If you want to get into real estate investing but don’t have enough capital, REITs are your chance.
REITs, or Real Estate Investment Trusts, run like a mutual fund would. They buy bundles of real estate, and you get a chance to buy the fund.
Just as a mutual fund buys a portfolio of companies, an REIT buys a portfolio of real estate.
They buy commercial, industrial, or residential real estate. The owners of the REIT are then paid part of the profits from these investments in dividends.
There are 2 distinct advantages to REITs.
1. By law, an REIT must pay 90% of its earnings to shareholders in a dividend
2. Investing in REITs gives you an additional layer of diversification
REIT Advantage #1
What a great feature to have. Instead of having to worry about management pissing away earnings, the shareholder gets money in hand.
This is how companies should be run. With the shareholder in mind.
Of course, an REIT isn’t a company and doesn’t have to deal with the types of liabilities that companies need to run. So this will never happen.
But it does happen in REITs. And it’s up to shareholders to take advantage.
Keep in mind is that dividends from an REIT are taxed differently than dividends from a corporation. REIT dividends are taxed as income, not as capital gains.
Therefore, you should hold REITs in a tax deferred IRA or 401k.
The only exception to this is if the REIT dividend becomes a qualified dividend, which must be held throughout a set holding period.
REIT Advantage #2
Because an REIT is invested in real estate instead of a company, it provides diversification through a different asset class.
This is important because equities (stocks) tend to generally move in the same direction. Equities tend to rise and fall during the same time.
So, a portfolio of only stocks will lose value quickly during a market crisis. The investor would then have no choice but to wait out the storm.
But if you diversify your asset classes (stocks, bonds, real estate) so that you aren’t all in stocks, then you can shift money in and out of these asset classes as you need to.
In fact, the investing legend Benjamin Graham emphasized the importance of always holding both stocks and bonds. His teachings on how to balance these holdings were absolutely brilliant.
Graham urged his readers to carry more bonds when stocks were up, and carry more stocks when they were down. They may seem counterintuitive, but bear with me and listen up. This is important to understand.
The worst time to buy a stock is when it has already seen massive gains. A stock that has performed extremely well will no longer be undervalued, and so it won’t have the margin of safety you need.
This is the foundation of value investing, and you can learn more about it in Benjamin Graham’s book The Intelligent Investor.
When a stock is beaten down, then at that time you can purchase shares at a discount. It’s like a clearance sale. Once you know how to calculate what the stock is worth, you can find the stocks that are trading at extreme discounts, and purchase assets for less than what they are worth.
This is exactly how to make money in the stock market, and do it successfully.
So what does this have to do with REITs?
Well if you remember what I was saying about asset class diversification… You want to shift money in and out of stocks and bonds depending on how stocks are valued.
When most stocks are overvalued, then this is the time you want more of your portfolio to be bonds and REITs instead of stocks.
Then when stocks crash and trade at discount, bargain prices– you’ll have the cash to be able to buy many of them. That’s when you want to transfer the money out of your bonds and REITs and into stocks.
REITs maximize gains if you use them this way.
REITs: Great Inflation Hedge
REITs are also a great inflation hedge. Historically, real estate prices have risen with inflation. Since their inception in the 1970s, REITs have done fantastically well amidst federal deficits and government debt.
Many residential real estate properties have increased substantially in the past 20 years. You saw it with the real estate bubble, and it’s recovering again. REITs are great for giving you peace of mind against the fear of unlimited money printing.
But don’t think that all REITs are without risk. Many of them use a ton of debt to purchase their properties.
Some of the REITs that are most heavily leveraged will get absolutely devastated when interest rates finally rise. Many of them are heavily dependent on interest rates, and operate with low spreads.
You don’t want to be invested in those kind of REITs when interest rates rise.
These type of REITs are known as Mortgage REITs. Be extra careful when investigating those. You might also hear of Hybrid REITs. These are a mix of Equity REITs (just real estate) and Mortgage REITS.
So when you invest in a REIT, pick one that is more conservative than its peers. Especially about debt. They should have a solid balance sheet.
If you don’t know how to figure this out or don’t want to, then invest in an REIT ETF like VNQ. These ETFs hold a bundle of REITs and keep you safe through diversification.
This will limit your gains, but I understand that some don’t have the desire to research. That would then be the best option for you.
If you are interested in learning how to research an REIT, well you’re in luck because it’s no different than researching a company.
I’ve dedicated plenty content towards helping you research a company.
1. Where to Find Ideas for Stocks
2. How to Analyze a Company
3. Stock Market Challenge
4. 7 Steps to Understanding the Stock Market
Definitely check out all of those, especially #2.
You’ll learn how to research a company. It will directly relate to helping you research a REIT. The methodology and even websites used are exactly the same.
Having the power to understand the balance sheet of a REIT is so critically important. You’ll never have to worry about your investments ever again. And best of all, you only have to learn it once.
It’s a skill that will pay you dividends for life. Do it.
**A Simple REITs Guide for Beginners**
**All Rights Reserved. Investing for Beginners 2013**
**Photo shown above can be found here: Photo Attribution**