Real Estate Investment Trusts, or REITs, offer a simpler -- and safer -- way to reap the benefits of a diversified real estate portfolio through owning shares of a portfolio of property.
REITs, which are publicly traded on stock exchanges, are trusts that own properties like apartments, office buildings, hotels, warehouses, shopping centers, and health care facilities (such as hospitals and nursing homes). Most, but not all, operate these properties, too. About 10 percent of REITs are mortgage REITs that invest in mortgages rather than real property.
REITs were created by Congress in 1960 so that average investors could invest in large-scale, income-producing real estate. Instead of joining a real estate partnership, investors can buy REIT shares without any minimum investment requirements.
As of Jan. 1, 2012, there were 166 REITs registered with the SEC, the majority of which trade on the New York Stock Exchange. There are also REITs that are not publicly traded, which is why, according to the IRS, there are about 1,100 REITs in the U.S. that have filed tax returns.
In order to qualify as a REIT, companies must meet IRS provisions and have the majority of their assets and income tied to real estate investment. REITs must distribute 90 percent of their taxable income to shareholders every year. REITs can deduct dividends paid to shareholders from their corporate taxable income, so most REITs avoid paying corporate tax by simply sending all of their taxable income to shareholders.
If you own REIT shares, you pay federal and state taxes on the dividends you receive, and any capital gains distributions that the REIT makes if it sells property. REITs are usually eligible to be held in tax-deferred retirement accounts such as an IRA, a 401(k), or a pension plan.
Most REITs specialize in one or two property types and achieve diversification by owning these properties in various parts of the U.S. or around the globe. Some REITs choose instead to keep their portfolio focused on one geographical area but include several types of property.
Among the property owned by publicly traded REITs as of July 31, 2012, the major property types owned are:
- Regional shopping malls: 14 percent
- Apartments: 13 percent
- Health care facilities: 11 percent
- Offices: 10 percent
- Home financing: 9 percent
- Shopping centers: 7 percent
- Lodging and resorts: 5 percent
- Self storage: 5 percent
- Timber: 5 percent
In the past several decades, REITs have had a good run. According to the National Association of Real Estate Investment Trusts, "During the period from January 1978 through December 2010, equity REIT performance exceeded both the broad equity market and other forms of real estate investment by more than 1 percentage point per year, producing an average annual return of nearly 12.3 percent."
During the downturn, REITs were able to purchase deeply discounted property from private investors to add high-quality assets to their portfolios. REITs were also able to raise capital to pay off debt in recent years because investors turned to them for safety and reliable dividends.
While all REITs are affected by macroeconomics -- and supply is a major factor for every property type -- performance in different REIT sectors is affected by varied influences. For example:
- Retail. The retail sector is heavily affected by consumer confidence and employment. NAREIT shows that from October 2011 to October 2012, this sector earned 24 percent in total returns.
- Lodging. The lodging sector reacts more than any other sector to the domestic economy because rental rates change daily. Business travel is particularly important to this sector. Few new hotels are under construction now, so this sector is expected to improve over the next few years. NAREIT shows that from October 2011 to October 2012, this sector earned 3 percent in total returns.
- Health care. This sector is positively affected now by demographics, with an aging population expected to need more medical facilities and assisted living in the future. In addition, medical facilities typically have long-term leases that reduce volatility in this sector. NAREIT shows that from October 2011 to October 2012, this sector earned 16 percent in total returns.
- Office/Industrial. The recession led many companies to reduce their staff and their need for office space. At the same time, technology allows more people to work remotely. Office owners have focused on cost-cutting, efficiency, and acquiring undervalued assets. NAREIT shows that from October 2011 to October 2012, this sector earned 16 percent in total returns.
- Apartments. Demographics, consumer confidence, employment and supply all influence performance in the multifamily sector. NAREIT shows that from October 2011 to October 2012, this sector earned 6 percent in total returns.
To browse through the variety of REIT investments out there, check out NAREIT's REIT directory.
Michele Lerner is the author of "Homebuying: Tough Times, First Time, Any Time" and is a contributing writer to The Motley Fool.