Real Estate Investment Trusts: The affordable way to be a landlord

Lots of personal finance hustlers promote real estate investment as the way to get rich. While real estate investing can certainly generate cash flow, it also requires lots of time and capital.

You need to:

• have a downpayment of 20%;
• secure financing, which may require a commercial loan if you're purchasing an apartment building;
• find a property in good condition, or that can be brought into good condition in an area where people are willing to pay you enough rent to cover your costs;
• insure the property against loss, at least until you've paid off the note;
• insure yourself and/or your company against lawsuits for accidents that occur on your property.

And that's all before you find a tenant who will pay rent on time and not cause damage beyond normal wear and tear. I still shudder at the story of an acquaintance in college who told me about the damage he and his housemates caused once they learned their landlord had no plans to return their security deposit. A bowling ball and a skylight were involved. I presume a lawsuit followed. Your rental property can also burn down, get flooded, suffer extensive termite damage, or be destroyed by a tornado, earthquake, or drunk driver.

Even basic repairs and maintenance can be a pain in the tuchus. You could hire a property management company to handle rent collection and plumbers, but that reduces your profit.

In other words, being a landlord comes with a good deal of financial risk. There is, however, a way to invest in real estate with fewer headaches: the Real Estate Investment Trust or REIT.

What is a Real Estate Investment Trust?

A Real Estate Investment Trust is an entity that collects capital from investors and uses that capital to purchase or finance the purchase of income-producing real estate. The REIT structure was established by Congress in 1960 specifically to make it easier for small investors to invest in large-scale real estate projects.

REITs fall into three categories.

• Equity REITs own, build, and operate income-producing real estate.
• Mortgage REITs loan money, either directly to borrowers, or by investing in mortgage-backed securities.
• Hybrid REITs do a bit of both.

In order to qualify as an REIT, the company must:

• invest 75 percent or more of its total assets in real estate and cash;
• derive at least 75 percent of its gross income from real estate, including rents and interest on mortages; and
• distribute at least 90 percent of its taxable income as shareholder dividends.

REITs are often, but not always, listed on a major stock exchange. I'm not connected enough with a financial advisor to have a lead on unlisted or privately-traded REITs. Even if I was, I'd probably steer clear. It's harder to determine the value of a share when there isn't a ready market for it. Non-traded and unlisted REITs are therefore riskier and less liquid.¹

Shares of publicly-traded REITs, on the other hand, are bought and sold like any other stock. That means you can begin investing in real estate for the cost of one share.

Advantages of an REIT

We own shares of about a half dozen REITs. I like them for a few reasons.

Higher dividend yields

Because REITs need to distribute 90 percent of their taxable income, dividend yields tend to be higher than average. AvalonBay Communities, Inc (AVB), for example, currently pays a divided yield of about 3.5 percent. NNN REIT Inc offers a yield of more than 5 percent. Both are quite a bit higher than the yield for the S&P 500 overall.

Liquidity

Publicly-traded REITs are also liquid. If you need to convert your asset to cash, you can usually sell quickly, even if it's at a loss.

That isn't true when you own real estate directly. You may have to pay to evict a tenant. You'll probably have to pay 6% commission to a real estate agent. You may have to pay to fix the place up to ready it for sale. Then you have to wait for someone to buy the place and hope that you break even.

Diversification

You can find REITs for all kinds of real estate — residential, commercial, industrial, even farm and timberland. Buy a few shares of a few different kinds of REITs, and you're already more diversified than you'd be if you bought individual properties.

AvalonBay, for example, invests in multi-family residential real estate (e.g. apartments and townhomes). American Homes 4 Rent (AMH) and Invitation Homes (INVH) buy, build, manage, and rent single-family residential properties.

REITs such as NNN and Realty Income Corporation (O) specialize in commercial properties and long-term lease agreements — think grocery stores, movie theaters, fast food, big box stores, and fitness chains.

You can even invest in health care facilities, warehouses and self-storage companies, and data centers (such as Digital Realty Trust).

As importantly, REITs make it possible to be geographically diversified in a way that requires much more capital if you're a solo or mom-and-pop real estate investor. AvalonBay, for example, owns more than 88,000 apartment units across 12 states.

We own shares of American Homes 4 Rent, NNN, Realty Income, and Digital Realty Trust.

Someone else manages things

Bowling balls through skylights, evictions, and lease negotiations are someone else's job. You collect dividends, and hopefully experience modest growth in the value of your shares.

Risks and downsides

REITs aren't all rosy, however. If, say, a once-in-a-century pandemic comes along and forces people to work from home indefinitely, your commercial office REIT could be in trouble. A hurricane, flood, or tornado could wipe out portions of a residential REIT's holdings. The same goes for wildfires and timberland REITs.

Another downside: REITs are generally not growth stocks. Instead, you get steady dividends from lease and mortgage payments and maybe a bit of price appreciation. If you want to find the next Tesla, Alphabet, or Amazon, it will not come from this sector.

Lastly, dividends from an REIT may be taxed at the same rate as ordinary income rather than as qualified dividend income or capital gains. If you hold your shares in a tax-deferred account, however, you only pay taxes when you withdraw your money. At that point, it's all ordinary income anyway and your tax rate will depend on how much you withdraw in a particular year.

Conclusion

REITs let you earn money from real estate without needing to manage properties, save a downpayment, or arrange financing. They can help reduce volatility in your portfolio, because real estate has a low correlation to stocks. When consumer discretionary stocks (such as car manufacturers) fall, REITs generally continue to pay dividends.

Most of the personal finance advice I've read suggests allocating 5 to 10 percent of your portfolio to real estate. Be aware of the risks and the drawbacks, however. Stick to publicly-traded REITs. Buy a few different kinds — e.g. medical, residential, retail, industrial — that cover a few different regions.

Learn more

• What's a REIT (Real Estate Investment Trust)? from Nareit, the industry's advocacy group.
• Opinion: Don’t become a landlord — own these REITs instead from MarketWatch highlights a few residential REITs
• Real Estate Investment Trusts (REITs), from Investor.gov.