Equity REITs allow investors to benefit from a diversified portfolio of income-producing commercial real estate. How do equity REITs work, and how can you invest in them?
Equity REITs Defined
Equity real estate investment trusts, also known as equity REITs, are indirect investment vehicles that own or operate income-producing commercial real estate, such as office buildings, shopping centers, apartments, and many other property types.
Equity REITs are indirect investment vehicles because there is a professional money management team that selects the direct real estate investment properties on behalf of REIT shareholders.
Public equity REITs are registered with security regulators, such as the U.S. Securities Exchange Commission (“SEC”). Most public equity REITs trade in the secondary market on a stock exchange. These public REITs are liquid in that they can be sold during the market trading day with the proceeds from the sale received within a couple of days once the trade settles.
Some public equity REITs are registered with the SEC or other security regulators but are not listed on a stock exchange.
Private REITs are not registered with security regulators. Most private REITs are bought directly from the REIT sponsor and are less liquid than public REITs because the shares have to be repurchased by the fund sponsor.
Some private REITs set a limit to the percentage of outstanding shares they are willing to purchase each year. This repurchase limit can be as low as 5% of the outstanding shares.
Equity REIT Sectors
Equity REITs own and manage a wide variety of property types as shown in the following graphic and table:
Equity REIT Property Sectors
- Office REITs—own and manage office buildings
- Industrial REITs—own and manage warehouses and distribution centers
- Retail REITs—own and manage retail stores and shopping centers
- Lodging REITs—own and manage hotels and resorts
- Residential REITs—own and manage apartments and single-family residences
- Infrastructure REITs—own and manage infrastructure assets like cell towers and energy pipelines
- Self-storage REITs—own and manage storage facilities
- Healthcare REITs—own and manage medical and long-term care facilities
- Data Center REITs—own and manage information technology data centers
- Timberland REITs—own, manage, and harvest timberland
- Diversified REITs—own and manage mixed property types
- Specialized REITs—own properties that don’t fit into the other categories
How REITs Are Taxed
Real estate investment trusts receive special tax treatment if they meet certain conditions set out by taxing authorities. These conditions vary by country. The main criteria to be classified as a REIT in the U.S. are:
- The REIT must be owned by more than 100 shareholders.
- The REIT must have more than 75% of its assets invested in real estate, government securities, or cash.
- 75% or more of the REIT’s gross income must be derived from real estate activities.
- At least 90% of the REIT’s taxable income must be distributed to shareholders as dividends.
If a U.S. REIT meets the requirements, it can deduct its dividend payments from its taxable income, which means REITs pay little if any income tax.
Most corporations do not receive a tax deduction for dividends paid to shareholders, so these corporations pay dividends from after-tax income. REITs can pay higher dividend amounts than regular corporations because REITs pay dividends from pre-tax income.
How REITs Work
REIT operators distribute most of their taxable income to shareholders through dividends. These operators generate the majority of that income from the properties they own. They seek to grow their income and dividends by increasing the rent on their existing properties and by acquiring new properties.
REIT operators raise funds to purchase new income-producing properties by borrowing money and by issuing new stock shares.
Real estate investment trust operators also seek to improve profitability by selling existing properties and reinvesting the proceeds in properties that can generate a higher return.
Returns for Investing in Equity REITs
As equity REITs expand their real estate portfolios’ size and profitability, that leads to higher returns for REIT investors. The three factors that determine the total return for equity REIT investing are:
- The dividend yield
- The growth in the dividend over time
- Changes to what investors are willing to pay for REITs now versus later
Dividend yields have historically comprised about 40% to 60% of REIT returns. The dividend yield for U.S. equity REITs has averaged 3.71% over the past decade. U.S. equity REITs comprise about 65% of the global equity REIT market.
For the ten years ending June 30, 2020, global equity REITs returned 8.1% annualized, as measured by the S&P Global REIT Index. U.S. equity REITs, as measured by the Dow Jones U.S Equity All REIT Index, have returned 10.3% annualized for the decade ending June 30, 2020.
A reasonable return assumption for equity REITs over the next decade can be derived using the existing REIT dividend yield and adding a dividend growth rate assumption.
For example, with U.S. equity REIT dividend yields at 4%, if dividends grow at 2% to 3% per year, then a reasonable expected return for equity REITs is 6% to 7% annualized. This assumes investors are willing to pay the same amount in the future for each dollar of REIT earnings or dividends as they do today.
If REIT investors are willing to pay a higher multiple for earnings or dividends in the future than they do today, then investors could earn more than 6% to 7% annualized over the next decade.
If REIT investors are willing to pay less, then REIT returns will fall short of 6% to 7%. REITs will also fall short if REIT earnings grow slower than 2% per year.
Equity REIT Valuations
There are several valuation metrics investors can use to determine if REITs are more expensive or cheaper than they have been historically. Analyzing these metrics helps investors evaluate if REIT returns might be lower in the future because REITs are richly valued today.
Several of these valuation metrics are explained below.
The most straightforward metric is the dividend yield relative to both the average REIT dividend yield and yields on government bonds. NAREIT provides current and historical U.S. REIT dividend data for free.
Another metric for evaluating equity REITs is price to funds from operations. Funds from operations (“FFO”) measures a REIT’s net cash flow from operations.
FFO is calculated by taking the equity REIT earnings and adding non-cash expenses like depreciation and amortization and then subtracting gains on the sale of properties.
Investors can compare the current price-to-FFO for a REIT or REIT index to the historical price-to-FFO. Unfortunately, FFO calculations for equity REITs and indices are not always readily available for free.
Price to Net Asset Value
A final metric for analyzing REIT valuations is the price to net asset value. A REIT’s net asset value (“NAV”) reflects the per-share market value of the REIT’s assets minus its liabilities.
The NAV per share can then be compared to the equity REIT’s share price to see it is selling at a premium or discount relative to the net asset value.
When equity REITs sell for a discount to the net asset value, it suggests REITs are either undervalued or that REIT investors anticipate the market values for commercial real estate will fall, reducing the discount.
When equity REITs sell at a premium to the net asset value, it suggests REITs are either overvalued or that REIT investors anticipate the market values for commercial real estate will increase, eliminating the premium.
How To Invest in Equity REITs
While investors can research and invest in individual public REITs, most investors will find it easier to invest in an equity REIT mutual fund or exchange-traded fund.
An equity REIT exchange-traded fund is a low-cost way to invest in a diversified public REIT portfolio. An equity REIT ETF seeks to track a specific REIT index. An example of a U.S. equity ETF is the Schwab U.S REIT ETF (SCHH), which owns over 140 U.S. REITs. The ETF has an expense ratio of 0.07%.
The iShares Global REIT ETF is an example of a global REIT ETF that owns close to 300 REITs around the world. It has an expense ratio of 0.14%.
REIT Mutual Funds
Another option for equity REIT investing is an active REIT mutual fund. Rather than seeking to track a specific REIT benchmark, active REIT managers select individual REITS that they believe will outperform the index. Active REIT investors can overweight and underweight REIT sectors.
While some active REIT mutual funds have outperformed equity REIT indices and ETFs, most have not. According to Morningstar, only 28% of active U.S. equity REIT mutual funds have outperformed comparable REIT index funds and ETFs for the 10-years ending December 31, 2019.
Only 40% of active global equity REIT mutual funds have outperformed comparable global REIT index funds and ETFs for the 10-years ending December 31, 2019.
Private REITS will usually have a more concentrated portfolio than a public REIT ETF or mutual fund. In addition, private REITs will often charge a redemption fee if the holding is sold within the first few years of ownership. Private REITs are also less liquid as the REIT sponsor will only buy back a certain amount of outstanding shares each quarter.
Benefits of REIT Investing
Equity REIT investments allow investors to gain exposure to a diversified portfolio of income-producing commercial real estate while relying on professional managers to select and manage the properties.
Equity REIT investments provide investors with an attractive dividend yield that is higher than the overall stock market.
Public equity REIT ETFs and mutual funds are liquid and can have low expense ratios, providing investors with a convenient and flexible way to invest in real estate.
David Stein is the founder of the Money For the Rest of Us investment education platform. Since 2014, he has produced and hosted the Money For the Rest of Us investing podcast and led the Money for the Rest of Us Plus membership community. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David was an institutional investment advisor and asset manager. He was a managing partner at Fund Evaluation Group, LLC, a $70 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.