Real estate investment trusts, or REITs, add both income and growth potential to your portfolio. Most REITs invest in properties in subsectors like residential, office, or industrial.
However, some REITs invest in unique property types. These are generally grouped into a category of their own: Specialty REITs. Here’s a rundown of what specialty REITs are and the companies that are included in this category.
What's a specialty REIT?
A real estate investment trust, or REIT, is a type of company whose primary business is owning, managing, and/or developing real estate assets.
To be legally classified as a REIT, a company must meet specific requirements. Here are some of the main ones:
- REITs have to be structured as corporations.
- REITs must invest at least three-fourths of their assets in real estate or related investments.
- They must also derive at least three-fourths of their income from such assets. In other words, a REIT can’t get 50% of its income from real estate and 50% from an unrelated business.
- REITs must pay at least 90% of their taxable income to shareholders as dividends. This is the most well-known requirement of REITs and why they tend to pay above-average dividend yields.
- They must have at least 100 shareholders, and no five shareholders can own more than 50% of any REIT’s stock. In practice, REITs often limit shareholders to 10% ownership to comply with this rule.
If a REIT meets these requirements, there’s a big tax advantage. No matter how much money they earn, REITs don’t pay any corporate taxes whatsoever. Because REITs pass most of their income to shareholders, they're treated as pass-through entities like LLCs and partnerships.
On a similar note, REIT dividends generally don’t qualify for the preferential “qualified dividend” tax rates. But they do qualify for the new 20% pass-through income tax deduction.
Most REITs specialize in a single type of property, and there are some standard categories you'll often see. These include things like residential, office, and industrial properties. There are also diversified REITs, which specialize in more than one type of property.
A specialty REIT meets all of the REIT qualifications but doesn’t invest in one of the "standard" REIT subsectors. For example, a REIT that owns farmland would be considered a specialty REIT.
Risks of investing in specialty REITs
Specialty REITs cover a wide variety of property types, so it’s impossible to say that any risks affect all specialty REITs in the same way. For example, a REIT that owns farmland would have a completely different risk profile than one that owns casinos. That said, there are a few general risk factors that affect most REITs.
Interest rate risk
Generally speaking, rising interest rates are bad for REITs. Investors expect a "risk premium" for putting their money in risk-prone investments like REITs instead of risk-free investments like Treasuries.
When risk-free yields rise, REIT yields usually rise accordingly. (Note: The 10-year Treasury yield is a good REIT indicator.) Because price and yield have an inverse relationship, higher yields mean lower share prices.
This refers to how sensitive a REIT is to recessions and other adverse economic conditions. Because specialty REITs invest in different property types, there’s a wide spectrum of possible economic risk.
You can get a good idea of a REIT’s economic risk by considering two things. First, how economically sensitive are the businesses occupying the properties? Second, how easy is it for tenants to leave?
Hotels are an example of a highly sensitive property type. Not only do they rely on strong economic conditions to keep occupancy high, but the "lease" length of a hotel room is typically just one night.
On the other end of the spectrum are healthcare REITs. Healthcare is as close to recession-proof as any industry and tenants often sign leases for a decade or more.
Other property types are in the middle of these two extremes.
This affects certain types of REITs more than others. Oversupply occurs when more of a certain type of property is built than the market can support. For example, if there’s demand for 1,000 apartment units in a certain area and developers build 1,500, there’s too much supply. 500 apartments will sit vacant.
There are two types of real estate most at risk for oversupply:
- Those that have low construction costs and timeframes.
- Property types in areas where lots of growth is expected.
For example, self-storage REITs have experienced oversupply issues in recent years. They're quick and cheap to build. And senior housing REITs have seen oversupply problems, too. Developers built lots of properties in anticipation of future demand growth.