By Carla Pasternak
Owning shares in a real estate investment trust (REIT) is one of the simplest ways to purchase real estate. Real estate has "real" value that investors can touch, feel and understand. This tangible value, combined with the limited supply of high-quality real estate, makes REITs one of the most stable investment alternatives around.
Without REITs, an investor would have to invest large sums of money (often borrowed) to be able to buy properties. The investor would have to personally guarantee the loans and would be liable for whatever happened to the property.
With a REIT, the only risk is the amount invested.
REITs: the basics
Most REITs own land or buildings and make money by renting these spaces to individuals or businesses. Some REITs also earn interest on real estate securities, such as mortgage bonds. Other REITs simply fund various real estate ventures.
Most investors buy REITs for their rich dividends. The average diversified property REIT offers an annual dividend yield of 7.5% -- more than triple the average 2.0% yield paid out by members of the S&P 500 Index.
That's money in your pocket.
Even better, the cash usually keeps coming in regardless of whether a particular REITs' share price goes up or down. That's because to preserve their unique tax advantage, REITs are required by law to pay out 90% of their income as dividends to shareholders. In return, REITs are not subject to corporate income tax.
On the downside, since REITs don't pay income taxes, their dividends are usually fully taxable, which means the dividends you receive will be taxed as ordinary income, up to 35%. Most REIT dividends don't qualify for the reduced 15% dividend tax rate.
But even after the extra taxes, the yields most REITs pay are far higher than the taxable equivalent yield you'll get from most other common stocks. Savvy investors can avoid these extra taxes entirely by holding REITs in a tax-advantaged account like a Roth IRA.
Buy the stock, not the yield
While most people buy REITs for their rich dividend yields, investors who choose their stock based exclusively on its yield could be making a huge mistake. That's because corporate dividend payments are by no means guaranteed.
Even though a company might be paying a healthy 10% dividend yield now, it may not be able to sustain such a rich payout if its business model isn't solid. Since companies usually extract dividend cash from earnings, payouts could be slashed if profits are pinched.
For example, U.S. automakers were traditionally known for their handsome yields. But once the industry stopped turning a profit, dividends began to evaporate. Investors that bought Ford (NYSE: F) lost their dividend in 2006. After one dividend cut, General Motors (NYSE: GM) finally suspended its dividend in the summer of 2008.
The most profitable stocks are those that generate the greatest total return through dividends and share price appreciation. REITs with long track records of a steady dividend and share price growth are your best bet.
Investors should also look for companies that offer a dividend reinvestment plan (DRIP), which allows investors to reinvest dividend payments to buy more shares without incurring transaction fees.
But even if you can find a REIT that meets these criteria, one additional factor is paramount: It's important to know exactly what the REIT owns.
Property type is key
Many REITs specialize in a property type, such as offices, apartments, warehouses, regional malls, shopping centers, hotels or healthcare centers. Others, like Duke Realty (NYSE: DRE), own a mix of retail, industrial and office property. A few others invest in specialty properties, such as Entertainment Properties (NYSE: EPR), which owns movie theatres.
To get a feel for how a REIT makes money, you should always pay close attention to the type of property each REIT owns.
Each real estate sector is affected by different economic factors. If the job market is booming, for instance, then office REITs could be attractive because more people are working and more space is needed to accommodate them.
If consumer spending is on the decline, then a shopping center REIT like Regency Centers (NYSE: REG) might be headed for challenging times as retailers feel the pinch.
Property type can also tell you how predictable a stock's income stream might be. Mall REITs, which typically require tenants to sign 10-year leases, usually generate more predictable income than apartment REITs, which tend to lease for shorter periods of time. Knowing the quality and diversity of the REIT's tenants will also give you a sense of the reliability of its income.
Larger, diversified or geographically dispersed REITs are less exposed to regional weakness and major economic cycles. These REITs tend to be more stable over the long haul. A company such as Equity Residential (NYSE: EQR) owns apartments in various markets across the United States and is less sensitive to local economic conditions.
On the other hand, smaller, more specialized REITs often provide the greatest growth potential. A niche-player such as SL Green Realty (NYSE: SLG), which owns offices solely in and around New York City, is positioned for success if that particular market does well.
Even after you know what to look for, finding the best REIT for your money and with the greatest potential for long-term returns can be tricky. Pay close attention not just to each firm's dividend yield, but also to its property portfolio, its growth prospects and its valuation level relative to that of its peers for those with the best profit potential.
Disclosure: Neither Carla Pasternak nor StreetAuthority, LLC hold positions in any securities mentioned in this article.