For individuals who want to invest in commercial real estate assets, a Real Estate Investment Trust (REIT) is one of the most accessible options. But, are they a good investment?
In the following article, readers will learn what a REIT is, the pros and cons of investing in one, how they compare to individually syndicated private equity deals, and whether or not they are indeed a good investment.
First National Realty Partners is not a REIT. We are a commercial real estate private equity firm whose investment offerings are similar to those of a REIT. To learn more about them, click here.
What is a Real Estate Investment Trust?
The most logical place to start this discussion is with a simple definition. A Real Estate Investment Trust is a company that owns, operates, or finances commercial real estate. Broadly, there are two types of REITs that are popular with individual investors, equity REITs and Mortgage REITs.
An Equity REIT is the most common type and they own/operate income producing commercial real estate assets. Because each type of commercial property has its own operational quirks, equity REITs tend to specialize in one of them. For example, one of the largest equity REITs, American Tower Corp. specializes in the purchase and operation of communications infrastructure like cell phone towers. Or, another large REIT, Prologis, specializes in warehouse and industrial space.
As the name suggests, equity REITs invest in the equity portion of a property’s capital stack. They pair this equity investment with debt to acquire properties for their portfolio. This strategy can be contrasted with that of a Mortgage REIT, which invests in the debt portion of the capital stack.
While slightly less popular, mortgage REITs or “mREITs” are another option through which investors can gain exposure to commercial real estate. Instead of buying and operating properties like an equity REIT, mortgage REITs finance the purchase of income producing commercial real estate by purchasing mortgage backed securities or originating commercial mortgages. For example, Starwood Property Trust is a large mortgage REIT that provides financing for many different property types.
Regardless of the REIT type, the pros and cons of investing in one are generally the same.
Benefits of REIT Investment
While there are a number of potential benefits to a REIT investment, six of the most prominent are highlighted in the section below (NOTE: The scope of the discussion is limited to publicly traded REITs).
Under IRS rules, REITs do not have to pay taxes at the entity level as long as they meet certain criteria. Instead, income and profits are passed through to individual investors who pay taxes on the income and capital gains received. This structure avoids the “double-taxation” that is common with corporations.
In addition, capital appreciation is taxed at a lower level and certain portions of the dividend payment may be categorized as a “nontaxable return of capital.”
To qualify for the tax benefits described above, one of the criteria is that REITs must payout at least 90% of their taxable income in the form of dividends. As a result, REIT investments typically come with a high dividend yield relative to other options in the stock market. For example, National Retail Properties is a large equity REIT that invests in single tenant net lease properties. They pay a dividend in excess of 4.16%, which provides shareholders with a steady stream of dividend income.
When REIT dividends are combined with the potential for capital gains, the total annual return can be impressive. For example, National Retail Properties returned 12.47% in 2018 and 10.53% in 2019. But, it is important to remember that returns for a publicly traded REIT can also be somewhat volatile. The same REIT returned -23.69% in 2020. Since 1985, their best year was 2014 where the return was 29.81% and the worst year was 1987 where it returned -28.26%. For more information on the historical returns for National Retail Properties, click here.
Because REITs shares are traded on public stock exchanges, they can be bought and sold quickly with relatively low transaction costs. As a result, REIT shares offer far more liquidity than traditional real estate investments.
For many individual investors, especially first timers, a REIT is the most accessible way to gain exposure to commercial real estate assets. Anyone with a brokerage account and enough money to purchase at least one share can buy and sell REITs on major stock exchanges.
Within a REIT investment portfolio, there may be dozens or hundreds of properties which can create a diversified portfolio. For example, the National Retail Properties portfolio consists of 3,000+ assets with nearly 400 different tenants. As a result, investor capital is highly diversified within the purchase of a single REIT share.
Drawbacks of a REIT Investment
Like any investment, there are also a set of drawbacks that individuals should consider before allocating capital to a REIT. Four of them are highlighted below.
While a REIT is not required to pay taxes at the entity level, individuals must still pay taxes on the dividends received from the REIT, which are classified as ordinary income. Because dividends can be high, income taxes can also be high.
Interest Rate Volatility
REITs prices tend to be very sensitive to changes in interest rates for two reasons. First, rising interest rates mean that a REIT’s total cost of capital will be higher. As a result, there is less cash flow available to pay out to investors in the form of dividends. Second, because REITs aren’t able to retain as much of their earnings, they may need to raise external capital to keep growing. If that capital has to be raised at higher rates, it is harder for the REIT to achieve profitable growth.
Long Term Investments
For the best chance at high total returns, REIT investments should be held for the long-term which is usually 5-10 years. This time horizon may not always work for investors who have a shorter term preference.
Property Specific Risks
REITs tend to specialize in specific property types. For example, one REIT may purchase and operate office buildings. Others may seek to build a diversified portfolio of apartment buildings, data centers, shopping malls, self-storage facilities, or healthcare properties. For this reason, potential investors must consider the property specific risks that come with this type of specialization.
For example, if a REIT specializes in office buildings, investors need to consider things like whether there is adequate parking or if they are near major transportation hubs. Or, if a REIT specializes in apartment buildings, investors need to think about the risk of job loss and whether the property has enough amenities to support high levels of occupancy.
So, Are REITs a Good Investment?
With REITs defined and their pros and cons highlighted, we can get to the central question of this article, are REITs a good investment? The short answer is, they certainly can be. But, perhaps the more important question is, are REITs a suitable investment for everyone? The answer to this question is a bit more complex.
Potential REIT investors should perform the due diligence necessary to fully understand all aspects of this unique investment offering to determine if it is a suitable fit for their own preferences and investment objectives. If it isn’t, there are alternatives.
REITs vs. Private Equity Commercial Real Estate Firms
If investors prefer to stick with fully diversified real estate investing options, they could choose to invest in a real estate focused mutual fund like the Vanguard Real Estate Index fund, which invests in a basket of REITs. Or, they could choose a real estate focused exchange traded fund (ETF), which is very similar to a mutual fund, but shares are traded on major stock exchanges. While these are both viable alternatives to a REIT investment, we believe that the private equity structure offers several unique characteristics that may make it more suitable for certain investors.
A private equity firm is a company that invests in the equity of other businesses, including those that own real estate. Some private equity firms offer investments in real estate “funds” which would be very similar to a REIT. Others (us included) offer investments in a single deal, which allows investors to address one of the main critiques of a REIT. With an individual deal, potential investors have the opportunity to perform their own due diligence on the property before choosing to allocate capital. For example, they could review the asset class, the location, the tenants, the leases, the market, and the condition of the property itself. While this structure comes with its own risks and benefits, we believe that it allows individual investors to tailor the opportunity to their unique preferences and objectives.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.