There are a few different types of stocks that are tied to residential real estate.
For example, homebuilders are more successful during stronger housing markets. The same goes for real estate businesses like Zillow (NYSE: Z)(NYSE: ZG) and Redfin (NASDAQ: RDFN). Building supply stores like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) also benefit.
However, the stocks that let you directly invest in residential real estate are real estate investment trusts, or REITs. These companies own properties such as apartment buildings and single-family homes. Those properties generate rental income and other profits for investors.
What's a REIT?
A REIT is a special type of company designed to let investors put their money to work in real estate assets. There are two main categories of REITs -- equity and mortgage. Equity REITs own physical properties, while mortgage REITs invest in mortgage-backed securities and other financial assets. For the rest of this discussion, you can assume I'm referring to equity REITs.
In addition to meeting other qualifications, REITs must pay out at least 90% of their income to investors as dividends. In exchange for doing so, they're exempt from corporate taxation. This often makes REITs excellent choices for income investors and those who buy stocks through retirement accounts like IRAs.
Most REITs specialize in a certain type of property. Some REITs choose to invest in residential properties, such as apartments and single-family homes. Others focus on even more specific types of residential real estate.
What to look for when buying residential REITs
When it comes to residential REITs, there are a few things to look for.
First and foremost, you want to see consistency. Solid REITs produce consistent income and growth through a portfolio of properties whose occupancy and rental income aren't too sensitive to economic downturns. Consistent dividend growth is a nice feature as well. While past behavior isn't a guarantee of the future, it's a good idea to look for REITs with a multi-year track record of increasing their payout.
You also want to see REITs with a reasonable debt load compared to peers and a sustainable dividend. There's no set-in-stone rule about how much debt is too much, but I like to see less than half of a REIT's total capitalization in the form of debt. As for the dividend, high payout ratios are common with REITs, but I like to see no more than 90% of funds from operations (FFO).
It's also good to look for some type of competitive advantage. For example, larger REITs have efficiency advantages as well as greater financial flexibility that comes with scale.
Finally, I always look for REITs with management teams that actively create shareholder value. For example, many REITs use capital recycling as a major part of their strategy: They strategically sell properties to reinvest the proceeds in more attractive opportunities. Others create value by developing new properties from the ground up.
5 examples of great residential real estate stocks
There are dozens of residential REITs to choose from, many of which can make excellent long-term investments. Here are five of my favorites in a variety of sub-specialties, just to give you an idea of what's available.