Your 401(k) is maxed out. You’ve got your Roth IRA humming along. Your retirement is looking pretty sweet, but you want more. You’ve heard that investing in real estate is a good idea, and maybe you read somewhere that a real estate investment trust (REIT) is a great way to get into that space.
But what is a REIT? How does it work? Well, buckle up, and we’ll take you through it.
What is a REIT?
A real estate investment trust—the cool kids call it a REIT, pronounced “reet”—is basically a mutual fund that buys real estate instead of stocks. REITs have a special tax status that requires them to pay 90% of their profits back to the shareholders. This payment is called a dividend. If they follow this rule, then they aren’t taxed at the corporate level like every other type of business.
All REITs have to meet certain requirements to qualify:
- The trust must have at least 100 shareholders.
- No five of these shareholders may own more than 50% of the shares.
- At least 75% of the trust’s assets must be invested in real estate, cash or Treasuries.
- 75% of the gross income must be generated by real estate.
Is your head spinning yet? Well, this certainly isn’t the easiest way to invest in real estate. But there’s a lot to learn here. Basically, there are two types of REITs: equity REITs and mortgage REITs.
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We’ll take a look at both types below!
Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate. Some of these types may be:
- Apartment complexes
- Single-family homes
- Big-box retail space (a shopping center featuring at least one big store like Best Buy or Home Depot)
- Hotels and resorts
- Health care buildings and hospitals
- Long-term care facilities
- Self-storage facilities
- Office buildings
- Industrial buildings
- Data centers
- Mixed-use developments
Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.
Now, equity REITs make money for their investors in several ways:
- They make the most money by collecting rent on the property they own.
- As the property values go up, the values of the shareholders’ investments grow too, and the commercial properties generate even more income.
- REITs make money through buying and selling properties.
Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates. To maximize returns, mortgage REITs tend to use a lot of debt—like $5 of debt for every $1 in cash, and sometimes even more.
Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates.
Okay, this gets complicated, so let’s put it in numbers to try to simplify it. Let’s say a mortgage REIT raises $1 million from investors. It then borrows $5 million at a 2% interest short-term interest rate. This gives it $100,000 in annual expenses that it has to pay back. But it takes the $6 million in cash it now has to buy a bunch of mortgages owing 4% interest, which produces $240,000 in interest income for the REIT. This difference ($140,000 in our example) is the profit.
Because you’re smart, you may be asking yourself, What happens if the short-term interest rate goes up?
Any increase in the short-term interest rate eats into the profit—so if it doubled in our example above, there would be no profit. And if it goes up even higher, the REIT loses money. All of that makes mortgage REITs extremely volatile, and their dividends are also extremely unpredictable.
Should I invest in a REIT?
Let’s get this out of the way up front: Mortgage REITs are a terrible idea. They use debt to buy debt and they’re so risky you don’t want to come within 50 miles of one. What happens when interest rates go up? You lose money. What happens when people stop making their house payments? A REIT can probably withstand one or two homeowners who bail on their mortgages. But if we get into a situation similar to 2008 when millions of people lost their homes? Forget it.
Let’s get this out of the way up front: Mortgage REITs are a terrible idea. They use debt to buy debt and they’re so risky you don’t want to come within 50 miles of one.
Equity REITs are not as risky, and there are maybe one or two out there that perform as well as good growth stock mutual funds. But, in general, if you’re going to invest in real estate, then you should just buy real estate. When you invest in a REIT, you don’t have any control over which properties they buy or how the properties are managed or any decisions made about those properties.
This isn’t rocket science or brain surgery.
In general, if you’re going to invest in real estate, then you should just buy real estate. When you invest in a REIT, you don’t have any control over which properties they buy or how the properties are managed or any decisions made about those properties.
Invest in real estate the old-fashioned way
Real estate is a great investment, but you need to know what you’re doing, and you should be passionate about it. Start by learning about real estate from a pro—like one of our real estate Endorsed Local Providers (ELPs). A real estate ELP can educate you about the types of properties you can buy and what types of renters you can expect. They can help you get a deal. As Dave likes to say, “In real estate, money is made at the buy.” Our ELPs can teach you to be patient so you can buy real estate like a pro—for pennies on the dollar.
To keep your investment risk as low as possible, you should be debt-free, have an emergency fund of at least 3–6 months of expenses, be contributing 15% your income to retirement, and pay cash for your investment property. And, because HVACs breaks down and garbage disposals stop working, it’s a good idea to have money set aside for upkeep and repairs. As a landlord, that’s up to you.
Just like with REITs, you’ll make money several ways as the owner of an investment property. You’ll make money over the long term as the value of your property increases—especially when you buy a house at a low price, then ride out any downturns in the market, and sell it when the value has gone up.
You also make money with rental income. This is why most investors buy property. Because once you get a quality renter, your property will generate monthly income without too much effort on your part. Heck, you can even hire a property management company to handle repairs and maintenance for you, although that will cut into your profits.
Just keep in mind that dealing with renters can sometimes be unpleasant and time-consuming. And they can cost you a lot of money if they damage the property. Evicting a renter can be a headache, too. Depending on the laws in your area, it may require you to hire a lawyer. But if you’re prepared, the long-term benefits can be worthwhile.
Are you ready to buy some real estate?
If you’re passionate about owning investment property, now is a great time to talk to one of our real estate Endorsed Local Providers (ELPs). They’re experts at buying property in your area, they have the heart of a teacher, and they’ll educate you on all of the ins and outs of buying real estate.