What are REITs? REIT is the acronym for Real Estate Investment Trust. May ordinary people have leapfrogged into higher wealth by using these surprisingly accessible financial instruments. So how does one start to take advantage of these easy investing tools? Here are five simple principles to follow, as an introduction to building income from REITs.
First, choose the best REITs by doing some homework. There is a lot of information available, but one word of caution: Some financial advisors may want to steer you in the direction of Mutual Funds. The reason is because the banks and investment advisors make more profit if they can sell you Mutual Funds.
What is the difference between a REIT and a Mutual Fund? A REIT is typically a trust company, listed on a stock exchange, in which anyone can buy shares or units. In return, unit holders receive a monthly or quarterly dividend. The dividend is the vehicle by which an REIT investment is an income generator. Some REITs pay dividends which amount to yearly investment income of more than 8%.
A powerful factor in favor of REITs is that they own physical property (real estate) as the basis of their business. A Mutual Fund is a collection of ordinary stocks, in all kinds of companies, and the mutual fund management company manages the investments and return part of the profits to the Fund’s unit holders, after scooping cream off the top (the management fee).
With both REITs and Mutual Funds, the principal investment (the sum of money paid for the total investment) is not guaranteed. But it’s fairly clear that the unit values of REITs are highly unlikely to fall dramatically, since the trust owns large real estate investments to back them up, while the Mutual Funds typically don’t have that strong base. Management fees are also quite high for some Mutual Funds.
The Toronto Stock Exchange has a great website which provides filters and searches on various types of companies listed on the exchange. The website www.tmx.com is a good source to start researching REITs. A list of Canadian REITs can be found here. A list of US-based REITs can be found here.
Research should include reading the financials and comparing different REITs in terms of dividend return first of all. But it is also important to consider what the Price-Earnings Ratio looks like. This ratio is an indication of how expensive the units are relative to the annual earnings of the trust company. Although not the only measure to look at, the Price-Earnings Ratio or PE Ratio is a good yardstick of the quality of a REIT.
Generally a lower PE ratio is better, but too low, (under 5 or 6) indicates that the market does not expect much growth for the company. Some REIT investments are still good despite a low PE ratio, because the dividends are high. A high PE ratio (higher than 22) indicates a more risky investment. It’s also wise to look at how much long-term debt a Real Estate Trust company has on their balance sheet. Another measure to look at is the Dividend Payout Ratio. If this ratio is too high, then it means the dividends cannot be sustained over time and the company is not well managed.
On the Toronto Stock Exchange website (tmx.com) the financial details, including balance sheets and all the above-mentioned ratios, are published for all listed companies. Lower long-term debt on the balance sheet means a stronger financial position, because the debt has to be paid back at some point in time, impacting profitability, which could impact the long-term outlook for dividends. Dividends are regularly reviewed, and the good REITs have a steady increase in dividends over time. So Dividend History is another useful factor to consider when choosing REITs.
Find a good discount brokerage
Most people think that investing in REITs would require large amounts of money. This is not the case with a discount brokerage. For example, TD Ameritrade provides a US-based discount brokerage where any online equity trade (when you buy or sell your REIT units for example) has a flat rate of $9.99. Since we are not planning to buy and sell units every day, this fee is not high at all. The idea is to buy REIT units and hold on to them for a long time, because they will earn dividends.
None of these banks have a minimum amount to start trading. But to be realistic, a REIT like Liberty Property Trust (NYSE: LRY) had a closing price of $37.06 on the New York Stock Exchange on February 21, 2014. Since any shares have to be traded in blocks of 100, that means one could buy 100 units (shares) of LRY for $3,706.00, which would give a yearly return of 5% or $185 per year income. So if we keep on investing and build it up over time, until we have 10,000 units, we could have a tidy annual income of $18,580 from a very stable investment.
It’s important to note that the best results come from a longer term view, such as two or more years. A balanced REIT portfolio could contain two or three different REITs in different sectors, such as seniors’ housing, retail/commercial and residential rental.
Use the DRIPs
A DRIP is a Dividend Reinvestment Plan. This is yet another convenient way for investors to build up wealth over time. Dividends could be reinvested into more units every month or every quarter, instead of being paid out in cash. This means that your units would automatically grow by 4 or 5 or more each month or each quarter. If this option is offered by the REIT company then setting up a DRIP is as simple as making a phone call to your discount brokerage. The DRIP arrangement could also be stopped to receive the cash at any time.
Again, a DRIP would be a wise part of a long-term strategy. In addition, when the DRIP units accumulate into the investment, there is no brokerage fee, since there is not really an equity transaction taking place.
Set up an automatic flow
Another wise long-term strategy is to set up an automatic transfer into the investment account every month. Since most banks offer discount brokerages, this transfer could be as simple as a transaction between two accounts at the same bank. Many people are not disciplined enough to save money left over in a current or savings account at the end of the month. The temptation is much less if the money ‘disappears’ into the investment stream, and the satisfaction of seeing the investments grow over time more than makes up for the missed luxuries.
Finally, optimism makes financial sense.
On a more philosophical note, what if a ‘glass-full’ approach could help me manage my finances more successfully? The simple science still holds true. If I spend more than I earn, I’m going to slide down, not ride up. In the battle between Man and Money, the laws of Economics win every time. But here’s the thing: the ability to plan and delay gratification is squarely rooted in whether a person has an optimistic outlook or if they get stuck in a negative spiral. If a person has an optimistic outlook, it means they believe in living below their means and following a strategy such as setting up an automatic flow, as discussed. Do they believe and expect the best from themselves, other people and their circumstances? If so, then they must strive for balance.
In the 1970s, the economist Milton Freeman said that the sole purpose of any company should be to maximize profits, and that anything else is socialism. Now, keeping in mind that ‘socialism’ had a different and more threatening meaning in the 1970s, one should not judge Freeman by today’s standards.
Some people still believe he was right. But there is a new wave now, where companies are really run for many reasons. One could say that a company like Google is run with a view to have really happy employees and customers. Other companies may have a strong environmental focus. Some companies are registered as non-profit organizations and work for social causes. Some REITs are run to provide a valuable service to society, like seniors’ housing or shopping space in a community.
Although the shareholder is important, we must remember that the long-term viability of a company relies on more factors than shareholder value. For this reason, it shouldn’t be difficult to reconcile a need for balance between financial capital and social capital with investments in REITs. Financial capital is the pure money, while social capital is the contribution that a company makes to a fair and just society. For those looking for the best of both worlds, REITS do follow the principle of optimism and balance.
So with a bit of legwork, understanding and discipline, a regular stream of steady investment income is truly within the reach of most people. It doesn’t matter if it starts small.