Real estate investment trusts (REIT) tend to be a good choice when diversifying a portfolio, as they tend to offer higher and more consistent overall returns with a lower level of risk. When combined with the appreciation of real estate, REITs are often a good counterbalance in a portfolio heavily weighted toward stocks and bonds.
However, that doesn’t mean that these trusts are all created equal, or that all are right for your individual situation. If you are considering adding a real estate investment trust to your portfolio, there are some important points to consider.
Types of REITs
The first thing to understand is that there are several types of REITs, each with their own advantages and disadvantages.
Retail Investment Trusts. Just about a quarter of all REITs are retail REITs, and include both shopping centers and freestanding retail space. The advantages of retail REITs are that retail is relatively healthy at the moment, and strong anchor tenants like big box stores (including grocery, home improvement, and general retail like Walmart or Target) can ensure regular cash flow. However, the world of retail is changing, with more consumers looking to online shopping, meaning that non-anchor tenants in REIT’s are increasingly moving out of retail space, in some cases defaulting on their rent or going into bankruptcy. The future of the retail market and the tenants in these spaces, are important considerations.
Residential Investment Trusts. Another common type of REIT is a residential trust. As the name implies, this is a trust that owns real estate in residential properties, typically apartment buildings and multi-family homes. The advantages are that the dividends can be significant, particularly in larger metro areas where it’s more cost effective to rent rather than buy — and demand means that landlords can charge higher rents. On the downside, residential REITs in areas where the population is declining and job growth is slowing aren’t as lucrative.
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Mortgage Investment Trusts. In these trusts, you invest in the mortgages themselves, rather than the actual properties. These account for about 10 percent of all REITs. Mortgage trusts can offer significant dividends, but they also come with risks, because they are dependent upon secured and unsecured debt, and their value is heavily dependent on interest rates and stock market performance. Therefore, these REITS have more risk than others.
Office Investment Trusts. These are investments in office buildings, and tend to be a rather safe bet, because most tenants sign long-term leases. Like other REITs, though, office investments are heavily dependent on local markets.
Lodging Investment Trusts. These are trusts focused on the lodging industry, including resorts, hotels, and motels. Lodging trusts tend to have long-term security, but again, depend largely on the location and the market they serve, as well the quality of the properties.
Healthcare Investment Trusts. Finally, a growing area of real estate investment is in healthcare real estate, including hospitals, medical campuses, nursing facilities, and retirement homes. While an aging population and increases utilization of healthcare makes this sector a fast-growing and potentially lucrative option, questions about the funding of healthcare going forward could put a damper on growth.
Questions to Ask
Regardless of the type of REIT you’re considering, there are certain questions you need to ask yourself before proceeding. Obviously, the historical performance of the trust, including the appreciation over time and the dividend yields, is important, but you also want to evaluate the trust on potential future performance. This means looking at points such as:
- Depreciation of the properties over time and the effect on dividends
- The quality of the properties. Researching the value of the property in terms of its location as well. A group of well-maintained but unexceptional properties in a high growth area is a better investment than a new, state-of-art collection in a less prosperous area.
- The type and quality of the tenants. Does the REIT have a stable of reliable tenants who have a good outlook, or are they on shaky financial footing?
- Potential for growth. Consider whether there is potential for rent increases, growth in occupancy, plans for upgrades and improvements, and external growth prospects, i.e., the potential to purchase more properties for the trust.
Funds from Operations (FFO). This is the “real” cash flow of the trust, which includes the depreciation and amortization in the earnings.
As with any investment, it’s best to consult with your financial professionals and carefully review all the documentation before choosing a REIT. However, when you make the right choice, these trusts can be a solid addition to your portfolio.