REITs: Targeting income, capital appreciation, and diversification

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REITs: At the crossroads of fund investing and property management.

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As far as real estate platitudes go, “Buy land—they’re not making it anymore” might apply to you as an individual homeowner, or perhaps as the owner of a rental property or two, but what about the commercial real estate market? Most of us can’t swipe the debit card to buy an office building or shopping center.

But there’s another way to get a piece. It’s called a real estate investment trust, or REIT.

REITs were popularized in the 1960s to allow average investors to sink their money into many out-of-reach properties:

Most REITs are publicly traded holding companies—large pools of these income-producing properties. As an investor, you can get a piece of a REIT just like you can buy shares in a public company: Simply place an order through your broker to buy REIT shares listed on a major exchange.

You can invest in most publicly traded REITs the same way you’d buy a stock or exchange-traded fund (ETF)—through a standard brokerage account. Start by identifying your investment objectives. Are you looking for steady income, long-term growth, or exposure to a specific part of the real estate market, like health care or commercial properties? Then compare REITs by looking at fundamental metrics such as dividend yield, historical performance, fees, and the types of properties they own. Many brokers also offer screeners to help narrow your list.

Once you’ve chosen a REIT, investing is straightforward. Just enter the ticker symbol and number of shares you’d like to buy, then place the order through your brokerage platform. You can also get exposure through REIT-focused ETFs, which bundle multiple REITs into a single investment. Either way, you’ll typically receive dividends on a regular basis, and you can track your REIT investments the same way you would any other publicly traded stock.

REITs earn money from rent, services, and property sales related to and generated from their holdings. Some REITs are sector specific, while others have multiple property types in their portfolios. Plus, there are several REIT-based exchange-traded funds (ETFs) that let you invest in a pool of individual REITs. Others operate as mortgage REITs (mREITs) that invest in residential and commercial property mortgages and mortgage securities.

REITs are often referred to as “total return investments” because the IRS requires them to pay out at least 90% of their taxable income to shareholders each year through dividends. Investors look to REIT dividends for income generation and capital appreciation. Plus, as an asset class with little historical correlation to traditional stock markets, REITs can help diversify a portfolio.

REITs sound like a solid investment, and for many, they have been. But like all investments—and certainly real estate investments—REITs carry risks tied to the ebbs and flows of the real estate market itself, as well as interest rates. And they’re not immune to the vagaries of economic or social changes.

Companies must follow specific IRS rules and regulations to qualify as a REIT:

REIT dividends are typically treated as ordinary income and don’t get the same special treatment of reduced taxes that you might get on other types of corporate dividends.

As a result, many investors choose a tax-deferred account to park their REIT shares or REIT funds as a means of delaying those taxes until they start withdrawing money. If your IRA or 401(k) plan allows for REIT investment, this might be worth considering.

REITs come in all shapes and sizes and can be sector specific, limited to a specific geography, or include other holdings. Many of the largest REITs tend to focus on:

There are a handful of other REIT types, such as health care, data center, self-storage space, infrastructure, timberland, and farmland. Some REITs (and of course REIT ETFs) can be diversified or specialized. As with all investments, read the prospectus so you know what you’re investing in before you buy REIT or REIT ETF shares.

The biggest risk with REITs—as with any real estate investment—is that the value of the underlying real estate could decrease. For example, an economic downturn typically dampens demand for residential and commercial real estate. For real estate tied to retail sales, a recession typically slows sales at the cash register. Some stores close, while others struggle to pay the rent.

REITs are also sensitive to changes in interest rates, but there’s a bit of push and pull about the impact. On the one hand, increasing rates means higher borrowing costs for REITs and tends to temper property sales, putting pressure on real estate values.

On the flip side, rates tend to rise when economic growth is robust and inflation is edging higher. Either way, unexpected interest rate changes might lead to elevated price volatility, in the same way they affect the stock and bond markets.

REITs can offer an efficient and cost-effective means of generating income and capital appreciation while diversifying your portfolio. But, as with all investments, they’re not risk free. Property values ebb and flow—they can be hit by economic and social change, and they can surge amid economic strength. In a calmer “Goldilocks” economy that’s not too hot or cold, REITs can be a cash cow, paying steady dividends.

Although they’re not making any more land, as the saying goes, they are making improvements and upgrades to the land we do have, and REITs are a way to participate.