SANTANDER • BY CATHIE ERICSON
Are you looking for new ways to diversify your portfolio and create cash flow? Savvy investors know that investing in real estate is a tried-and-true way to build wealth. However, if you’ve looked into the real estate market lately, you might have been taken aback by high prices, multiple bid situations and a buying climate that might even feel overblown in some regions.
But that doesn’t mean you have to miss out on the value created by the real estate sector. A real estate investment trust (REIT) allows everyday investors to achieve the same benefits without the significant financial outlay or hassle of actually owning the property. Let’s find out more about REITs and how they might fit your investment goals.
What is a REIT?
A REIT is a fund that pools investors’ money to buy and manage commercial properties, such as office or apartment buildings, retail space, hotels and hospitals. It’s like a mutual fund, but for real estate. Buying shares in a REIT offers a way to invest in real estate that preserves your liquidity since you won’t have to tie up a significant amount of money in a physical property that may be challenging to unload, and it also removes the inconvenience of acting as landlord or owner.
In addition, a REIT can be an attractive method for generating income since each year, the fund is obligated to pay out 90% of its income from rent payments and other sources to its shareholders.
How much money can you make from a REIT?
Just as with any investment, your returns will fluctuate based on a variety of factors. An equity REIT, which owns commercial properties, can swing based on the value of the properties it holds— if it’s located in a growing area, the value can rise along with rents. On the other hand, if tenants flee or the owner has to slash lease prices, its worth can fall. Some funds are even investing in more niche sectors, such as data centers, storage facilities, warehouses or cell towers, which can also provide attractive and diverse options.
A mortgage REIT, also known as an mREIT, invests in mortgages and mortgage-backed securities for both commercial and residential properties. The value of these funds are based primarily on short-term interest rates, so their worth can fall as rates rise. For that reason, they are sometimes deemed as riskier than equity REITs.
Determining how shares are assessed can be tricky, as the main ways most people appraise stocks—the earnings per share (EPS) or price to earnings (P/E)—don’t apply to REITs. Instead, the fundamental method for comparing funds and determining their performance is to evaluate the “funds from operations (FFO),” which considers deprecation, preferred dividends and distributions. While this is the key number REITs will report, other metrics to consider include payout ratio and debt/EBITDA (earnings before interest, taxes, depreciation and amortization). [It’s a little complicated to explain here, but I think the linked article does a good job.]
How to invest in a REIT
Ready to dive in? You can buy shares of a REIT through any brokerage and can also use them to diversify your retirement accounts, such as your IRA or 401(k). Here are some factors to help you choose the right REIT for you.
Determine your real estate investment goals
While most people are primarily investing for the future, it’s also appealing to realize income today. That’s why REITs can be particularly attractive because they provide opportunities for both short-term and long-term income. Since REITs pay annual dividends, they can provide a steady cash flow based on the rents the fund collects from tenants. And as the property appreciates over time, investors reap the rewards of that long-term growth.
Decide what type of REIT meets your needs
Just as you can invest in a wide variety of stocks and mutual funds in different sectors, you choose a REIT that meets different interests and goals. Do your homework to determine how cyclical the industries are, the interest rate outlook and how that will affect specific funds and the prospects for the various sectors.
For example, healthcare REITs, which focus on hospitals, retirement homes and other medical facilities, will have a different risk factor than a hospitality-based one, which includes hotels and resorts. It’s important to take into account your level of risk tolerance—whether you can easily withstand ups and downs—when deciding what sectors to pursue.
Do ample research and figure out how all these elements work together to point you to a fund that is on a growth track or otherwise meets your goals.
Consider the tax implications
When you start to invest in REITs, you’ll realize that they differ from a typical stock fund in several ways, including how they are evaluated, as explored above. But another important consideration is the tax implications of REITs.
Since they are designed to generate income, investors will receive a 1099-DIV each year that breaks down their payments by type:
- Ordinary income will be taxed at your regular marginal tax rate; new deductions designated by the Tax Cuts and Jobs Act (TCJA) could lower this as it is now considered “pass-through” income.
- Capital gains, which also will be taxed according to your personal income level in the year the gain is received
- The nontaxable return of capital happens when the REIT’s cash distributions exceed earnings, such as if the company takes large depreciation expenses. While this isn’t taxable in the year you receive it; it will be taxed later as either a long- or short-term capital gain or loss when you eventually sell your shares.
As you consider whether a REIT is right for you, you’ll want to assess both the short- and long-term investment potential, as well as the tax implications, by talking with an investment advisor and a tax professional.
Investing in real estate through your primary residence, rental properties, or other vehicles can be a wise way to build wealth while also taking advantage of the ability to tap equity or enjoy a diversified income stream. Contact the professionals at Santander today to find out more about products and services that meet your needs.
Readers should consult their own attorneys or other tax advisors regarding any financial or tax strategies mentioned in this article. These materials are for informational purposes only and do not necessarily reflect the views or endorsement of Santander Bank.
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