What are REITs and Why Invest in REITs?

Why invest in REITs?

Real estate investment trusts (REITs) are funds that hold real estate in the form of properties (equity REITs) and/or mortgage assets. These income-producing assets are generally low risk; however, their risk is highly correlated with the credit quality of the underlying assets. Investors also benefit from income-producing dividends. REITs have a good performance track record but they do have a few blights on their investment record.

A Brief History of REITs

In the 1990s, real estate mortgages were issued to real estate buyers with lower credit quality than was typically accepted. This lending to below average or subprime credit increased the risk of the underlying assets. 

When the economy slowed down, the real estate borrowers – mostly homeowners – could not pay their mortgages. The REITs lost their value. The resultant domino effect in the global financial markets is known as the 1998 subprime mortgage crisis.

Today, REITs are a lower risk investment. More attention is paid to the credit quality of the underlying assets. The iShares Residential Real Estate Capped ETF was one of the highest performing REIT ETFs in 2015. The iShares Mortgage Real Estate Capped ETF, which tracks the benchmark FTSE NAREIT All Mortgage Capped Index, has a five-year return of 4.81% and a dividend yield of 11.45%.

How to Invest in REITs 

You have many options for investing in REITs. REITs diversify by geography and real estate sector.

Stock-exchange-listed REIT – The price of stock-listed REITs are fully transparent and trade on a public exchange. Prices are quoted as they change throughout the day. Publicly traded REITs are valued like other public stocks.

You will want to review growth in earnings per share and dividends. Like a commodity investment such as gold, changes in the value of the underlying real estate and mortgage assets should be monitored.

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REIT Mutual Fund – REIT mutual funds are trusts that own real estate and/or mortgage assets.  Instead of putting your money in one stock, you can diversify across many real estate assets. Mutual funds choose which real estate assets to invest in based on extensive due diligence, while ETFs (below) are exposed to all the holdings of an index.

REIT Exchange-traded Fund (ETF) – A REIT ETF tracks a REIT index and trades like a stock on an exchange. The iShares Mortgage Real Estate Capped ETF, which tracks the benchmark FTSE NAREIT All Mortgage Capped Index, has a five-year return of 4.81% and a dividend yield of 11.45%.

Different Types of REITs

REIT sectors respond differently to different cycles in the economy. During a strong economy, commercial REITs do well, such as office REITs, retail REITs, and REITs with hotel assets. People travel when the economy is doing well. These REITs are the first to suffer when the economic growth decelerates.

Mortgage REITs – cobble together mortgages in the secondary market. Like bonds, they are sensitive to interest rates. When interest rates rise, the value of mortgage REITs falls as investors seek higher performing assets. The cost of financing real estate also increases

Residential REITs – pool resident properties, including housing and apartment buildings. Real estate in cities experiencing strong economic and job growth tend to appreciate.

Retail REITs – invest in real estate with exposure to the retail sector, including shopping malls, retail chains and convenience stores.

Office REITs – invest in office buildings and derive income from rent. This sector does well when economic growth is strong.

Healthcare REITs – invest in real estate in the healthcare industry, including hospitals, medical centres and retirement homes. An ageing population with a longer lifespan is driving growth in healthcare services and the value of real estate assets.

While you can invest in REITs individually, a REIT ETF or mutual will spread your risk across a broader portfolio of real estate assets.

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