possesses many of these characteristics, it is likely to 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 will likely trade at a premium valuation.
No selection process is bullet-proof. However, it is essential to have some core filters which you can use to minimize losing investments while maximizing your chances of picking winning investments.
The four filters we look at are:
- Is management aligned with investors in REIT governance structure, compensation, and insider ownership? Generally, internally managed REITs with considerable insider ownership of the common stock and compensation that is linked to performance will outperform REITs that lack one or more of these traits.
- Are the assets considered high quality or low quality? The more challenged the sector is, the more important it is to insist on quality. Same-store NOI, leasing spreads, and occupancy are great indicators to look at when trying to determine asset quality.
- Does the REIT have a strong balance sheet? Looking at credit ratings is an easy way to do this, as well as the debt-to-asset, fixed cost coverage, and debt to EBITDA ratios relative to the sector.
- Does the REIT offer an attractive valuation? The more sure you are of the REIT passing the first three filters, the less of a discount you need to insist on, but generally it is good to buy REITs that trade at a discount to their historical price-to-FFO and/or price-to-NAV (net asset value) ratio.
Putting it all together
REITs can be great instruments for long-term wealth compounding and passive income generation. That said, not all REITs are built equally.
For more aggressive and adventurous investors, picking individual REITs can be a fun and rewarding way to invest in real estate.
For those wanting to remain passive and/or who lack confidence in their ability to pick winning REITs, investing in ETFs like Vanguard’s VNQ REIT fund is advisable.
Are you interested in learning how to start REITs?