An Overview of Real Estate Investment Trusts (REITs) for Investors (Part 2)

 

An Overview of Real Estate Investment Trusts (REITs) for Investors (Part 2)

Discover the hazards of REIT investing, compare REITs with equities and rental property, discover how to evaluate REITs, and avoid common investment blunders.

 

The Risks of REITs

 

In many conversations, you will find people stating that REITs are a perfect balance between pure equities securities and actual real property.

 

They are not.

 

Any good investment needs you to make a trade-off in favor of gains.  With REITs, the same approach applies, albeit the risks involved are slightly different.

 

Interest Rates

 

In many ways, interest rates are one of those aspects that define the success or failure of any particular economy.  When the rates climb, firms and consumers must lock in higher yields, which in theory damages the economy.

 

The indirect impact on REITs is particularly significant, as many REITs use borrowed cash for acquiring new real estate.

 

Another indirect consequence affects the value of bonds.  For some time now, government bonds have offered appealing rates for anyone willing to take on extra risk.

 

Many income investors are expected to migrate their money from REITs to bonds, simply owing to the combination of safety and constant income.  Such a change will obviously influence supply-demand dynamics for REITs, placing downward pressure on their pricing.

 

Are REITs usually negatively affected by increasing interest rates?

 

No, they are not.

 

While there are REITs that will always underperform when the Federal Reserve raises rates, there are also some that prosper.

 

The most crucial lesson to remember is:

 

Never forget about interest rates when you are contemplating REITs as an investment.

 

Property Market Risk

 

Many would presume that all dangers related with the real estate market proper have been avoided when one buys shares in a REIT.

 

They are not.  In reality, the risks specific to real estate are some of the most significant variables to consider when analyzing REITs.  For example, REITs that specialize in retail malls will see their values decline as the overall economy slows down.

 

The same is true for REITs that are active in the hospitality sector.  After all, who wants to travel to restaurants and hotels when the economy is in recession?

 

Vacation rentals tend to be far more susceptible to overall market conditions and are among the first to react to any downturn.

 

On the other side, industrial REITs tend to be the first to profit from a rebound.

 

Essentially, any sort of REIT is, in its own manner, directly subject to the highs and lows of the broader property market.

 

Market Volatility

 

It is sometimes argued that real estate investments do not exhibit the same level of volatility as stocks.

 

This provision undoubtedly applies to direct property transactions.

 

It does not apply to REITs, especially publicly traded REITs.

 

The latter undergo supply-demand pressures much like any other publicly traded securities.  As a result, REITs can exhibit huge swings in either direction, even while the fundamentals stay intact.

 

While volatility is generally a bad indication, there is nothing an investor can do about it when it comes to REITs.  At least, until you buy REITs with a very long horizon in mind.

 

Dividend Cuts

 

One risk that many new investors ignore is the danger of dividend reduction.

 

When a REIT promotes a significant yield on its shares, it rarely explains that this dividend can be lowered at any time.  There are numerous of reasons why any given REIT may lower its distributions, including but not limited to:

 

• Decrease in rental income

 

• Increase in unoccupied units

 

• Higher interest rates

 

• Management decides to keep more money for the company

 

While bigger yields claimed by REITs may be eye-catching, they require much deeper investigation.  In many situations, such yields are the results of decreased share prices, which represent bad fundamentals.

 

Managerial Risk

 

As an investor, it is easy to forget that anyone who oversees a corporation is human.

 

Managers, like all individuals, are prone to errors, both great and minor.  However, when it comes to REITs, managerial blunders can be very costly.  At the most basic level, a wise manager would ensure that the company gets high-quality real estate with strong long-term prospects and avoid taking on too much debt.  This way, the manager helps sustain the income-generating potential of the REIT.

 

Conversely, an irresponsible manager can swiftly deteriorate the value of the REIT, especially when trying to produce more revenue.

 

As you can see, it is critically necessary to examine the competence of a manager before purchasing any shares.  Fortunately, there is plenty of information available about any specific REIT, as most corporations are compelled to submit extensive reports regarding their operations. 

 

Yes, reading a company report is boring.  Most of the time, my coffee stain ends up on page 46 when I eventually give up.  However, the information provided within such reports can be invaluable to an investor.

 

REITs versus Rental Property

 

The question of REITs versus rental properties comes up very regularly, in no small part because the two have many similarities with each other.

 

The truth is that neither of the two is necessarily better than the other in all cases; rather, each one has its own advantages and downsides.

 

REITs vs Rental Property

REITs                                      Rental Property

Lower hurdles to entrance     Larger initial investment

 

Easy to buy and sell                 May take time to sell

 

Managed by experts                May require property management

 

Diversification                           Possible One or more properties

 

Less control                               Greater control

 

When it comes to rental homes, you should constantly keep in mind that you bear all responsibility for the investment.  

There can be occasions when you cannot collect rent from a tenant.  There will also be occasions when the plumbing stops working or a tenant decides to withhold rent until you fix the kitchen sink.  You will have to make hundreds if not thousands of decisions, big and small, as a landlord.

 

Meanwhile, REITs allow you entire control without any of the difficulties involved with managing someone else.  In other words, REITs provide convenience, while rental properties offer independence.  Neither is better than the other; you simply have to choose which one you want.

 

REITs versus Stocks

 

A typical topic asked by many investors is if REITs are a better investment than equities.

 

In my opinion, the question is intrinsically problematic because it assumes that one is better than the other without considering one's individual needs and circumstances.

 

The simplest approach to distinguish between stocks and REITs is to recognize that the latter is merely another sort of stock.  In other terms, REITs are equities issued by firms that own commercial real estate.

 

Therefore, it is completely appropriate to handle REITs as one would regard any other stock.

 

By buying shares in a corporation, you are buying a little piece of that business.  In the case of REITs, the corporations in question make income through their real estate holdings.  For income-oriented investors, this spells out a fundamental advantage, as REITs typically offer considerably greater dividends than most stocks.

 

On the other side, growth stocks offer much better potential to earn wealth through capitalappreciation.  It is vital to keep in mind that many REITs are designed to generate substantial dividends, so investors who are not especially interested in income should hunt around for growth-oriented REITs.

 

REITs vs Real Estate ETFs

 

REITs and Real Estate ETFs are comparable, yet they also have noteworthy differences.

 

In fact, many uninformed investors conflate the two, but they should realize that ETFs are merely one option to obtain exposure to real estate.

 

When you buy a REIT, you are buying shares in a particular firm that owns real estate.  In consequence, when you acquire a Real Estate ETF, you are buying an asset that contains shares in many REITs.

 

By extension, Real Estate ETFs offer significantly better diversity than individual REITs because they hold numerous of them.  It is akin to owning one apartment building versus buying a fund that owns numerous apartment buildings, including warehouses, office buildings, and shopping complexes.

 

With that said, some investors prefer to buy individual REITs instead of ETFs for various reasons.

 

Some of the most typical reasons are increased control and better diversification across property kinds.

 

How to Evaluate a REIT Before Buying Shares

 

When it comes to REITs, many new investors make the mistake of merely examining the dividend return.

 

The truth is that dividend yield alone indicates virtually little about a company.

 

Most professional investors and analysts utilize a range of indicators when studying REITs and evaluating whether or not they are worth buying.

 

Some of the most important REIT-specific ratios include the following:

 

 Funds From Operations (FFO)

 

When examining REITs, it is crucial to understand that earnings as reported by REIT businesses do not reflect the complete story.

 

FFO was established to address this particular issue, as it provides a more realistic view of a REIT's underlying cash flows.

 

FFO accounts for some of the accounting methods that are special to REITs, such as depreciation of assets, and, as such, it is a far better predictor of performance.  When comparing one REIT to another, it is usually a smart idea to go with FFO as your primary evaluation statistic.

 

Adjusted Funds From Operations (AFFO)

 

When it comes to AFFO, it is crucial to recognise that it is simply an upgraded form of FFO.

 

Most analysts and REIT investors consider AFFO to be the single most essential indicator when it comes to REITs, as it factors in different expenses that are ultimately paid by the REIT, including repair and maintenance charges.  In short, AFFO provides an even more precise assessment of a REIT's performance.

 

Occupancy Rate

 

When looking at income-producing real estate, it is impossible to ignore the relevance of occupancy rates.

 

Simply stated, an occupied structure generates revenue, while a vacant building does not.  As such, greater occupancy rates generally translate into better revenues and higher dividends for REIT investors.  

With that stated, pricing should always be put into context, which is why it is crucial to assess the larger market conditions while examining occupancy.  If other REITs in the same industry post similar or lower occupancy rates, there is not much to worry about.

 

Debt

 

Debt is not necessarily a negative thing, especially when it comes to REITs.

 

The rationale behind this is simple: real estate is one of the most capital-intensive assets in existence.  When buying a building, a REIT will nearly always take on debt in order to finance the transaction.  

The higher the loan-to-value ratio is, the more risk the REIT takes on.  At the same hand, increased leverage often leads to better potential returns if the REIT is managed appropriately.  

The last thing to know is that debt can be significantly difficult to pay off during periods of instability, which is something to bear in mind during your analysis.

 

Quality of Assets

 

When most people think about real estate, the first thing that springs to mind is location, and this rule also applies to REITs.

 

In other words, a prime office building located in a big metropolitan region is far more valuable than a run-down retail store somewhere in the middle of nowhere.

 

As a rule of thumb, it is always a good idea to check the quality of assets owned by the REIT in question.  In most circumstances, higher grade buildings in desirable locations offer far better value and security than their lower-quality equivalents.

 

Management

 

Many people forget that real estate companies are run by management, just like any other business.

 

Therefore, it is critically necessary to study the background and track record of any REIT managers before making any commitments.

 

Some managers have tremendous experience handling tough market situations, which means their REITs are considerably more likely to withstand challenging times.  At the same time, some rookie managers will learn a very costly lesson when their REITs underperform.

 

How Beginners Can Actually Buy REITs

 

Buying REITs is actually pretty simple, especially for people who already know how to trade stocks.

 

Here is a list of all necessary steps:

 

 Set Your Investment Goals

 

Before buying any REIT, it is necessary to have a general notion about why you are buying it.

 

For example, some REITs are significantly superior in terms of income, while others offer much better growth potential.

 

Your financial goals are vital since they will define what kind of REIT you should buy.

 

Open an Account

 

Next, you need to open a brokerage account so that you can buy REITs.  Make sure to engage with a reliable broker that has access to REITs or ETFs.

 

Many investors choose REITs that are publicly traded because they are considerably easier to buy and sell.  On the other hand, there are alternatives for those who live outside of the United States.

 

Research

 

Once you have an account, undertake research so that you completely comprehend what it is that you are about to acquire.

 

Never buy anything because it looks good on paper or some anonymous forum moderator stated so.  Always perform thorough investigation, including reading through an annual report.  This paper will give you information about the company, its occupancy rates, debt, and much more.

 

Make sure to pay additional attention to the management practices in a REIT because they will ultimately decide its financial performance.  

Do not buy a REIT based on one metric, such as the dividend yield.  At the very least, check the FFO and debt-to-asset ratios, along with occupancy rates.

 

Diversify

 

Never put all of your money into one REIT, no matter how enticing it may be.

 

Diversify your investments among numerous REITs so that you limit the risk associated with any particular REIT.  Ideally, you should distribute your money throughout REITs with different property kinds.

 

 Long Term Focus

 

Remember that REITs are supposed to be owned for the long term.

 

It is usual for their pricing to fluctuate on a daily basis.

 

As a result, it is crucial to acquire the right mindset and realize that most returns will come from long-term ownership.

 

The Most Common Mistakes Made By New REIT Investors

 

When learning about REITs, beginners tend to make the same mistakes over and over again.

 

Yield Chasing

 

Yield chasing is a practice wherein an investor buys shares in a REIT because it delivers a higher-than-average dividend yield.

 

The truth is, bigger yields frequently come at the expense of more risk, which is something to consider about.

 

Underestimating the Impact of Debt

 

Debt is one of the main dangers connected with REITs.

 

Many REIT investors fail to properly comprehend the dangers brought by debt.

 

Thinking Short-Term

 

Many REIT investors are much too focused on short-term gains.  As a result, they fail to benefit from the long-term growth that REITs offer.  

Another typical concern is trying to time the market, which is considerably harder than most people understand.

 

Concentration Risk

 

Some REIT investors make the mistake of putting too much money in one particular form of REIT, such as shopping malls. 

 

This exposes them to undue credit risk, which is significantly more harmful than market risk.  In summary, you should never put all of your money in one type of REIT, even if it is a terrific real estate asset class.

 

Reacting to Market Volatility

 

The third issue to discuss is the danger posed by market volatility.

 

Many REIT investors are considerably too reactive to news and market changes, rendering them subject to panic selling.

 

Frequently Asked Questions

 

Are REITs a Good Investment for Beginners?

 

Yes, REITs are a terrific method for beginners to get engaged with real estate investing. 

 

They provide indirect exposure to real estate while presenting significantly lower hurdles to access. 

 

At the same time, REITs are still investments and as such, their values might grow and fall.

 

Do REITs Always Pay Dividends?

 

No, most REITs pay dividends, but they are not compelled to do so. 

 

Additionally, a REIT that used to pay substantial dividends can lower or even discontinue its distributions.

 

Can REITs Lose Value?

 

Yes, they surely can.  In reality, most REITs undergo periods of underperformance over their tenure. 

 

Any REIT investor should be aware that the share price of any individual REIT might fluctuate wildly and be prepared to absorb huge losses.

 

Are REITs Safer Than Stocks?

 

It depends on various aspects, but in most circumstances, they are not considerably safer or more volatile than your ordinary stock.

 

Should REITs Be Part of My Portfolio?

 

Yes, in most circumstances, they should.  REITs can be a fantastic method to diversify your portfolio because of their low correlations with other asset types, including equities and bonds. 

 

However, it is vital to only commit a set amount of your portfolio to REITs, as opposed to other types of investments.

 

Conclusion

 

REITs maintain a unique position in the financial markets.

 

They are not stocks, yet they act like stocks.  They are not real estate, but they offer indirect exposure to real estate.  As a result, REITs have garnered quite a following among investors.

 

However, it is crucial to grasp the fact that REITs, despite their attraction, are nonetheless burdened with dangers that should be taken into account before buying shares.

 

It is also vital to remember that REITs should be regarded as part of a diversified portfolio that consists of various forms of investments. 

 

This manner, you minimize much of the risk associated with investing in a single asset class, such as stocks or real estate.

 

Ultimately, it is vital to keep in mind that when it comes to REITs, context is everything. 

 

The REIT you buy, when you buy it, and your investment goals all matter. 

 

As such, it is imprudent to try to acquire the greatest REIT available, especially if you do not fully understand the fundamentals. 

 

Instead, focus on finding a reputable REIT that suits your investing objectives and give solid returns for years, if not decades, to come.