Why the best real estate investment is not physical

Investing in physical real estate like rental properties has long been popular to diversify one’s portfolio next to stocks and bonds. However, there is a strong case to be made that the best real estate investment today is not physical at all — it may be, actually, investing in real estate investment trusts, or REITs. 
We’re going to share an overview of what REITs are, their benefits, and why they may be real estate investments worth considering instead of investing in physical property in the current investment climate. Read our article or watch our video on Youtube! 

What are REITs?

REITs (‘Real-Estate-Investment-Trusts’) are companies that own income-producing real estate. Some examples of sectors REITs invest in include apartments, office buildings, hotels, hospitals, shopping malls, cell towers, and more.

REITs were created in order to allow average investors to invest in large-scale real estate with the ease of using one’s investment portfolio.  

For a company to qualify as a REIT, it must adhere to certain rules set by the Securities and Exchange Commission (SEC). Some of the main requirements are:

• REITs must derive at least 75% of their gross income from rent or mortgage interest.
• At least 75% of their assets must be in real estate investments, cash, or Treasuries.
• They must distribute at least 90% of taxable income to shareholders annually in the form of dividends.
• REIT shares must be registered with the SEC and traded on a public exchange.

By abiding by these rules, REITs can avoid paying corporate tax. Thus, their profits are able to be distributed to shareholders efficiently.

REITs provide a way for anyone to invest in real estate without needing to directly own, manage, or finance property. You simply invest in shares of a REIT like you would any other stock.

The advantages of investing in REITs

As an investment vehicle, REITs offer a unique combination of benefits that make them an attractive addition to investment portfolios when used appropriately. Before diving into the major benefits, let’s quickly recap what exactly REITs are. REITs are companies that own, operate or finance income-generating real estate. Some examples of common property types owned by REITs include:

• Apartments
• Offices
• Warehouses
• Hospitals
• Shopping Malls
• Hotels
• Cell Towers

1. Higher dividend yields

One of the primary reasons investors are attracted to REITs is their high dividend yields. The average REIT currently yields around 4.3%, which is notably higher than the dividend yield on the S&P 500 index which stands at around 1.6%.

REITs can provide such robust dividend payouts because of the favorable tax treatment mentioned earlier. Avoiding taxation on corporate income leaves more cash available to distribute to shareholders. The dividend payout requirement also ensures investors are rewarded with a steady income.

Within the universe of REITs, certain property sector REITs stand out for their high yields:

• Residential REITs: These own apartment communities and average a 3-4% yield. Examples include Mid-America Apartment Communities (MAA) and Camden Property Trust (CPT).
• Mortgage REITs: They originate mortgages or invest in mortgage-backed securities that may yield 12% per annum or more. Examples include Annaly Capital Management (NLY) and AGNC Investment Corp (AGNC).
• Retail REITs: REITs owning malls, outlets, and shopping centers average yields of 4-6%. Examples include Realty Income (O) and National Retail Properties (NNN).

The high dividend yields across REIT sectors make them attractive holdings for income-oriented investors.

2. Real estate diversification

Another major advantage of REITs is they provide investors with diversified access to real estate assets.

REITs often hold dozens or even hundreds of properties spread across different geographic regions and real estate types. Buying shares in a REIT instantly diversifies your investment dollars across its entire real estate portfolio.

For example, consider a REIT that owns a mix of apartment communities, shopping centers, and office buildings. An investment of just a few thousand dollars could gain exposure to all those varied property types and markets.

Investing in individual rental properties can require prohibitive capital to achieve the same level of diversification. Utilizing REITs makes wide diversification accessible without needing to buy entire properties on your own.

Some examples of diversified REITs include:

• Realty Income (O): Owns thousands of commercial properties leased to hundreds of tenants. Property types include retail, industrial, and agriculture.
• W.P. Carey (WPC): Has a property portfolio of high-quality commercial real estate, diversified in location, property type, and industry.
• Vanguard Real Estate ETF (VNQ): Holds shares in many different REITs, providing highly diversified exposure to the overall U.S. REIT market.

Beyond diversification across property types, REITs can also diversify an investment portfolio that otherwise has minimal real estate exposure. Adding a REIT allocation diversifies away from just owning stocks and bonds.

3. Liquidity

Liquidity refers to how quickly an asset can be converted to cash. Real estate investments like rental properties are relatively illiquid—it can take months to sell a property. REITs, on the other hand, offer daily liquidity since they trade on stock exchanges just like regular stocks.

Being able to buy and sell REIT shares instantly is a major advantage compared to direct real estate ownership. It provides flexibility to enter and exit positions according to your investing strategy and liquidity needs.

The easier liquidity of REITs comes with the caveat that their share prices will fluctuate daily based on market factors while underlying property values tend to move slower. Near-term price volatility is a trade-off that should be acknowledged.

However, over multi-year periods REITs have historically had lower price volatility than stocks. Their dividends also help cushion any share price declines during periods of market volatility.

4. Passive income

Owning and managing rental properties involves very active management. Landlords have to handle responsibilities like:

• Finding and screening tenants
• Collecting rents
• Maintaining and repairing properties
• Dealing with occupants violating leases or failing to pay rent

REITs remove these day-to-day management burdens from the investor. You can earn rental income from REIT-owned properties in a completely passive manner. The REIT handles all property management duties in exchange for collecting a management fee.

This passive income is one of the things that makes REITs appropriate even for investors who don’t want to deal with hands-on real estate investing.

5. Low volatility

While they do carry some risk, REITs have demonstrated lower price volatility historically than bonds and stocks:

(Source: REIT.com)

The relatively low volatility of REITs can be attributed to real estate’s inherent stability as an asset class compared to stocks. The value of quality properties tends to not fluctuate dramatically, acting as a ballast for REIT share prices over the long run.

Keep in mind periods of economic recession can still negatively impact REITs just like other equities. However, investors with long time horizons can more comfortably ride out periods of higher REIT volatility.

6. Low minimums

A further advantage of REITs is that the barrier to entry is very low—you can invest at the price of a single share. Many REITs trade in double digits per share.

Compare this to investing in rental real estate directly, where minimums to buy an investment property often run $100,000 or more.

The low cost of entry of REITs allows retail investors to gain diversified real estate exposure and earn dividends without needing tens of thousands in capital.

7. Tax advantages

We’ve already covered the tax advantage REITs have at the corporate level by deducting dividends paid out. But REITs can also benefit investors from a tax perspective.

Here are some of the key tax benefits for REIT investors:

• Qualified Business Income Deduction: For tax years 2018-2025, REIT dividends qualify for a 20% deduction against qualified business income.
• Capital Gains Treatment: Long-term capital gains tax rates can apply to price appreciation if shares are held for over one year. Short-term gains are taxed as ordinary income.
• Return of Capital: Some dividends may be considered nontaxable return of capital, lowering cost basis and deferring tax.
• Estate Planning: Stepped-up cost basis at death may apply. Heirs may inherit shares at market value, eliminating tax on gains.

These tax treatments may help further boost after-tax returns for REIT investors. However, consult a tax professional to understand how they apply to your specific situation.

Key risks and considerations

While this article focuses on the advantages, any overview of REIT investing would be incomplete without briefly discussing the key risks:

• Interest Rate Sensitivity: REITs may underperform when interest rates rise. Higher rates make it more expensive to finance properties.
• Economic Conditions: Periods of economic recession can lead to lower occupancy and rental rates. REIT prices may thus decline during recessions.
• Premium Valuations: Some REITs trade at premiums to their net asset value, increasing the risk of overpaying.
• Concentration Risk: Owning REITs concentrated in one sector (like malls) carries more risk than diversified REITs.
• Leverage: Some REITs use ample debt financing, increasing risk in their business model. Conservative leverage is safer.

Reasons why REITs may be the best real estate investment today

REITs offer many benefits for real estate investors. However, there are some specific reasons why they are an especially attractive choice in today’s environment:

1. Interest rates are high and rising

Interest rates have been rising steadily since March 2022. The Federal Reserve has been aggressively hiking rates to combat inflation. This could benefit REITs in two ways:

• New debt and mortgages will be at higher rates, giving an advantage to REITs that are already locked in low long-term fixed rates.
• Higher rates tend to hit growth stocks the most. Money rotates out of high-valuation growth stocks as rates rise, potentially boosting demand for REITs in a relative sense.

2. Many REITs use little leverage

Many REITs use less leverage than in the past. In 2008-2009, the debt/asset ratio for many equity REITs was over 50%. Now, many REITs have become more conservative and you can find ratios of around 35%, meaning today’s REITs take on less debt and have cleaner balance sheets.

3. Long debt maturities

The average REIT debt maturity schedule is around seven years. This means most of their debt is locked in at fixed rates for many years into the future. They have less refinancing risk in the near term.

4. Real estate values may decline

Higher rates make mortgages more expensive, which can put downward pressure on real estate prices. Actual real estate owned directly could depreciate in value in the short run. REITs allow investing in real estate without taking on that immediate valuation risk, in particular, if they are trading below book value. 

5. REIT valuations are lower than historical averages

Due to higher interest rates and some economic uncertainty, REIT valuations are well below historical norms. The average retail REIT price to FFO (funds from operations) ratio is around 15x. The historical average is closer to 20x FFO. So effectively, retail REITs, as an example, are “on-sale” relative to history.

6. Inflation hedge

Real estate tends to hold its value during inflation thanks to rising rents and property values. REITs provide exposure to that. Bonds and cash lose purchasing power during inflation while stocks are vulnerable to Fed hikes.

Examples of top-performing REIT sectors

REITs exist across many real estate niches. Here are some of the sectors that are primed to excel in the current environment:

• Data Center REITs: Data center demand is booming thanks to cloud computing, Internet traffic growth, 5G rollout, and remote work/learning. Top data center REITs like Equinix (EQIX) and Digital Realty (DLR) benefit from strong tailwinds.

• Cell Tower REITs: Cell towers have pricing power through long-term leases with mobile carriers. The rollout of 5G networks requires more equipment on towers. Crown Castle (CCI) and American Tower (AMT) are leaders.

• Industrial REITs: Increased e-commerce and supply chain re-shoring are fueling industrial demand. Prologis (PLD) and Rexford Industrial (REXR) focus on high-quality warehouse/logistics real estate.

• Healthcare REITs: Demographic trends drive growth in medical office buildings and senior housing. Welltower (WELL) and Ventas (VTR) are top players in this space.

• Grocery-Anchored Retail REITs: Retail with essential services like grocery stores tend to be internet-resistant. Realty Income (O) and National Retail Properties (NNN) are stalwarts here.

Should you invest in individual REITs, REIT ETFs or mutual funds?

If you decide to invest in REITs, you can either select individual REIT stocks to invest in or invest broadly in REITs through a mutual fund or ETF (exchange-traded fund).

Investing in individual REITs allows you to hand-pick companies in sectors you’re most bullish on. However, it involves more research and stock-picking skills.

REIT ETFs and mutual funds provide instant diversification. Some popular examples are Vanguard Real Estate ETF (VNQ), Schwab US REIT ETF (SCHH), and Fidelity Real Estate Investment Index Fund (FSRNX).

The right choice comes down to your goals, risk tolerance, and how much time you want to dedicate to analysis. Many investors choose a blended approach, investing in some individual names supplemented with a broad-based REIT fund.

No matter how you gain exposure, REITs can be a suitable addition to an investment portfolio. They provide income, diversification, lower volatility, and inflation hedging characteristics — all beneficial during periods of economic uncertainty. While past performance is no guarantee of future results, REITs have historically typically rewarded patient long-term investors.

To sum up

REITs provide a way to invest in real estate without directly owning physical property. They offer advantages like liquidity, diversification, stable cash flow, and tax efficiency that direct real estate investments lack. The key conditions, some of which appear favorable for REIT investing today specifically are:

• REITs use less leverage than in the past.
• For many REITs, their debt is locked in at low fixed rates for many years.
• Valuations are below historical averages.
• Interest rates are rising rapidly, which may benefit certain, low-leverage REITs. 
• Real estate prices could face pressure in the near term.

For these reasons, REITs likely represent a suitable real estate investment option for many investors in the current environment. They provide an attractive combination of income, inflation protection, and lower volatility compared to bonds and growth stocks that tend to be vulnerable to Fed rate hikes. While investing in physical real estate can also be rewarding, REITs offer a different way to gain exposure for the typical investor.