One Good Way to Dip Your Toe into Real Estate Investing

For a more liquid method of participating in the real estate investment market or a good way to diversify your portfolio, try looking into REITs.

Since they were first introduced 50 years ago, real estate investment trusts, better known as REITs, have become a bedrock investment tool for many Americans. Their popularity has soared over the past 10 years in particular, during which time the equity market capitalization of U.S. REITs has grown from $90 billion to about $200 billion.

A REIT is a company that owns and operates income-producing real estate property or mortgages. They receive special tax considerations, typically offer high yields, and pay dividends to investors. REIT shares are traded on the major U.S. stock exchanges.

REITs were created in 1960 as a way to give average investors the opportunity to invest in large-scale, income-producing real estate through the purchase and sale of liquid securities. Before this, only large institutions and wealthy individuals with the financial resources to make direct real estate investments had access to commercial real estate equity as a core investment asset.

There are three different types of REITS:

• Equity: These currently account for the majority of REITS. Equity REITs own and usually manage commercial properties, with revenue derived primarily from rents. Equity REITs invest in all kinds of commercial property: shopping malls, office buildings, apartments, warehouses, hotels, and so on. Some invest specifically in one particular kind of real estate (e.g., office buildings) or in a specific state or region of the country.
• Mortgage: These either lend money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities. Revenue is generated primarily by the interest earned on the mortgage loans.
• Hybrid: These are a combination of equity REITs and mortgage REITs that invest in both commercial properties and mortgages. Shares in REITs can either be purchased directly on an open exchange or by investing in a REIT mutual fund. Many REITs are also accompanied by dividend reinvestment plans (or DRIPs), in which dividends are automatically reinvested back into the REIT, thus potentially increasing long-term returns.

To qualify as a REIT, a U.S. company must meet certain Internal Revenue Code requirements. It must invest at least 75 percent of total assets in real estate; derive at least 75 percent of its gross income as rents from real property or interest from mortgages on real property; and annually distribute at least 90 percent of its taxable income to shareholders in the form of dividends.

While they are not without risk, REITs enable investors to significantly reduce the risk of investing in commercial real estate or mortgages by providing diversification. According to modern portfolio theory, diversification is key to minimizing overall investment risk, and REITs enable individuals to spread their investment dollars out over many different properties and mortgages.

They also provide much-needed liquidity. Before REITs, real state as an investment class was extremely illiquid; in other words, it was very difficult to sell quickly and easily. Their liquidity, however, makes REITs the most efficient way for investors to add commercial real estate exposure to their portfolios.

Don Sadler is a freelance writer and editor specializing in business and finance.