Real estate investment trusts (REITs) are companies that specialize in investing in real estate by owning and renting commercial properties or by collecting mortgage interest.  Investing in REITs is a great way to get your feet wet in real estate without becoming a landlord.  You simply buy and sell shares of a REIT on a stock exchange like you would any other stock.  Because REITs usually pay out almost all (>90%) of their taxable earnings you can earn substantially higher dividend yields through REITs than you could with traditional stocks.

A short history of REITs

In 1960, Congress created REITs as a way for individual investors (people like you and me) to directly invest in large scale commercial properties (things like shopping malls, or massive apartment complexes).  Currently, there are about 150 publicly traded REITs in the US, with a combined worth of around $400 billion.  In the old days, you would have had to save millions of dollars (and probably partner with other investors) in order to be able to invest in a shopping mall or giant apartment complex.  Now you can buy shares of a REIT on a stock exchange, just like you would any other stock.

Flavors of REITs

REITs can make money through two primary means, and come in three main flavors depending on the nature of their income.

• Equity REITs - Invests in and owns physical properties like shopping malls, apartments, commercial property, industrial property, health care property, etc.  If a property investment class exists, there is a REIT investing in it.  Their profits come from collecting rents.
• Mortgage REITs - Invests in and owns mortgages.  They may directly loan money to a property buyer for a mortgage or they may purchase mortgage backed securities.  Mortgage REITs borrow money at lower short-term interest rates and then loan it back (in the form of a mortgage) at a higher interest rate.  They make money on the spread between these two interest rates.  The bigger this spread the more money they can make.
• Hybrid REITs - These use both both of the above strategies.

Within the world of mortgage REITs, there are two more investment styles that you need to be familiar with, agency and non-agency. Agency, when used in the world of REITs, refers to government backed or supported agencies that gaurantee repayment of the mortgage principal, such as Ginnie Mae, Freddie Mac, and Fannie Mae.

• Agency REITs - Invest in mortgages backed by government supported agencies.  Because their investments are government supported, these REITs have less risk associated with them.
• Non-Agency REITs - Invest in mortgages NOT backed by government supported agencies.  These have more risk associated with them.

Characteristics of a REIT (the short version)

To make a long story short and simple, REITs are corporations that invest almost entirely in real estate with shares that can be publicly traded on stock markets.  REITs have access to corporate level debt and equity, which puts them in a much more favorable borrowing situation than you or I would be as individual real estate investors.  By law, REITs must pay out at least 90% of their taxable earnings to shareholders.  Because REITs must distribute almost all of their earnings, they tend to provide much higher dividend yields than traditional stocks.  The REIT does not pay taxes on these earnings, instead the dividends are considered ordinary and the investor pays pays taxes at the higher ordinary dividend rate.

Characteristics of a REIT (the long version)

REITs arent just glorified landlords.  According to US tax laws, in order to qualify as a REIT, a company must (*):

• Be structured as a corporation, trust, or association
• Be managed by a board of directors or trustees
• Have transferable shares
• Be taxable as a domestic corporation
• Not be a financial institution or an insurance company Bank of America cant be a REIT just because it owns a lot of foreclosed properties.
• Be jointly owned by 100 persons or more If you and your friend Bob buy a 4-plex together, you cant claim to be a REIT.
• Have 95% of its income derived from dividends, interest, and property income.  Basically, REITs must specialize in real estate.
• Pay dividends of at least 90% of the REITs taxable income
• Have no more than 50% of the shares held by five or fewer individuals during the last half of each taxable year (5/50 rule)
• Have at least 75% of its total assets invested in real estate
• Derive at least 75% of its gross income from rents or mortgage interest
• Have no more than 25% of its assets invested in taxable REIT subsidiaries (a fancy tax term for subsidiary companies that provide services to tenants such as cleaning, landscaping, concierge, etc.).

How do REITs compare with being an individual real estate owner?

Many financial independence hopefuls (myself included) are either considering investing in real estate, or have already committed to investing in real estate.  This begs the question Should you direct your money towards buying property or investing in REITs?  The correct answer depends on the investor.  But here are a few things to consider.

Rental property is a business.  Rental property is not a passive investment, its a business.  You (the owner) are in charge of buying the property, selecting tenants, collecting rents, ensuring that maintenance and renovations are done, etc.  You can outsource some or all of these tasks to a management company (for a fee), but you are still responsible for ensuring that they get done.

REITs are just like stocks passive income.  You dont have to actively manage a REIT.  In fact, you dont have do much of anything except check in on your stock periodically and collect your dividend checks.  The tradeoff is that someone else is making all the decisions about how the company is being run.

Liquidity.  You can sell your REIT holdings in an instant.  It takes several months at a minimum to sell a rental property.  Depending on your situation and personality, this may or may not be an issue for you.

Returns are roughly equal.  Ive been scouring the internet trying to see what a landlord can expect in terms of return on investment.  People have reported numbers ranging from the negatives (yes, people lose money on investment properties all the time ) to the double digits.  On average, people seem to report around a 7% yield on rental property.  All real estate markets are different, so the expected yield for property near you might be higher or lower.  On the other hand, its not very hard to select a REIT, or a basket of REITs, yielding around 7%.  In the long run, as the mortgage is paid off and the property value rises over time, I suspect that youll do better buying property, but I dont have any solid information yet on how much better.  Like all things in real estate, its probably local.

Why invest in REITs?

1. Diversification into real estate - REITs allow diversification into real estate, something which would normally only  be available to you if you were willing to become a landlord.

2. High yields - Because REITs must pay out at least 90% of their taxable income to shareholders, they tend to have much higher yields than more traditional stocks. Usually between 4%-10%, with some REITs even moving into double digit yields.  Many REITs do not consistently raise their dividends, like traditional dividend growth stocks do, because their payout ratios are so high that they do not have a buffer against income fluctuations.

3. REITs can show solid dividend growth - Some REITs do have characteristics of good dividend growth stocks a minimum of a 10 year history of increasing dividend payments.  Heres a short list of some REITs with a consistent history of increasing dividend payments pulled from the dividend champions and contenders lists.

• HCP Inc. (HCP 27 years of consistent increases)
• Universal Health Realty Trust (UHT 26 years of consistent increases)
• Federal Realty Investment Trust (FRT 44 years of consistent increases)
• Essex Property Trust (ESS 18 years of consistent increases)
• National Health Investors (NHI 10 years of consistent increases)
• Omega Healthcare Investors (OHI 10 years of consistent increases)
• Tanger Factory Outlet Centers (SKT 19 years of consistent increases)
• National Retail Properties (NNN 23 years of consistent increases)
• Realty Income Corp. (O 18 years of consistent increases)
• Urstadt Biddle Properties (UBA 18 years of consistent increases)

4. Liquidity. REITs are traded just like stocks and as such are very liquid investments.  You can dump your REITs any time with the push of a button.

Conclusions

REITs can be a valuable addition to your dividend portfolio, giving you exposure to the real estate market.  REITs tend to produce high yields, and some companies exhibit all the characteristics of dividend growth stocks.  REITs can also substitute for owning rental property and being a landlord if you are not interested in the hassles of running a business.

(*) List adapted from Wikipedia

Disclosure: I have nothing to disclose.