Buying real estate is expensive. Even if you live outside of a major city, the odds are a house purchase is going to be one of the priciest things you purchase during your life.
And for the average person, investing in real estate by buying physical buildings is a very tricky thing to do. Yes some people might rent out a second home but buying offices or retail stores is simply not within the grasp of the average person.
That’s why real estate investment trusts — or ‘REITs’ for short — are a popular way of investing in property. Just as you wouldn’t try to invest in Facebook by buying the whole company, REITs let you buy shares representing a small holding in a larger property portfolio.
What is a Real Estate Investment Trust?
A real estate investment trust is a company that invests in different types of real estate. That could include everything from flats people live in to data centres used by technology companies.
Owning shares in a real estate investment trust is a means by which you can invest in those properties. And because those shares aren’t going to cost you hundreds of thousands of pounds, they’re also a cheaper way to do it.
Lots of international stock markets offer REITs and each one will have their own laws governing them. As a result, and even if they look similar, the way REITs operate varies from country to country, so you should check any local laws before investing in them.
How do REITs work?
On a practical level REITs work in much the same way stocks do. Shares in REITs are usually listed on exchanges and can be traded by market participants.
The difference usually lies in the regulations that govern them.
In the UK, REITs are governed by quite a specific set of rules that do have an impact on your investments, so it pays to be aware of them.
What qualifies as a REIT?
Qualifying as a REIT in the UK means adhering to a range of regulations. Some of the major ones include:
- They have shares traded on a stock exchange recognised by regulatory authorities.
- A REIT must distribute 90% of its tax-exempt income profits to shareholders. If income has been derived from investment in another REIT then 100% must be distributed.
- At least 75% of the REIT’s gross assets and 75% of its profits must be derived from property rentals.
- A REIT must not be a closed company, meaning it cannot be controlled by five or fewer investors. An exemption to this is if a company has 35% of its shares owned by the public.
Advantages of investing in REITs
UK REITs offer a number of advantages to investors and there are a range of reasons why people buy shares in them.
- Easy access to real estate markets. REIT shares are exchange-traded meaning they are far more liquid than buying physical properties.
- More affordable than buying regular property. REIT shares are much cheaper than physical properties, meaning you can get exposure to the real estate market without having to spend vast sums of cash.
- Allows investors to access a broader range of real estate than they would be likely to afford. REITs invest in office buildings, shopping centres and more. These are properties that would otherwise be tricky to access.
- REITs provide a means of diversifying your portfolio away from company stocks. Real estate is its own market and something lots of investors look at to diversify their holdings.
- The requirement to distribute profits means REITs have historically provided a dependable source of dividends for income investors.
- A reasonable hedge against inflation. Although they’re far from perfect, research from asset manager DWS found REITs in the commercial property sector were a reasonably strong hedge against inflation from the 1950s until the 2010s.
- REITs are exempt from corporation tax for any profits derived from rental businesses. That can be beneficial to you as an investor but you should remember that any dividends paid out will be subject to income tax as well.
Risks of investing in REITs
REITs carry risks with them, just like any other asset class. Before investing you should understand the investment risks that come with them. That includes:
- Market risks. Like the stock market, the real estate market is subject to market volatility, bubbles and potential crashes. REIT investments mean you are subject to these market risks.
- Fees. REITs are managed by investment professionals. They need to be paid for their work and that means paying a fee. This is less a risk but something you should be aware of as it will eat into your potential earnings.
- Liquidity risks. REITs are more liquid than physical properties but they often have lower liquidity than company stocks. In market downturns this can mean it's harder to sell your holdings if you want to.
- Leverage risks. UK REITs are only able to borrow up to 25% of the value of their holdings. But even this amount could expose a company to a high level of risk and a market downturn could mean serious losses for the company.
Types of REITs
REITs vary massively in terms of the properties they invest in. As a result, investors tend to separate REITs into different categories. Sometimes there can be overlap but generally REITs have a specific goal in mind and only belong to one category.
Equity REITs buy properties and derive their income from renting them out. That could include housing, offices or commercial warehouses.
A mortgage REIT provides funding for properties and receives money in the form of interest. So they’ll provide cash to someone building something like an office block and receive interest payments on the money they’ve lent.
Alternatively they might buy mortgage-backed securities. A bank might fund a property project and then turn that mortgage into a product that can be invested in. Some mortgage REITs also invest in these products.
REITs by property type
As their name suggests, residential REITs invest in properties that people live in. That could include houses but also apartment blocks or student accommodation.
Some residential REITs include:
Retail REITs focus on investing in retail outlets. That could include things like shopping centres or high street real estate.
Some retail REITs include:
Healthcare REITs invest in properties that are used by healthcare professionals. That could include hospitals, surgeries or care homes.
Some healthcare REITs include:
It may seem niche but there are actually lots of REITs that operate or lease self-storage facilities.
Some self-storage REITs include:
Data centre REITs
These may also seem like a niche investment to make but there are lots of REITs that invest in data centres.
Some data centre REITs include:
Infrastructure REITs have a broad remit. They invest in the sorts of things we need to keep our economy running. That might include energy facilities, transport systems or water works.
Some infrastructure REITs include:
Hotel and hospitality REITs
Hotel and hospitality REITs invest in holiday and leisure properties. That might mean having holdings in amusement parks, hotels or casinos.
Some hotel and hospitality REITs include:
Historic returns of REITs
As they can invest in such a wide spectrum of assets, REITs diverge substantially in the returns they have historically provided
Even REITs active in the same sector, say healthcare, will produce vastly different returns because of other factors, like the people managing the trust, the location of their properties and geographical differences.
How are REITs taxed?
UK REITs are exempt from paying corporation tax on rental income. This is good because it means there is more income for the company to distribute to shareholders.
But you still have to pay tax on that investment income. Distributions from REITs are called property income distributions (PIDs).
PIDs are taxed at source at 20%, the current basic income tax level. If you pay a higher band of income tax then you could be liable to pay more.
REIT tax is complex and involves a lot of nuances, so if you want to get to grips with the finite details of the subject then be sure to do some thorough research.
Be aware that REITs are also treated differently from country to country, so UK REITs are not treated the same as US ones. Any rules governing them are likely to impact your return on investment, so make sure you’re aware of them.
How do interest rates impact REITs?
As REITs invest in such a broad range of real estate, you can’t really say they’ll all respond in the same way to rises or falls in interest rates.
But in general, lower rates do appear to have benefitted REITs. One study undertaken by credit rating agency S&P Global Ratings found that US REITs tended to yield higher returns when there were lower interest rates.
Part of the reason for that is lower rates allow more people to borrow and thus build more property. That would potentially lead to REITs finding it cheaper to borrow money to invest in projects as well.
The thing is, stocks have also performed well in a low interest rate environment. And as we’ve said already, REITs have such a broad remit that there were bound to be other factors at play there as well.
As with other asset classes, it’s good to be aware of how investments and interest rates interact but you shouldn’t invest in REITs based solely upon that relationship.
REITs and the stock market
Most investors want to know two things about REITS when comparing them to the wider stock market.
The first is if they are safer. The answer is that they aren’t any more or less safe. As we’ve seen already, REITs invest in a wide range of properties.
And just as there are a wide range of companies with different risks attached to them, the risk associated with an individual REIT will depend on its own characteristics, including the things it invests in and the people managing it.
Lots of investors also want to compare the returns REITs provide to stocks. The overall picture here is actually negative.
Research from investment bank Numis found that UK-listed REITs underperformed the total return of the FTSE 100 in the decade ending in January 2020. But again, individual REITs invest in unique things and most investors buy shares in them as such, not as a group.
How to start investing in REITs in the UK
The experience of investing in REITs is pretty much the same as one you’d have investing in shares.
As they’re exchange-traded, you simply buy shares in them via your brokerage account (see how to open an investment account).
How much of your portfolio should be in REITs?
Investors like to have black and white answers to questions like this. Sadly they’re rarely forthcoming (have a read of our ‘how to start investing in stocks’ guide if you want to learn more about why that is).
REITs could be a way of diversifying your portfolio and, if you are attempting to do that, they would just be one of many different assets that you put money into
But there’s no hard and fast rule here. It would likely be a mistake to put all of your money into REITs as you could just end up being heavily exposed to a particular part of the real estate sector.
At the same time, you may find no REITs that you think are investment worthy. In that case you shouldn’t just be buying them for the sake of it
So the answer here is to treat REITs much like you would any other asset class. Don’t overexpose yourself to them and if you don’t think they’ll make a good investment then don’t buy them.
How to evaluate REITs?
Like stocks, there are lots of different data points to consider when investing in REITs.
The key thing to remember here is that some common metrics, notably earnings per share and price to earnings ratios, don’t work that well when applied to REITs.
Here are some other things that you can look at instead.
- Income statement — An income statement is the first step towards valuing any business. This tells you how much money a company has coming in and how much it's spending. Looking here will give you an initial understanding of how healthy a company is.
- Funds from operations — Part of the problem with evaluating REITs is that properties are subject to depreciation, meaning they lose value over time. The company has to record these as losses on their income statement, even though the business itself hasn’t lost any cash.
Funds from operations is where a REIT factors out the effect of depreciation so that you can get a better idea of their cash earnings. That doesn’t mean you should ignore depreciation — it’s still very important — but it can skew the cash earnings of a REIT. Funds from operations also factors out any gains made from property sales. These would be included as a gain on the company’s income statement but are removed from funds from operations as they are a one-off piece of income and are thus not supposed to be reflective of a REIT’s normal business.
- Adjusted funds from operations — This is similar to funds from operations but it also takes into account additional expenses, like the amount a REIT has to pay for the upkeep of its properties.
- Adjusted funds from operations payout ratio — This is a way of estimating how much a REIT will payout as a dividend. It is calculated by taking the most recent dividend yield and dividing it by the adjusted funds from operations per share.
- Debt — Although UK REITs are restricted in how much debt they can take on, you should be wary of their debt and make sure it’s not going to mean risking your money by investing.
- Net asset value (NAV) — The NAV of a REIT tells you how much the company’s holdings are worth. This is not the same as its share price. Although a REIT’s shares might trade in line with its NAV, it can also be above or below it. If it’s above it then it may be a sign investors expect the REIT to perform well or that it’s done so already. If they’re trading below NAV that could mean the REIT is underperforming or projected to do so.
Which REITs pay the highest dividends?
Investors often find a high dividend appealing but it’s not always the best place to start.
Dividend yields are often based on the last dividend payout as a percentage of the REIT’s current share price.
That means yields rise as share prices fall. So a higher dividend may actually be a sign that a REIT is not performing well, which is obviously something to be wary of.
Hunting for the biggest dividends is thus not necessarily the best thing to do. You also have to look at some of the valuation metrics we just mentioned and figure out if it’s a good business to invest in.
How to calculate REIT dividend yields
You can calculate the dividend yield on REITs in a couple of ways.
- You take the value of the dividends paid out over the REIT’s latest fiscal year and divide that amount by its current share price.
- You estimate the future value of the REIT’s dividend payouts over the next 12 month period and divide them by the current share price.
Both of these options are used by analysts and data providers. If you are looking at data online or from any other source it’s worth knowing which method is being used, so as not to be misled.
How to calculate payout ratio for REITs
You can calculate the payout ratio for REITs in a couple of ways.
- You take the total value of all dividends paid out in a 12 month period by a REIT and divide it by the adjusted funds from operations.
- You take the total value of all dividends paid out in a 12 month period by a REIT and divide it by funds from operations.
Again, both methods can be used by analysts, so if you are looking at data from a third-party source then make sure you know what you’re really being told.
Most bought REITs on Freetrade
- BMO Commercial Property Trust — A REIT that invests in commercial properties, including offices and industrial sites.
- Ecofin Global Utilities & Infrastructure Trust — A REIT that invests in infrastructure projects, including energy and transportation facilities.
- CorEnergy Infrastructure Trust — a trust that invests primarily in US energy infrastructure.
- Digital Realty Trust — A REIT that invests in data centres.
- Medical Properties Trust — A REIT that invests in hospital facilities in multiple countries.
What is the difference between REITs and Real Estate Mutual Funds?
REITs are exchange-traded and close end, meaning only a set number of shares can be issued by the company.
In contrast, real estate mutual funds are not exchange-traded and are open ended, meaning more shares are issued as more people buy into the fund.
Are REITs a good investment long term?
Research from investment bank Numis found that UK-listed REITs underperformed the FTSE 100 for the decade ending in January 2020.
But each REIT is different and the assets they invest in vary massively, so their worthiness as investments will depend on those unique factors, as opposed to the characteristics they share with other REITs.
How do REITs pay down debt if they're required to distribute 90 of their income every year?
Debts are an expense and thus paid out of company revenues, not net income. It is the net income that is distributed to shareholders. That means any necessary debt payments are made before income is distributed to shareholders.
Is investing in REITs better than owning real estate properties?
It is certainly easier because REITs tend to be cheaper and much more liquid than physical properties.
But you may buy a house to live in or for your children, which REITs obviously cannot offer.
Ultimately, you can’t really say that it’s ‘better’ to buy real estate or a REIT because it depends on what your goals are.
Why do some REITs have poor payout ratios, despite the 90% rule?
The amount a REIT pays out will depend on how profitable it is. Just because a REIT has to payout 90% of earnings, doesn’t mean its earnings will be high. And if they’re not then it’s going to mean it has a poor payout ratio.