REIT Investing: Great Passive Income

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2 weeks ago

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Real estate investing is something that historically has generated plenty of wealth for people. The biggest issue for most, however, is actually getting the first property and getting started owning real estate. Not only that but being a landlord can be an extremely time intensive job that requires lots of labor at any given time of the day or night. If becoming a landlord doesn’t sound that appealing, but you still want to get into the real estate investing game, then REIT investing might be just what you’re looking for. You might be asking yourself, what exactly is REIT investing? Real estate can be a staple to your investment portfolio, but it can seem like a stretch. If you’re like many out there, you don’t even own the home you’re living in, you’re renting. So how could you ever get into real estate? Don’t worry, there is a way.

What Are REIT Investments?

A REIT, or Real Estate Investment Trust, is a company that owns or manages an incoming producing real estate property. The rent that is generated from these types of properties are distributed to shareholders in the form of dividends, which is how you make your passive income.

REITs are similar to mutual funds or index funds and trade on the major market exchanges just like most investments. REITs also allow for individual investors to pool their money together and own real estate in fractions. This is great because in most cases, these investors wouldn’t be able to afford the same properties in full on their own. This is part of the reason why REITs have gotten so popular in recent years.

When you own stock in a REIT, you own an extremely small portion of an apartment complex, office building, or whatever other real estate the REIT company might currently own that is a part of their money generating portfolio. It’s just like when you own stock in a large company, you own a small portion of that company.

Because of the general nature of real estate investing, REITs generally do better in low interest rate markets. When there are higher rates, it’s usually a bit more of a turbulent ride for the REIT market. This is why it’s important to diversify!

In order for a REIT to actually qualify to be a REIT, the company that backs it must adhere to very specific guidelines that are put in place by congress. These guidelines include:

  • Is considered a corporation according to the IRS revenue code
  • Is managed by a board of directors
  • Has at least 100 shareholders
  • Have no more than 50% of its shares held by five or fewer individuals
  • Has at least 75% of its assets in real estate, US Treasuries, or cash
  • Generates at least 75% of its net income from real estate
  • 95% of its income must be passive like rent
  • At least 90% of its taxable income is paid to shareholders via dividends

The main reason that companies have to abide by so many different rules before they can offer a REIT to the public is so that investors are more protected. Sure, there is always going to be some amount of risk when it comes to investing in general. But by having these guidelines in place, the investor is more protected from any type of schemes that more fraudulent companies might be trying to do.

Types of REITs

Just like there are different types of stocks and bonds, there are also different types of REITs. Below classify the different types of REITs

Equity REITs

Right now, the vast majority of REITs are equity REITs. An equity REIT buys, manages, builds, remodel, and sells real estate. The main revenue that will make you your passive income mainly derives from the rental income that the various properties generate. The different types of real estate properties that equity REITs include can be residential, retail, offices, industrial, and hotels. There are also equity REITs that specialize in each of these categories, meaning that if you want your real estate portfolio to consist mainly of residential properties, you can find a REIT that specifically invests in single family homes or apartment complexes. Likewise, you can find other specialty REITs, such as a retail REIT that will invest in shopping centers and strip malls.

Mortgage REITs

The remaining amount REITs that aren’t equity-based REITs are Mortgage REITs. Mortgage REITs only make up about 10% of REITs on the market, with equity REITs making up the other 90%. A mortgage REIT lends money to different real estate buyers so they can go buy real estate themselves. They also buy existing mortgages or a mortgage-backed security. The revenue that generates your passive income is paid through the interest paid on the mortgage loans that the REIT owns. Part of the reason that Equity REITs are more available on the market is that Mortgage based REITs can carry more risk since people are more likely to default on a mortgage. Like Equity REITs, Mortgage REITs can often specialize as well, and can offer either residential or commercial mortgage-based REITs.

How Do You Make Money on A REIT?

Like any investment, the ultimate goal of investing in a REIT is to make money. REITs can let investors invest in real estate the same way they invest in any other industry or business. That’s by purchasing REIT stock through a mutual fund or an exchange traded fund (ETD) on the stock market exchange. When you own shares in a REIT, you earn a portion of the money generated by that investment.

A major selling point for many investors is that REITs are exempt from corporate taxes as long as they adhere to the guidelines that congress gives them that have been outlined above. Because the income that comes from a REIT isn’t taxed, there is more money to give out to the shareholders. With this being said, shareholders will have to pay capital gains taxes on the dividends at their ordinary income tax rate. Investors can deduct up to 20% of REIT dividends, which will effectively lower the maximum tax rate from 39.6% to 29.6%. REITs often provide high dividends, and those dividend yields can increase over time as the properties that are owned by the REIT’s appreciate in asset value.

eREIT

The biggest downfall with investing in REIT that are designed to be bought and sold as a mutual fund or ETF is that they typically require a minimum amount to invest, which is usually $3,000. If a $3,000 minimum is too much for you to get started, you can always look into companies like Fundrise that offer their customers an eREIT.

Think of an eREIT as a new way to do crowdfunded real estate. What makes Fundrise such a great platform for people new to REITs in general is that you can get started investing in Fundrise for as low at $500. The way Fundrise works is that they pool relatively small sums of money from a variety of everyday investors and use the money to help real estate developers finance their projects. As previously stated, you can get started investing in Fundrise with their Fundrise Starter Portfolio for as low as $500. The advisory fee is 0.15%, and the management fee is 0.85% for this portfolio.

Since these investments are not publicly traded like a traditional REIT, they are less liquid. This means that if you want to invest in Fundrise, you should not use money that you’re going to need or want to use for something else in the next five years. For investing time commitments, Fundrise is considered to be a medium-term investment.

REIT ETFs

A REIT ETF is an exchange-traded fund that invests mainly in equity REITs. Like pretty much all other ETDs, these are not actively managed but built around one of the indexes of publicly traded real estate. The most common indexes that are used for real estate are the MSCI US REIT Index and the Dow Jones US REIT Index. 

Big investment companies like Vanguard offer their own REIT ETF named the Vanguard Real Estate ETF (VNQ) that includes some major US real estate companies like Equinox Inc, Public Storage, American Tower Corp, and Equity Residential. This is one that I personally own and love having a part of my portfolio for the diversification that it provides. Like most Vanguard ETFs, the expense ratio is extremely low, coming in at 0.12% annual. The annual yield averages out to 4.42%, and the minimum investment is $3,000.

REIT Investment Returns

The dividend income that REITs are known to provide make them a very good-looking investment option for those investors looking to form a passive income and for those who are retired and are looking to create another income stream. REITs typically will pay out almost all of their profits as dividends. Because of the different incentives that go along with REIT dividends, this is all the more reason to look into REITs as a way to diversify your portfolio and generate another stream of passive income.

If you’ve heard of dividend aristocrats, you might wonder why it’s better to invest in REITs than it would be to invest directly into the companies that these companies own if you want more dividends. While dividend aristocrats do have some of the same advantages that REITs have as well as others, the real estate market doesn’t always line up with the larger economy overall. To put it simply, investing in REITs are a good addition to a diversified portfolio and can also reduce volatility. On top of this, buying REITs directly can be less expensive to the investor versus buying stock in each company directly.

These points have been proven to be true over the course of decades worth of data. From 1870 to 2015, the housing market delivered an average annual return of just over 7 percent, which is slightly ahead of the stock market which averaged 6.89 percent annually over the same time frame. While this doesn’t seem like that big of a difference, you have to also keep in mind that not only did real estate outperform the stock market, but it also did it with far less risk and volatility in the market. There is plenty of market research to back these claims.

Something to keep in mind when looking into investments overall is that while some areas might provide higher returns on your investment over the long run, it is still best practice to diversify your entire portfolio to help mitigate risk in multiple areas. Another thing to keep in mind is that it’s best to invest in REITs for the long-term, as their short-term performance can be disappointing if you catch the real estate market in a down period.

Are REITs a Good Investment?

There is a lot of talk about owning rental property because it can be a great form of passive income if you play your cards right. This can be especially true if you use a turnkey service like Roofstock. It can be a no mess, no fuss, monthly rent check that you can pocket as additional profit. As has been advocated in this article, you should always have an extremely diversified portfolio for a number of reasons, and real estate should definitely be a part of that diversification mix. Landlords love being landlords because they continue to generate wealth in their sleep.

However, if you can’t afford to buy a rental property right now (or maybe ever, then investing in REITs are a great way to add that diversity of real estate into your portfolio. With great options like Fundrise that can get you started in real estate investing for as low as $500, this can open up a whole new segment of investing for people who otherwise wouldn’t have been able to afford it.

So, if you’re asking if REITs are a good investment, the answer is yes. REITs can generate some cash flow in the form of dividends and help diversity your portfolio.

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