Real estate investment trusts (REITs) are a relatively small investment category; there were just 123 equity REITs in the FTSE NAREIT index, which comprises all the REITs traded in on the NYSE, NASDAQ and AMEX exchanges, in the fourth quarter of 2011. However, even though the REIT investment universe is small, it contains many subcategories and within those subcategories each REIT is unique.
"REITs often appear simple but are very complex investments," says Mike Maynes, a Boca Raton, Fla.-based Certified Financial Planner. They "can play a meaningful role in an investment portfolio by providing a non-correlated asset, income and possibly capital appreciation," Maynes adds. He says that most asset-allocation models call for investors to put 1 to 7% of their funds in REITs.
If you're looking to add REITs to your portfolio, read on. This article will describe the key features of three subcategories of equity REITs: industrial REITs, multifamily REITs and hotel REITs.
Industrial REITs, considered a subsector of the industrial/office category, represent about 7% of equity REITs included in the FTSE NAREIT index. Industrial REITs acquire, own and manage industrial properties, such as warehouses, distribution centers, manufacturing centers, flex/office buildings, undeveloped land, business parks and high-tech space.
Industrial REITs are described by the number of properties owned, the number of customers/tenants they have, the number of locations they operate in, and the number of rentable square feet they own. To attain diversification, an industrial REIT will often have holdings that encompass a variety of geographic locations, industries and tenants.
Industrial REITs often choose geographic locations that are strategically located for distribution. Railroads, airports, seaports and major freeway interchanges are considered elements of a strategic location, because they facilitate the movement of goods. REITs also locate their holdings in geographic areas that are performing well economically. REIT managers look at what is driving the economies in their target cities and assess whether demand for industrial properties is likely to grow, remain stable or decline in upcoming years. They might further focus on markets that meet a minimum population threshold or that have a certain amount of industrial real estate. Locations with limited industrial land, which translates to limited supply and limited competition, are also a plus.
The tenants of industrial REIT properties are wide ranging, but they might be in the business of construction, engineering, food, beverages or information technology. Other possible tenants include manufacturers, transportation companies, logistics providers and retailers. National and international firms tend to make desirable tenants, because they are established, proven businesses that are likely to pay the rent.
By owning diverse properties with diverse tenants, an industrial REIT can protect itself against swings in rental income caused by a decline in a particular region or industry. Staggering the lease termination dates of the portfolio's properties also protects the REIT against a sudden loss of income if a bunch of properties were to go vacant all at once. Properties that are flexible and can be turned from one use to another can also help an industrial REIT maintain its revenue stream by making vacant properties marketable to a wider variety of prospective tenants.
Most residential REITs are multifamily REITs, also called apartment REITs. As of the fourth quarter of 2011, 15 out of 123 equity REITs, or 12%, were multifamily REITs. Apartment REITs characterize themselves by the number of properties they own and the number of units those properties contain.
An apartment REIT owns a portfolio of rental apartment properties. These are commonly large residential properties, such as mid-rise and high-rise buildings, student housing and senior housing. Multifamily properties often have hundreds of residential rental units at a single property. Some multifamily developments even have thousands of units. Some apartment REITs are "fully integrated," meaning that they not only own properties, but also develop, redevelop and manage them.
Multifamily REITs derive their performance from rent prices and occupancy rates. As such, multifamily REITs look to invest in markets that have strong economic growth and high barriers to entry, and that are poised to benefit from population shifts, such as the aging baby boomer generation moving into senior housing and Generation Y moving out of their parents' homes and into apartments. New household formation also means increased demand for housing.
Employment is another fundamental of multifamily REIT performance. If there are no jobs in a particular city, there will be reduced demand for housing. On the other hand, tighter incomes can improve demand for rental housing, compared to owned housing, and help multifamily REITs if renting is more affordable than owning. That being said, in some markets, such as Washington, D.C., people will rent by choice even if owning is more affordable, because of the flexibility that renting offers. Along with Manhattan, Washington, D.C. is one of the biggest multifamily housing markets in the United States, based on total sales volume of multifamily units. In general, apartment markets are strongest on the East and West coasts, so some multifamily REITs concentrate their holdings in these areas.
Many multifamily REITs focus on higher-end and luxury properties that attract higher-quality tenants and support more expensive rents. Owning such properties generally means that REITs must manage amenities like club houses, swimming pools, gyms, game rooms and business centers that are part of high-end properties. However, high-end amenities can help retain renters even when buying is more affordable. For the same monthly payment, it might be possible to rent a much nicer place than one could buy.
One risk of multifamily REITs is a loss of income if it can't retain current residents and attract new ones. This might happen if housing market competition makes a different type of housing or a competing property more attractive. Lower home prices can also negatively affect multifamily REITs as tenants decide to become homeowners. This shift can reduce rents and occupancy rates for multifamily properties. Flat or declining wages can also spell trouble as it limits property owners' ability to raise rents.
Multifamily REITs are considered a good way to diversify one's real estate investments, because when home ownership declines, renting increases and apartment REITs perform relatively well. Indeed, some housing analysts thought multifamily REITs benefited from the housing bubble burst as foreclosures, depressed prices and tight financing made renting more attractive than buying. According to the National Association of Real Estate Investment Trusts (NAREIT), when rents rise, the additional revenue gets passed on directly to shareholders because by law, REITs have to pay out 90% of taxable income as a dividend.
Rather than owning an apartment building, investing in an apartment REIT provides much greater diversification across different properties and geographic areas, as well as time savings and professional property management.
Hotel REITs, not surprisingly, own hotel properties and are also known as lodging or resort REITs. As of Q4 2011, 14 of these REITs were publicly traded on the FTSE NAREIT index. Like multifamily REITs, hotel REITs are described by the number of properties and the number of rooms they own.
There are many different types of hotel properties that a hotel REIT might own, including limited service, full service, resort, conference center, suite and airport properties. You might be surprised to learn that some hotel properties operated under the popular Marriott, Hyatt, Hilton, Starwood and Fairmont brands are owned by hotel REITs. REITs can also have a joint venture interest in hotels, rather than complete ownership.
Hotel REITs derive value from the underlying value of the hotel properties the REIT owns and from the income generated by those properties. Hotel earnings are influenced by consumer and business demand for travel and lodging services, room rates, occupancy rates and demand for different property and room types (e.g., higher-end, lower-end). A hotel REIT can also earn income by licensing a hotel brand. This can help a hotel REIT diversify its income stream and reduce its investment risk. Acquiring hotels with national brand-name recognition can be a hotel REIT investment strategy.
Investors commonly use funds from operations (FFO) and adjusted funds from operations (AFFO) to evaluate REIT earnings. A unique financial measurement used in hotel REIT financial analysis to evaluate the performance of individual hotel properties and compare performance among different properties, is revenue per available room, which multiplies a hotel's occupancy rate by its average daily room rate.
Determining which category or subcategories of REIT to invest in is only a first step.
"Investors should weigh various factors when selecting a REIT that's right for their investment plan, including the trust's experience and years of successful business operation, track record, filings, debt, overall reputation and taxation on the REIT," says David B. White, J.D., CPA, CLU, ChFC, and president of David. B. White Financial in Detroit, Mich.
He also suggests that investors look at funds from operations to make sure the REIT is fully covering the dividend payout, and there are still more factors to consider.
"Investors should be mindful of several potential pitfalls when investing in REITs, including splashy materials, lack of full disclosure in the sales process, lack of liquidity and a long-term investment hold. Investors should also look out for dividends which can be cut, especially if the FFO doesn't cover the dividend," White adds.
The Bottom Line
REITs offer investors a convenient and inexpensive way to gain exposure to a diverse group of real estate holdings. As a unique asset class that moves differently from stocks and bonds, they make a logical addition to a portfolio.
More From Investopedia