What is a REIT and how do they work?

what is a REIT Is it time to add real estate to your investment portfolio? Maybe.

Here’s the good news: You can reap the benefits of property ownership without getting late-night calls about clogged toilets, or scrambling to fill the space left vacant when that Indian-Canadian fusion restaurant goes under (which, let's be honest, it will).

Let’s talk about REITs.

Have you ever wondered who owns the building where you work? Or that new apartment complex they’re building down the street? (No? Huh. We thought everybody did that.) Well, anyways… your building might be owned by Dave, who works over in Receivables; that cute bartender you were chatting up last night; and a retired florist who lives in Fresno, California -- which is to say your office building may be owned by a REIT.

Real Estate Investment Trusts, or REITs, are similar to mutual funds or ETFs. But instead of owning a basket of stocks, the REIT owns a portfolio of commercial or residential properties or mortgages. Investors can buy shares of a REIT much as they would in a company or mutual fund. REITs, which were created by federal law in 1960, have become increasingly popular in recent years as people scramble for higher returns on their income-producing investments.

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REITs offer a great potential upside, including a steady income stream (they are required to distribute 90% of their income to shareholders), and the opportunity for solid long-term asset growth reflective of the real estate market. REIT’s have averaged an 11.8% annual return over the past 20 years, compared to 8.6% for the S&P 500 Index. But there are limitations and vulnerabilities, too. Those nice returns reflect the risk inherent in investing in a narrow category -- one that experiences ups, downs and outright collapses on a roughly 15-18 year cycle. So, it’s important to do a really deep info-dive before investing in a REIT.

Let’s jump right in…

There are two classes of REITs -- public and non-traded. Public REITs are traded on stock exchanges while non-traded REITs require shareholders to buy and sell their shares from the company that operates the trust. Public REITs are the best choice for most investors for several reasons, including liquidity. If things go sideways with a public REIT, investors can dump their shares quickly and easily. That’s not always the case with non-traded trusts. During the downturn of 2008, some real estate investment companies froze their REITs, leaving shareholders stuck with their investment as real estate values went into a death spiral.

Public REITs also offer greater transparency and, according to research firm Morningstar, better long-term results and faster recovery from downturns than private REITs. What’s more, non-traded trusts often demand upfront fees ranging up to 12%-15%. And you know how the Wela crew feels about excessive fees. (We’re against them.)

Related: The 7 Layer Dip Of Fees To Avoid When Investing

When shopping for a REIT it’s important to know the composition and quality of its holdings. Equity REITs acquire commercial property -- apartment buildings, shopping centers, warehouses, even timberland -- and generate their income from tenant rent. You’re looking for outfits that operate top-notch space with quality, long-term tenants. If the REIT owns a strip center with a vape shop, a place that will sell your stuff on eBay, and the Pretty Kitty Pet Emporium, skip it.

Mortgage REITs earn their living by trafficking in real estate mortgages and mortgage-backed securities. REITs typically focus on a specific category such as residential (apartment buildings, hotels, manufactured housing), retail (malls and shopping centers), or healthcare (hospitals, assisted living centers, medical offices). Investors need to consider the current state and future outlook for a REIT’s chosen sector when evaluating the trust. Many residential-focused REIT’s limit their investments to specific markets, usually large cities, thus the prospects for those local economies should be factored into an investment decision.

The caliber and experience of a REIT’s management team is also critical. Real estate is a savage business. Success requires careful selection of asset properties, effective tenant recruitment, and highly efficient execution of every management function from marketing to maintenance. It’s a jungle out there, so stick with established trusts that have a track record of maintaining a decent payout across multiple market gyrations.

Keep an eye on the REIT’s debt, too. Trusts that use a significant amount of borrowed capital will be more vulnerable when interest rates rise. Mortgage REITs tend to be more leveraged than Equity trusts.

While the return on REITs can be enticing, don’t go overboard. They should compose no more than 5%-10% of a portfolio. As with any investment vehicle, diversity is critical – the REIT allocation should be spread across several real estate categories. A great way to diversify – and avoid hours of research on individual REITs – is to invest in a REIT ETF. Yep – a basket of REITs that in turn hold baskets of properties and mortgages. Can’t get much more diverse than that! One ETF that Wela tends to hold is the Vanguard REIT Index ETF (VNQ).

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Real estate is a core element of the U.S. economy, and REIT’s make it possible for the average investor to participate in its historic growth. Choose wisely and REITs could be, to borrow from one veteran real estate investor, a “terrific” addition to the portfolio -- maybe even YUUUUGE.