REITs are one of the most-accessible avenues for investors to start investing in real estate.
As a refresher, real estate investment trusts, or REITs, are companies whose business is investing in real estate. They sell ownership shares, and distribute at least 90% of their taxable income to shareholders. REITs offer liquidity, exposure, and potential returns, without the hassle of being a landlord.
A solid investment portfolio should include REITs, and they are a great way to start investing in real estate.
About 1,100 REITs are available in the U.S. alone. While we think residential real estate is the best real estate investment, the world of real estate investing offers numerous options that fit investors with different risk tolerances and financial goals.
The most popular categories of REITs include residential, retail, office, and mortgage.
Residential REITs
Residential REITs buy — you guessed it — residential real estate. Like most equity REITs — the kind that owns physical real estate assets — they purchase property, operate it, and pass the proceeds through to shareholders.
Residential REITs invest in multifamily housing: apartments, condos, duplexes, and single-family developments.
One advantage of residential REITs is the stability of consumer demand for housing. Unlike other commodities, demand for housing always exists: when times are hard, most of us would rather skip the avocado toast than forgo a roof over our heads. Protecting the housing market is also a major policy objective for politicians and lawmakers.
Housing is impacted by market changes and interest rates, but the fundamental human need for housing isn’t going away any time soon, and there will always be margin for investors to earn returns by supplying that need.
The disadvantage of residential REITs is that, well, they’re residential. Unlike a commercial REIT acquiring properties and leasing to corporate customers who intend to use office space for multiple years, residential tenants are more short-term and managing residential properties can be difficult with maintenance and marketing.
Higher turnover and more flexibility can mean unpredictable income, but it also creates opportunities to move quickly and earn returns in response to market developments.
The performance of a residential REIT depends on the kind of housing in which the REIT invests. Luxury condos in a hot downtown neighborhood might command a lofty price today, but if recession arrives, their owners might not be able to liquidate their investment easily.
On the other hand, Class C housing in more-affordable regions might boast impressive cap rates, but those assets are more susceptible to other risks like surprise maintenance and renovations.
Residential properties can vary dramatically, and it’s important for investors to ensure the REIT they choose has an investment strategy that aligns with their goals.
Retail REITs
Retail REITs are one of the largest categories of REITs. They invest in shopping centers, malls, and other retail spaces.
One advantage of retail REITs is that property owners selling to large, corporate parties gain some consistency that residential property owners lack. Triple-net leases smooth costs over time and make financial planning easier.
Retail outlets with strong financials are likely to be excellent tenants. But, if a shopping mall loses an anchor tenant, this could put the venture at risk.
There are some additional risks associated with retail REITs. Some forms of retail are significantly more recession-resilient than others, and retail REITs aren’t guaranteed the consistent demand that residential REITs often benefit from. This makes tenant selection a high priority for retail REITs, and increases their chances of being impacted by recession
Additionally, there is a longer-term concern that disruptive retail models like ecommerce — which impacted brick-and-mortar during the pandemic — will threaten the long-term relevance of physical stores. While some evidence suggests that consumer demand for in-person experiences will bounce back, malls aren’t what they used to be.
Office REITs
Office REITs are often less-risky than their counterparts, because office space is expensive to construct and is a necessity. Although the past 18 months have proved that work from home is possible, office space is still essential for many industries, which means it’s one of the last places corporate tenants will look for budget cuts when recession arrives. Additionally, office leases can range from 5 to 10 years and provide property owners with predictable income streams.
Although office REITs come with less garden-variety risk than most other REITs, they do face some amount of risk. The major question-mark hanging over office REITs is the same one retail REITs will have to contend with.
Before the COVID-19 pandemic, few of us would have envisioned how many people now work from home.. Coupled with the rise of the gig economy, office investments could face serious trouble in the coming years.
Office space is necessary for many industries— but the pandemic showed that number is probably lower than many investors thought.
Mortgage REITs
Some REITs don’t own physical property at all. As the name suggests, mortgage REITs invest not in physical property, but mortgages and mortgage-backed securities.
Mortgage REITs aren’t directly exposed to many of real estate’s risks because they don’t own physical property. They face second-order danger from risks like market fluctuations but the layer of insulation between equities and mortgages offers some protection.
The biggest risk mortgage REITs face is monetary policy. Changing interest rates can be significant opportunities or threats to a mortgage REIT.
Rising interest rates can decrease the value of a mortgage REIT’s holdings (because interest rates are inversely correlated with bond prices), but falling rates could decrease earnings on interest by encouraging prepayment and refinancing.
Other types of REITs
If there’s a profitable way to use land, there’s a REIT that invests in it including cell towers, timberland, data centers, warehousing.. The advantages and disadvantages of these REITs vary widely.
The TLDR: real estate investment can function as a relatively safer substitution for investment in another asset class.
Investors who appreciate the flexibility, durability, tax advantages, and high potential returns of real estate investment, but also want exposure to fast-growing industries like logistics and the internet can effectively diversify their portfolios with REITs that invest in categories like these.
The central risk of these REITs is that it’s possible for the industry the REIT piggybacks on to perform well while the REIT suffers. Many asset classes are generally riskier than real estate: a hypothetical REIT that owns and leases crypto-mining facilities is exposed to much greater upsides and downsides than a REIT consisting of residential properties.
The other side of that coin is that, if a land-intensive industry takes a trip to the moon, the organization that gets to keep the rent payments is likely to end up pretty happy.
Concluding Thoughts
Because of their accessibility, diversification, simplicity, and strong potential returns, we think all investors should include a REIT in their portfolio. The numerous varieties of REITs are certainly a good thing for the industry. Although we’re partial to residential REITs, all types of REITs have a place in a well diversified portfolio.
