While there's no such thing as a 100% safe real estate investment trust, or REIT, some are certainly safer investments than others. The safest REITs tend to have some characteristics in common, so here are five guidelines you can use to identify the safest REITs to invest in:
- Focus on publicly-traded equity REITs.
- Avoid the most cyclical types of real estate.
- Steer clear of declining industries.
- Seek out industry leaders.
- Look at track records.
With these things in mind, let's take a closer look at how you can apply each one to your investment strategy.
Focus on publicly-traded equity REITs
There are two key phrases in this guideline -- publicly-traded and equity REITs.
To be clear, I'm not saying that public non-listed REITs and private REITs are all bad investments. However, there's certainly an elevated risk level with both of those. There's a lack of liquidity when compared with publicly-traded REITs, less transparency when it comes to fees, and other important information (especially with private REITs), and a few other major drawbacks.
Second, it's important to point out that there are two broad categories of REITs -- equity REITs and mortgage REITs. Equity REITs own and operate commercial properties while mortgage REITs focus on mortgages, mortgage-backed securities, and other non-property investments. Mortgage REITs are known for their high yields but are generally not safe investments.
Avoid the most cyclical types of real estate
If you aren't familiar with the term, "cyclical" essentially means that something is economically sensitive. For example, luxury resorts are a cyclical business because, during recessions and other tough economic times, consumers tend to cut back on discretionary spending.
So, if your goal is to invest in the safest possible REITs, it's a good idea to stay away from the most cyclical real estate property types. Hotels can be highly cyclical, as can mall and shopping center retail outlets. To be perfectly clear, there are some excellent REITs in these categories. They just aren't the best choice if safety and stability are your top priorities.
Steer clear of declining industries
A strong demographic or industry tailwind can add an enormous element of safety to a REIT. For example, demand for healthcare is expected to steadily rise over the next few decades as the baby boomer generation ages, so this should be a positive catalyst for REITs that invest in this market. Similar trends can be identified for apartments and warehouses, as well, just to name a couple.
On the other hand, there are some types of commercial real estate that don't have this advantage. Retail is the most obvious example. As more retail sales migrate online, the need for physical retail properties (especially for businesses that sell discretionary products) will continue to decline. So, if safety is what you're after, avoid declining markets like this. A dividend payout ratio that's higher than 100% can be a sign of declining fundamentals.
Seek out industry leaders
This isn't necessarily a set-in-stone rule, but generally speaking, the larger and more established businesses in an industry tend to be the most rock-solid. So, if you decide you want to invest in an apartment REIT, it could be a smart idea to focus on the sector leaders like Equity Residential (NYSE: EQR) or AvalonBay (NYSE: AVB) as opposed to a smaller regional player. Likewise, if you want to invest in industrial properties, Prologis (NYSE: PLD) is probably a safer play than a small, up-and-coming warehouse operator.
To be clear, there's money to be made with smaller REITs. I own quite a few in my own portfolio and am excited about their long-term growth potential. However, I can tell you from firsthand experience that the larger, established REITs tend to be far more stable.
Look at track records
First and foremost, a REIT's past performance doesn't guarantee its future results, and this is true for other equity investments as well. Just because a REIT has increased its dividend every year and has never had to cut the payout doesn't guarantee that the same will be true going forward.
Having said that, a long-established track record of dividend increases and overall strong performance is certainly a good indicator of safety and stability. For example, one of my personal favorite REITs, Realty Income (NYSE: O), has paid 592 consecutive monthly dividends, has increased its monthly payment at least every three months for more than 22 years in a row, and has delivered a 16.8% annualized total return since its 1994 NYSE listing, handily beating the S&P 500 index and the Dow Jones Industrial Average. That's a strong track record. And while this doesn't promise that the company will continue to grow its dividend, I'd be shocked if it didn't do everything in its power to keep this record alive for decades into the future.
So, if you want safety, take a look in the rearview mirror. Many of the most rock-solid REITs take pride in being able to increase their dividends annually for many years and never having to slash the payout, even during tough times. One specific thing to look for is how a REIT fared during the 2008 to 2009 Great Recession. If a REIT didn't have to slash its dividend and its stock didn't fall into a tailspin during that period (many REITs did), it could be a great sign of a safe and recession-resistant business model.
There's no such thing as a completely safe REIT
As a final thought, it's important to define the word "safe" in the context of REITs.
Let's be perfectly clear. There is no such thing as a safe REIT. That is, no matter what REITs you invest in, there's no guarantee that your dividends will continue to increase or will even keep coming at all. There's also no guarantee that the company will be able to execute on its growth strategy, that its tenants will continue paying rent, or that management won't shift their strategy and take on an unreasonable amount of debt. In short, even the safest REITs could cause you to lose money.
Having said all of that, the point of trying to find the safest REITs is to minimize the risk that any of these adverse things will happen. So, while "safest" doesn't necessarily mean "bulletproof," by applying these general principles when looking for REITs to invest in, you can get pretty close.