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How to Find the Best REITs and Real Estate Funds

Are REITs a smart investment strategy right now?  This article explains the current state of play surrounding REITs and lays out the different types of REITs, funds, and ETFs available, as well as strategies for more advanced investors.

Getting Started: Investing in REITs

If you’re a novice, you don’t want to complicate things unnecessarily. There are several good REIT index funds, ETFs and other solid mutual funds that get you broad access to the REIT world and the tax advantages of REITs without having to take on a lot of specific subsector risk.

To get started, you can sign up online for one of NerdWallet’s recommended brokerage accounts offering access to a variety of mutual funds and ETFs:

  • For those looking to get started immediately, we recommend top online brokers E*TRADE and Scottrade for ease of use and powerful trading platforms.

The Housing Market Recovery Impact

If you’re looking for additional income or investment vehicles, pickings are slim indeed. CDs and treasuries won’t help much since interest rates are so low – and rates on fixed annuities are pretty dismal these days too. Blame it on the Federal Reserve, which continues to buy up financial assets as part and parcel of its QE3 quantitative easing policy – artificially increasing prices on financial assets, and pushing down yields across the board.

Those low yields, though, have translated into cheap mortgages for those who can get them – and a corresponding increase in house prices:

Graphic Source: National Association of Real Estate Investment Trusts

  There’s a counterargument that house prices are inflated because of government policies that fail to allow markets to clear and artificially low interest rates as the Fed tries to flood a sagging economy with liquidity. But house prices are house prices, and there is a recovery of some sort going on.

So how can you get involved in it as an investor? You can buy real estate yourself directly – or leverage the capital markets to diversify across many properties, using REITs.

REIT Taxation 101: Sidestepping Double-Taxation

The term REIT stands for real estate investment trust. In a nutshell, these are corporations with special treatment under the tax code: They don’t have to pay income taxes on their own earnings, like other C-corporations do. Instead, they get to deduct the dividends they pay to shareholders. In other words, REITs are exempt from the scourge of double taxation that normally plagues C corporations and publicly held companies.

Here’s how it works, in practice: Imagine two companies that each have identical operating earnings, and each kicks out all of its after-tax operating earnings in dividends. One is a regular C corporation and the other is a REIT. Both have operating profits, pre-tax, of $1 per share.

The corporation must first pay income tax of 35 cents on every dollar of earnings. Since dividends are not deductible to non-REIT C-corporations, it can only come up with a dividend of 65 cents payable to the shareholder.

The REIT, on the other hand, is entitled to deduct the dividend they pay to shareholders. It has no problem paying out the entire dollar.  Yes, it’s taxable to the shareholder. But so is the 65 cents on the dollar the shareholder gets from the garden-variety, non-REIT publicly-traded C-Corporation. The REIT shareholder, then, is taxed only once, not twice.

In order to qualify for this tax advantage, though, they have to kick out 90 percent or more of their operating earnings to shareholders in the form of dividends. They also have to have 95 percent or more of their income attributable to interest, property income and/or dividends. Additionally, to retain its eligibility for favorable tax treatment, the REIT must hold 75 percent of its assets in real estate investments and derive 75 percent or more of its gross income from rents and/or mortgage interest.

Types of REITs

REITs can hold actual properties, or they can hold pools of mortgage securities. The former are generally called ‘equity’ REITs – they maintain an ownership interest in the real estate itself; and the latter are called mortgage REITs. Equity REITs make money from

rent payments and the occasional profitable sale of inventory; Mortgage REITs primarily generate income from the principal and interest payments of the borrowers. We’re primarily concerned with equity REITs in this article.

Naturally, there are all kinds of equity REITs, as well. The National Association or Real Estate Investment Trusts has established the following equity REIT categories:

  • Industrials
  • Office
  • Mixed
  • Retail – shopping centers, regional malls, and free-standing
  • Residential – apartments, manufactured homes
  • Diversified
  • Lodging/resorts
  • Health care
  • Self-storage
  • Timber
  • Infrastructure

There are also commercial and residential mortgage REITs, too, in the non-equity category. These are currently sporting some attractive yields – 10.89 percent. all told. But understand that as yields rise, so do risks. We’ll take a closer look at the mortgage REIT space in a future column.

Equity REIT Performance

The FTSE NAREIT Equity REIT Index is up 15.29 percent over the 12 months ending 1 April, on a total return basis. It’s annualized returns for the three year period prior to that date is 17.17 percent. (Measures commercial real estate). A more general measure, representing all publicly-traded equity REITs, commercial or otherwise, is the NAREIT All-Equity REIT Index, which has actually posted very similar numbers over time.

REIT’s in general also got a rating of “stable” from Moody’s Investors Service analysts – which is their way of saying, “meh.” The exception was multifamily REITs, which they rate as “positive.”

Why multifamily? One reason is demographics. There are a lot of millennials and echo-boomers – those born between 1980 and 1995, who are now hitting prime renting age… and a lousy economy is preventing them from buying those three-bedroom houses in the suburbs that their parents got to buy, which is swelling demand for rentals at the expense of McMansions and cozy little homes in the suburbs alike. Multi-family demand has also gotten a big recent boost from hundreds of thousands of homeowners getting foreclosed on – and dumped into the rental market. The big squeeze had the effect of piling people into multi-family housing – and the demand should buoy revenues in the field for some time to come.

Additionally, Dow Jones has developed an index measuring US residential REIT performance. This one has struggled over the trailing 12 months, posting a 1.49 percent loss. But over the past three years it has also generated returns just over 17 percent. Residential REIT performance since the index’s exception is 10.61 percent through the end of March 2013, which actually puts residential properties on rough par with the commercial FTSE NAREIT Equity REIT index.

Rezis look pricey on a valuation perspective, though: a trailing 12 month P/E of over 56 (49 on a forward-looking basis). The price to book ratio is 2.49 for a dividend yield of 3.27 percent. That said, there are already signs that more competitors in the multi-family REIT space are compressing returns. That’s significant at a 50+ P/E, even with a nice dividend.

Advanced Investors’ Guide to REITs

If you want to get involved in specific REITs, you can choose between publicly-traded and non-publicly traded REITs. Beginners should stick to the publicly-traded ones. Non-traded REITs can be very illiquid, with fewer SEC protections for investors. Not that they’re necessarily terrible. You can buy good ones at a deep discount in many cases, because of the low liquidity, and yields are good. They just are not something suitable for the novice REIT investor.

How much should you hold in REITs? Well, the National Association of Real Estate Investment Trusts, naturally, recommends quite a bit. They’ve published an asset allocation calculator recommending an optimum REIT exposure of 33 percent. But that’s for pension funds. Pension funds don’t own houses. If you own a home, you already have a substantial exposure to the fortunes of real estate. So take that into consideration before backing up the truck to buy REIT shares: You don’t want your home value to crater at the same time your investment portfolio does! You don’t want to diversify yourself into mediocrity – but you don’t want to set yourself up for a fall, either. Stay balanced.

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