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So, are you wondering if you should invest in REITs to grow your money? Is it a good investment to include it in your investment portfolio? If yes, how do you choose what REITs to buy and also what deadly mistakes you should avoid while investing in REITs?
In this blog post, I am going to share with you what you MUST know when it comes to REITs investing.
What Are REITs?
REITs stands for real estate investment trusts which pool money from individual investors and use the money to buy and then operate properties such as shopping malls, hotels, office buildings and hospitals for rental income.
It is listed on stock exchange and trades like stocks, so you can buy and sell through your stock brokerage accounts.
When you buy shares of REITs, you become a part owner of their underlying properties.
So, how do REITs work?
Okay, REITs operate a very simple and transparent business.
They buys properties, and then rent them out and collect monthly rental from their tenants.
It works just like how an Airbnb host rents out his apartment for rental income.
But, the difference is that REITs are doing it on a much bigger scale and they hire a team of professionals to manage the properties.
There are many different types of REITs:
- Retail REITs ( i.e. investing in shopping malls)
- Hospitality REITs ( i.e. invest in hotels, resorts, etc)
- Commercial REITs ( i.e. invest in office buildings, etc )
- Industrial REITs ( i.e. invest in warehouses and distribution centers )
- Healthcare REITs (i.e. invest in hospitals, medical centres, senior housing, nursing facilities and etc)
- Data center REITs
- Infrastructure REITs (e.g. fibre optic cables, telecommunication towers, energy pipes, wireless infrastruture, etc)
Here’s a few examples of REITs.
Duke Realty is an industrial REITs that owns and operates approximately 155 million rentable square feet of industrial properties (i.e. warehouses) in 20 major U.S. logistics markets.
And most of its income comes from the renting out its warehouses.
Here’s another example.
Simon Property Group Inc, one of the largest retail REITs, owns and operates shopping malls.
Most of its income comes from the rent that it collects from its tenants.
Now, you know how REITs works.
So, how can you make money from investing in REITs?
There are two ways that you, as a REITs investor, can make money.
First, you receive regular dividend income from REITs (i.e. passive income) mostly on a quarterly basis.
This is because REITs are required by law to pay out at least 90% of its operating income (i.e. rental income) to its shareholders.
Secondly, there is potential for capital appreciation.
That means if the REITs share price goes up, you will make a profit from selling your REITs investement.
Let’s take a look at one example.
National Health Investors (NHI) is a healthcare REITs which primarily invests in seniors housing and skilled nursing facilities.
One way it does this is through sale-and-leaseback deals where operators sell their facilities to NHI and then lease them back from it.
Now, let’s look at how you can make money by investing a REITs like NHI.
Below is the dividend history of NHI.
As you can see from the table, it pays out dividends every quarter without fail.
More importantly, the dividends are increasing steadily year after year and its dividend yield is considered quite high at around 5%.
So, if you invest $100,000 in NHI, you can expect about $5,000 in dividend income every year.
Now, let’s take a look at its price chart.
As you can see from the chart above, its share price has been in an uptrend and has been making new highs.
If you had invested in it, you would be looking at a profit.
Are REITs A Good Investment?
So, are REITS a good investment?
Should you invest in REITs?
I am a big fan of REITs, and I personally invest in quite a number of REITs.
Here’s why I think REITs are a good investment.
Reason #1: It gives you stable income.
REITs are required by law to distribute at least 90% of its rental income to its investors on a regularly basis ( i.e. quarterly or semi-annually).
And the average yield of REITs is about 3.5% to 5% which is higher than what you will get from investing in investment-grade bonds or putting your money in a high-yield savings account.
Reason #2: It gives your exposure to the real estate market and diversifies your investment portfolio.
By investing in REITs, you can get exposure to some part of the real estate market (e.g. shopping malls, data centers and telecommunication towers ) that is difficult for individual investors to get access to.
Also, it’s a much easier, quicker and cheaper way to get into real estate compared to buying physical properties which generally requires more capital and takes a very long time to complete one transaction.
With REITs in your investment portfolio, you will have a more diversified portfolio which in turn reduces your risk.
Reason #3: It protects you against inflation.
Real estate is long known to be a good hedge against inflation.
As inflation rises, your money will lose its buying power but the value of your property and the rent that the tenant pays typically goes up with inflation.
So, it’s good to include real estate in your investment portfolio to protect yourself against unexpected inflation.
Although REITs have their distintive advantages compared to other investments asset class such as stocks and bonds, they are NOT riskless investments.
In fact, all investing comes with risk.
It’s just a matter of how much risk you are taking with a particular investment.
So, back to the question, are REITs a good investment?
If by that question, you mean whether or not you can make money with REITs, then the answer is yes.
Investing in REITs can make you money, just like stock investing.
BUT, just like stock investing, it’s also possible to lose some (or even all) of your money.
You see, REITS are good as an investment asset class.
When you talk about a good investment, it will ONLY happen if you choose the right REITs to buy and buy it at a reasonable price.
Now, the question becomes, “Should you invest in REITs?”
You should ONLY invest in REITs if :
- You know how to choose REITs (i.e. you should NEVER invest in something that you don’t understand)
- You have an investment plan for REITs ( i.e. what’s your entry price? how much do you plan to invest? how long do you plan to hold it? when do you plan to sell it?)
How To Choose REITs
So, how do you choose which REITs to invest in?
When it comes to REITs investing, there are a few things you must look at:
- Gearing Ratio & Interest Coverage ratio
- Quality of the underlying properties
- Concentration of its property investments
- Dividend yield of the REITs
- Dividend history
- Long-term prospect
Factor #1: Gearing Ratio
It’s common for REITs to borrow money to fund its property purchases, just like how businesses use debt to fund their operations.
Gearing ratio measures a REIT’s total long-term and short-term borrowings over its total assets.
Gearing ratio = Total Debts/ Total Assets
The higher the gearing ratio, the higher its financial leverage.
It also means that it has a greater amount of debts that it has to service.
Generally, you should not invest in REITs with an unhealthy gearing ratio (i.e. more than 45%)
This is because REITs with a high gearing ratio have a greater risk of default when there is an increase in interest rate and drop in business revenue.
Next, you should look at its interest coverage ratio which indicates the ability of the REITs to generate enough revenue to service its debts.
Interest coverage ratio = Earnings Before Tax & Interest / Interest Expenses
Generally, you should not invest REITs with an interest coverage ratio that is less than 2.
Too high an interest coverage ratio is also not very good because it means that the REITs is not using debts efficiently.
Factor #2: Quality of the underlying properties
When you buy REITs, you are essentially buying parts of the underlying properties.
Now, let’s just imagine that you are buying physical residential rental properties.
Do you look for properties in a good location?
Do you look for properties with nearby amenities?
Do you look for properties with existing tenants?
I bet, you do.
Because you want to buy a good rental property that is going to make you money.
And, it’s the same as investing in REITs.
You want to invest in REITs with a portfolio of high quality properties that can generate stable rental income for the long term.
So, how do you tell if the properties in their portfolio are of high quality?
There are a few things that you can look at.
- Location (i.e. does it have a good location?)
- Occupancy rate ( the higher the occupancy rate, the better it is)
- Stability in its rental income (i.e. there is not big fluctuation in its rental income.)
For example, if you want to invest in retail REITS (i.e. shopping malls), you should check if the shopping malls they have in their portfolio are high traffic shopping malls at an excellent location and also have a high occupancy rate.
Factor #3: Concentration of its property investments
There are REITs that invest in many different properties, but there are also REITs that only have very few properties in its portfolio.
So, which one is better?
First, let me give you an analogy.
Let’s assume that you are given two options to own part of the following two investment portfolios:
Option #1: 20 different rental properties at good location with existing tenants across a number of major cities in the US
Option #2: 5 rental properties at good location with existing tenants in Los Angeles.
Which option would you choose?
Most probably option #1.
Because you can spread risk out between many different properties across many different cities and not put all your eggs in one basket.
So in general, you should avoid buying REITs that only have very few properties or have one single property that makes up most of its portfolio.
Doing this will reduce your concentration risk.
Factor #4: Dividend yield of the REITs
Next, you should look at the dividend yield of the REITs.
What is dividend yield?
It is the amount of money REITs pays out per share (over the course of one year) divided by the price per share.
Dividend yield = Annual dividend per share/ price per share
The higher the dividend yield, the higher the return on your investment.
But, higher dividend yield does NOT necessarily mean it’s a better investment.
It’s an indication that the investment carries higher risk.
So, as a rule of thumb, you should not go after the highest yield REITs because it generally means the REITs are very risky and have a greater chance of having its dividends cut (or even default).
Factor #5: Dividend history
Closely related to dividend yield, it’s dividend history.
Why should you care about dividend history?
Examining REITs’ dividend history can give you an idea of whether it has been paying out dividends consistently and whether there is a steady growth in its dividend payouts.
It’s obvious why you want to see consistent dividend payout from REITs.
But, why does dividend growth also matter?
The reason is that it shows that the REITs have the ability to continually increase its rental income.
As a REITs investor, one of your main goals is to earn a consistent dividend income year after year.
That’s why it’s important to check the dividend history.
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REITs are a good investment because it can provide you consistent dividend income as well as potential capital appreciation. On top of that, it’s also a good hedge against inflation. But, if you want to be successful in REITs investing, you MUST know how to choose REITs the right way and have an investment plan in place for your REITs.