Residential REITs allow everyday investors to put their money in assets that are out of most people's reach. For example, most people can’t afford to buy a Manhattan apartment building -- but there are REITs that let you invest in them.
Here’s what you should know about investing in residential REITs before you get started.
What is a residential REIT?
A real estate investment trust, or REIT, is a specialized type of company that invests in real estate assets. REITs that invest in commercial properties are known as equity REITs. REITs that invest in mortgages, mortgage-backed securities, and similar assets are known as mortgage REITs. Generally, the term "REIT" is used in reference to an equity REIT. For the rest of this discussion, assume I’m referring to equity REITs.
To qualify as a REIT, according to industry group NAREIT, a company must meet some strict requirements, including distributing at least 90% of taxable income to shareholders as dividends and investing at least three-fourths of assets in real estate.
If a REIT meets all the requirements, a real estate company doesn’t pay corporate income tax on its profits. The only taxation of REIT dividends takes place after they're distributed to shareholders. REIT dividends generally don’t meet the IRS definition of "qualified dividends" for tax purposes, but the lack of corporate tax liability is still a big perk for investors. This is especially true for those who own REITs in tax-advantaged retirement accounts.
So what's a residential REIT?
A residential REIT is a real estate investment trust that owns and operates rental property. Some own apartment buildings, and some specialize in a type like urban high-rise apartment buildings. Others focus on a specific group of people, like students. Some own single-family rentals.
Some residential REITs primarily grow through development -- that is, by building new properties from the ground up. Others choose to grow through acquisitions. They create value by purchasing (and often improving) existing properties. Some REITs do a combination of these.
Risks of investing in residential REITs
Residential REITs can produce impressive total returns over time, but they aren’t without risk. While there are dozens of potential risk factors when it comes to stock investing, here are four in particular that residential REIT investors should know.
Interest rate risk
No discussion of REIT investing would be complete without mentioning interest rates. Rising interest rates -- especially long-term Treasury yields -- are a usually negative catalyst for REIT stock prices. Investors expect a "risk premium" when investing in income-based stocks and bonds. As risk-free yields rise, yields paid by REITs and other income investments tend to rise as well. Since yield and price have an inverse relationship, higher yields translate to lower stock prices. As you can see, the 10-year Treasury yield and REIT prices almost always move in opposite directions: