Real estate investment trusts (REITs) can add income to your portfolio without sacrificing growth potential. However, most REITs invest the bulk of their assets in a single type of property, which can scare some investors.
Not all REITs stick to a single property type. Diversified REITs invest in a combination of two or more types of commercial real estate. Here’s what you should know before you start your search for a diversified REIT to add to your portfolio.
What is a diversified REIT?
Before we define a diversified REIT, let's talk about REITs in general. A real estate investment trust is a corporation whose primary business is investing in real estate assets.
To be legally classified as a REIT, a company must meet specific requirements, including the following. REITs must
- be structured as corporations,
- invest at least three-fourths of their assets in real estate or related investments,
- derive at least three-fourths of their income from such assets,
- pay at least 90% of their taxable income to shareholders as dividends,
- have at least 100 shareholders, and
- no five shareholders can own more than 50% of any REIT’s stock.
If a REIT meets these requirements, it enjoys a big tax advantage. No matter how much money they earn, REITs don’t pay any corporate taxes. Because REITs are required to pass most of their income to shareholders, they're treated in the same way as other pass-through entities, such as LLCs and partnerships.
Here’s why this matters. With most dividend stocks, corporate profits are effectively taxed twice -- once when the company pays corporate tax on the income, and again when investors pay tax on the dividends they receive. REIT profits are only taxed once (or potentially not at all if owned in a retirement account).
There are two broad categories of REITs -- equity and mortgage. Equity REITs own, operate, and/or develop commercial properties. These are normally associated with the term "REIT." Mortgage REITs own mortgages, mortgage-backed securities, and other such assets. They're so different that they're actually part of the financial sector, not real estate. A hybrid REIT owns a combination of mortgages and actual properties.
So what's a diversified REIT?
A diversified REIT (not to be confused with a hybrid REIT) is an equity REIT that owns more than one type of commercial property. Most equity REITs specialize in a single type of property. A REIT whose portfolio consists of office buildings and apartments is a diversified REIT.
Risks of investing in diversified REITs
Risk factors affect diversified REITs in different ways because there are many possible asset combinations. For example, a diversified REIT that invests in office and industrial properties has a completely different risk profile than one that invests in hotel and retail properties.
Having said that, there are a few risk factors that affect all types of equity REITs:
Interest rate risk
Generally speaking, rising interest rates are bad for REITs. When investors buy an income-based asset that involves risk, like a REIT, they expect a larger return than what they'd get from a risk-free investment, like a long-term Treasury security. When risk-free rates rise (the 10-year Treasury is a good REIT indicator), REIT yields typically rise accordingly. Since price and yield have an inverse relationship, rising rates put pressure on REIT stock prices.
Most REITs rely on borrowed money to fund growth. Rising rates make it more costly to borrow money, which can erode profit margins and cause REITs to pump the brakes on growth.
All REIT subsectors can be affected by oversupply, although it affects some areas of commercial real estate more than others. If more new properties are built than market demand calls for, it creates an oversupply situation. For example, if there is demand for 10,000 self-storage units in a particular market and developers build 15,000, there’s too much supply. This leads to vacancies and loss of pricing power.
The types of real estate that are at highest risk of oversupply in strong economies include those with relatively low building costs, like self-storage. Those with lots of expected growth in the future, such as senior housing, are also at high risk. On the other hand, property types that cost a lot and take a long time to build, such as urban high-rise apartment buildings, are generally at lower risk of running into oversupply issues.
This is another factor that affects certain types of properties more than others. So there’s no way to make a blanket statement on how recession-prone diversified REITs are. When it comes to economic sensitivity of commercial real estate, there are two main factors to consider: cyclicality (economic sensitivity of the tenant businesses) and lease structure.
Hotels are an example of a recession-prone type of commercial property. They not only depend on strong economies to keep prices high and rooms filled, but the lease length is daily. After all, if a hotel guest runs out of money, they are under no obligation to stay.
Healthcare properties are on the other end of the spectrum. Healthcare isn't very recession-prone and tenants tend to sign long-term leases. Think about it: Businesses like medical practices and hospitals don’t relocate often.
Most other types of properties are somewhere in the middle. By evaluating business cyclicality and lease structure, you can make a fairly accurate determination of how recession-prone your REITs are.
4 examples of diversified REITs
Here are four diversified REITs with various portfolio compositions to help you start your search. I’m not necessarily recommending any of these, but it wouldn’t be practical to list all 21 publicly-traded diversified REITs.