(It’s that time once again, for the fabulous feature known as Investing 101. For those of you who are new, this is where I attempt to answer some questions about common investments that are posted by…well, me again. It’s not a perfect system, but it helps to convey the information. Now, onto the questions!)
Q: What exactly is a REIT?
A: REIT is short for Real Estate Investment Trust. They are essentially specialized stocks, of companies that invest in real estate ranging from residential homes to office buildings to industrial sites, depending on the particular REIT. There are two basic types of REITs: equity REITs, which own and operate buildings directly, and mortgage REITs, which lend money to property owners or buy up mortgage-backed securities.
Q: Why invest in REITs, then? Why not just invest in regular stocks?
A: Investing part of your money in REITs will help to diversify your holdings. Because REITs are based on real estate, they gain and lose value differently than other stocks. When most other stocks are up, REITs might be down; and when other stocks are down, REITs can be up (such was the case at the turn of the 21st century).
Furthermore, a particularly noteworthy feature of REITs is that they are required to pay out 95% of their income to their investors. By doing so, they can avoid paying corporate income tax, and therefore aren’t subject to the double taxation that affects most corporate dividends. They tend to pay out more than most other stocks for this reason, and are especially useful for investors who are seeking income and want investments beyond bonds and other lending investments.
Q: Sounds good, but why shouldn’t I just buy property and invest in real estate directly?
A: Well, that’s certainly one possibility. But, contrary to what you see on late night infomercials, buying real estate directly isn’t that easy or inexpensive. You need to search out a suitable property, get financing, and have the highest bid on the property just to secure it. Then, if you aren’t planning to do all the maintenance and upkeep work yourself, you will need to hire a property management company to take care of the day to day issues for you. You’ll still have to supervise the work, though, and frequently inspect the property to insure all your wishes are being met.
And all those issues are before you get into things like insurance, taxes, federal, state, and local regulations…
Q: Alright, alright, I get your point. How should I go about buying REITs?
A: Like any other stock, you can buy and sell REITs via a stockbroker (either online or off). Now, as with any stock, you need to be willing and able to do lots of research before settling on which REIT(s) to buy for your portfolio. Individual REITs can also be volatile and subject to rapid changes in value, or even bankruptcy.
Luckily, just as with stocks, there are mutual funds that invest in REITs. By holding them in aggregate, you can help to smooth out the bumps in the investment road and eliminate the possibility that choosing the wrong REIT will drop the value of your investment to zero. Most mutual fund companies should offer a REIT fund; being partial to Vanguard, I like their REIT index fund.
Q: That’s a pretty good plan. Any final thoughts?
A: Just a word of caution: REIT dividend income is generally fully taxable, like bond dividend income, rather than being taxed at the lower capital gains rates (as is the case with qualified stock dividends). It’s the downside of the rules that allow them to avoid corporate income taxes; the IRS giveth, and the IRS taketh away. As a result, REITs and REIT mutual funds should be kept in retirement accounts whenever possible, so as to minimize your possible tax bill.
That concludes our short look into REITs (and REIT mutual funds) as a possible investment choice. Hopefully, you’re all feeling a bit more informed and enlightened about this particular method of investing in real estate.