Matt Frankel: What I like to look for are unique and irreplaceable assets or at least assets that you can't really find anywhere else. For example, if you're looking at a hotel REIT, anybody can own an extended stay hotel, a standard extended stay building. Not everyone can own a giant conference center or a hotel with a big entertainment venue attached to it or something to that effect. Not every office REIT owns the Empire State Building. [MUSIC]
Deidre Woollard: You are listening to the Millionacres Podcast. Our mission at Millionacres is to educate and empower investors to make great decisions and achieve real estate investing success. We provide regular content and perspective for everyone from those just starting out to season pros with decades of experience. At Millionacres, we work every day to help you demystify real estate investing and build real wealth.
Matt Frankel: Good. I'm enjoying a day in my office, I am not in my house, so it's a pretty good day. By accident, I guess you would say, I was reading through some stock forms, this was little over ten years ago and I stumbled across a company called Realty Income that we've talked about a few times before. I started digging into it and I got fascinated with the whole business model and wanted to learn more about what a REIT is and how it works and why it can be such a long-term investment. The reason was because Realty Income, normally you think of real estate is a boring investment, a lot of investors do, they don't really know much about it. I was reading a statistic in their presentation that since their IPO, they had beat the S&P 500 handily and on a consistent basis and with less risk than you're taking in most stocks, the bell went off my head, how do they do that? That's what got me started looking into REITs and the more I learned, the more I liked.
REITs were created to open up an asset class that had historically been the realm of the rich, to everyday investors. Not many people listening here could go out and buy a shopping mall, for example and even if you could, would you really know what to do with it after you closed on it. REITs allow you to invest in not just one, but a whole portfolio of shopping malls if you want to or office spaces like the one I'm in right now or the Empire State Building is a publicly traded real estate company. It really just opens up this asset class that like I said was, once just a realm of rich developers to everyday investors and it's a really exciting asset class. It's no wonder these rich developers were interested in it for so long and now anybody can get a little piece of the action.
Sure, the easy answer is REITs are companies that primarily own and invest in real estate assets. But you can't just go buy a bunch of properties, incorporate and call yourself a REIT, you have to meet certain requirements first. There's a list of requirements, I won't bore you with most of them, but there's a few significant ones. One, a REIT has to have at least a hundred shareholders. This is why most REITs don't start out as REITs because if you're just running a real estate partnership with three investors, for example, you can't just call yourself a REIT. As more investors come on then partnerships will transition to being REITs. Another, the REIT has to invest at least three-quarters of its asset in real estate investments and must derive at least three-quarters of its income from those real estate investments. REITs can own other businesses.
There's one REIT I know that owns a concert venue, so that's not necessarily real estate income if it's selling merchandise and things like that. One owns a restaurant chain that I know of. But at least 75 percent of their income has to come from real estate. Third and the most publicly known requirement is that REITs need to payout at least 90 percent of their taxable income in order to be considered REITs. If they do this, they get to avoid corporate taxes. Most stocks are taxed effectively twice. I own shares of Apple, for example, and the profits that Apple makes are taxed on the corporate level when Apple earns them. Then when they pay me a dividend that's taxed on a personal level, so that same money is taxed twice.
REITs get to avoid that and become essentially pass-through businesses by paying out at least 90 percent of their taxable income, they don't have to pay any corporate tax. Overtime, this can really add up to a big tax advantage for investors. Taxes are I'd say the biggest benefit of becoming a REIT. There's a few other legal reasons you might want to be a REIT, the taxes to be a pass-through business, especially after the Tax Cuts and Jobs Act brought the 20 percent deduction for pass-through income because REIT investors are allowed to use that, you're considered to have a pass-through business if you're a REIT shareholder. Because they avoid corporate taxes, it makes them ideal investments for retirement accounts.
Retirement accounts, you don't pay income tax on those until you withdraw the money as income. With the REIT in a retirement account, you can avoid tax on both the corporate and personal level, so it makes them really an ideal compounding machine for retirement accounts. Usually, when someone says the term REIT, they're talking about an Equity REIT. An Equity REIT is the kind that owns properties. If a company primarily owns physical buildings, they are an Equity REIT. Mortgage REIT owns financial instruments such as mortgage-backed securities, some own mortgage servicing rights, things to that nature, not actual properties. They own the mortgages and the financial instruments behind real estate. They are such different investments that mortgage rates aren't even part of the real estate sector.
Mortgage REITs are technically included in the financial sector like banks, so they're a very different type of investment. Mortgage rates, the primary goal is income. What mortgage rates do is, they borrow a lot of money at low interest rates to buy a bunch of mortgages that pay higher interest rates and make a profit off the difference and they pass that income through. If you look at some of the popular mortgage rates, they pay dividends in the 10 percent range. Sustainably because they're not trying to grow the principal, they're just trying to produce as much income as possible at a safe level. Equity REITs, on the other hand, what are known as total return investments, meaning they want to provide a combination of income and growth.
I mentioned that REITs have to pay out 90 percent of their taxable income, so the average REIT pays out more than the average stock in the S&P 500. But at the same time, properties appreciate in value overtime. REITs can employ other strategies like what's known as capital recycling, strategically selling one property and buying another one that has more growth opportunity to create more shareholder value. Equity REITs are really total returns. They want to increase shareholder value and produce a nice stream of income overtime whereas Mortgage REITs are really just income investments and are very different when you're trying to analyze them and things like that than Equity REITs. Normally the term REIT and Equity REIT are used interchangeably. Yes, for sure they're very reactive to interest rates, all REITs are somewhat reactive to changing interest rates. For example, if the Federal Funds rate spikes really quickly, it's generally a negative thing for Equity REITs as well. But it could be really devastating to Mortgage REITs. Mortgage REITs, I mentioned earlier, they borrow at lower short-term interest rates to buy mortgages that pay higher long-term interest rates. Well if the short-term interest rates spike, these mortgage companies have a portfolio of mortgages that are paying one rate and if the short-term rate they have to borrow at spikes, that gap between those narrows and their profit margins can evaporate really quickly. Mortgage REITs have ways of counteracting that, buying interest rate swaps and other derivatives to hedge against interest rate rises. But they are very reactive to rising interest rates, they're very reactive to falling interest rates because that makes a lot of pre-payment risk. People refinance them more as we've seen in the past few months. People refinance their mortgages in record volumes if mortgage rates drop. I think mortgage refinancing has more than doubled year-over-year in the second quarter, so that also creates a problem for mortgages because they're buying these mortgage securities to pay out a certain amount of interest and if people prepay them, they're not getting any interest. The prepayment risk is a big thing for mortgage REITs, so they're very reactive to interest rate swings up and down.
Mortgage REITs do the best when interest rate remains steady. Interest rate swings to the upside or the downside can really wreak havoc on Mortgage REIT profits and their share prices as a result, which is, if you look at the three-month chart of pretty much any Mortgage REIT, you'll see exactly what I'm talking about. Yes. As we've seen during the COVID pandemic, this could be a good or a bad thing, depending on what kind of REIT you have. Real estate as a general asset class is not as reactive to economic swings, in general, as the overall stock market. If you look back at the '08-'09 market meltdown, which was caused by real estate, real estate actually outperformed the S&P 500. But what you've seen in the COVID pandemic, real estate has moved not with the stock market, but in a bad way. Real estate was one of the worst performing things just because it's a physical building and it depends on people being able to go places and that hasn't been a thing recently. Generally, real estate, it adds an element of diversification to your portfolio because real estate is not considered to be the same asset classes as stocks or bonds. Yeah. I want to say 11 different REIT sectors according to the official database. Residential is one of them, just a big one, apartment buildings. Most Residential REITs own apartment buildings. Hotel REITs are another one. Office REITs, there's Industrial REITs which are warehouses and things like that. Like you mentioned, you can own warehouses. There are Healthcare REITs that own properties like hospitals and medical offices. There are what are called Diversified REITs that have a mixed approach to investing.
There are Communications REITs that own cell towers and things like that. There's Data Center REITs that own these big sprawling data centers that companies like Facebook and Google keep all their network equipment in. I can go on with that, but the point is, different REIT sectors can react very differently to economic swings. There's a few variables. One is lease length. When you think of an office building, the average office tenant signs a lease that's like 7-10 years long, I believe. The average apartment tenant signs a lease that's one-year long. The average hotel tenant signs a lease that's a day. They rent hotel rooms by the day. Self-storage is another REIT category. Their tenants sign month-to-month leases usually, so that's one big thing. The other is the cyclicality of the underlying business. Offices are generally not cyclical. In bad economic times, companies don't need office space. In bad economic times, companies still need healthcare, so Healthcare REITs aren't very cyclical. On the opposite side of that, hotels in bad economies, people can easily cut back on their travel and not to mention that, but their lease length is one day, so hotels get the worst of both worlds. Hotels are by far the most cyclical type of REIT. Apartment REITs, for example, are kind of a mixed bag. There have a short lease length, one-year, but people still need places to live no matter what the economy is doing, which tends to help.
Apartment REITs are in the middle when it comes to cyclicality. Healthcare, I would say is the least cyclical type of REIT, meaning least economically reactive. It's by far the most essential service of any REITs. I mean, you've got nothing if you don't have your health. So people need access to healthcare no matter what the economy's doing and healthcare tenants tend to be on long-term leases and the switching costs are very high when it comes to healthcare properties and office properties and things like that. It's rare that a doctor just packs up and moves to another office without a valid reason like expanding their practice. It's rare that a hospital just vacates and moves to a different building. There's a big spectrum when it comes to the reactivity or the volatility of REITs. It's not while we think of real estate is just one sector, there's a big broad spectrum within it. Sure. I think I own about a dozen different REITs right now.
If you don't want to own a dozen different REITs, there are index funds that just allow you to invest in the real estate sector as a whole. The Vanguard Real Estate Fund, ticker symbol is V-N-Q. If you don't want to do a bunch of guesswork, really is a market cap-weighted real estate index fund that gives you 120, I believe, REITs in your portfolio in one single investment, but having said that, you could definitely diversify. If you have a portfolio of Hotel REITs and a portfolio of Office REITs, those are two totally different types of risk profiles. For example, I own a Hotel REIT, I own an Apartment REIT, I don't own any Mortgage REITs, but I own an Office REIT, an Industrial REITs, etc. It's like my own little stock portfolio within a portfolio, I think of it as, it's called a moderate risk tolerance at this point. I don't want to put all of my money into a Hotel REIT even though if things work out really well, that could be the best long-term return or retail for that matter. I don't want to put all my money into a Mall REIT right now. It could go to zero or it could quadruple in a few years if all things go well, but I'm not willing to take that risk. It's important to diversify, especially if you want exposure to the more volatile sectors or sub-sectors of REITs in your portfolio. It is and it isn't.
At the end of the day you want to make sure you have a good business. First and foremost, I want to make sure that the business is sound. I want a business that has long-term growth potential. I want a business that is well-run. I look at the management team. I look at things that cannot be quantified with numbers first and foremost, before I look into any real analytical parts. What I would say is make sure you are investing in a good business first. Going beyond that, the numbers are a little different, as you said, between the rest of the investment world and the real estate world.
For example, when you're looking at a stock, what's the first metric you think of? Probably earnings per share or the price-to-earnings ratio or something to the effect of earnings. In real estate, that doesn't really translate well. I don't really want to get into the mathematics of it, but there is a metric called depreciation in real estate that really distorts profitability. It's good for investors because it makes taxable income much lower but it's bad in the sense that it makes it tougher to evaluate just based on traditional methods of calculating income. In real estate, you want to focus on a metric called funds from operations or FFO for short. You don't really need to know the calculation just because all REITs report it with their earnings. But what you need to know is that's the best measure of how profitable real estate investment trust is, and how much money it has available to pay dividends, how quickly its earnings are growing and things like that. That's the one metric that really doesn't translate well at all from traditional investments. Beyond that, you want to look at things like vacancy rates or occupancy rates rather. If REITs occupancy rates are falling, that's generally a negative sign. You want to look at the payout ratio. If a REIT's dividend is more than its FFO that I was just mentioning, that might be a sign that its income is unsustainable. A lot of metrics translate really well, but you just need to know a few real estate-specific things in order to be able to effectively evaluate these stocks but above all, like I said, I want to reemphasize, you want to invest in good businesses first. If you invest in good businesses first, devaluation is a secondary thing.
You can invest in cheap stocks all-day but if they're not good businesses, you're not going to do well in the long run. There are actually three different types of REITs when it talks to investability. There are publicly traded REITs, which is what you were talking about right now and what I invest in. There are what are called public non-traded REITs that anybody can invest in, but they work more like an investment partnership than a publicly traded stock. There are a bunch of non-traded REITs that you could find listed. There is a ton of different directories for these. NAREIT, N-A-R-E-I-T.com, I believe is where they keep a really good directory of all the non-traded REITs. Those are REITs that anybody can invest in, but they're just not listed on the exchange. Then you have private REITs which are not listed on an exchange and you have to be accepted as an investor. Those don't have to just accept anybody who wants to invest. Those are the three different types of REITs. I generally suggest sticking to publicly traded REITs. They're more transparent with the management costs and expenses and really how they're using your money.
A lot of private REITs have big sales conditions right off the top. Think of a mutual fund with a sales charge. So that's something that you can sometimes get suckered into with a non-traded REIT. There are some good ones, but it's a lot less transparent it's the point, and I'd like to stick to the publicly traded sector. Yeah. It's a very good point. The non-listed one's only let people redeem their shares quarterly, if that frequently, at a predetermined price based on the REIT's assets. It's not a liquid market. If I wanted to sell my realty income shares while I'm talking to you, I could with a simple click of a button. It's a different kind of dynamic. If you're a new investor, I'd say proceed with caution when it comes to non-traded REITs of any kind. Sure. Well, we mentioned the taxes on to the REIT itself. REITs don't pay corporate taxes at all. On the individual level, assuming you're not holding them in a retirement account like an IRA, REITs can be complex on the taxation side. For one thing, most dividend stocks pay what are called qualified dividends. All you really need to know about that, is a qualified dividend gets the preferable tax rates that capital gains get. If you search capital gains tax rates, those are the rates that you pay on most stock dividends. REITs on the other hand, generally don't meet the definition of qualified dividends. Meaning that you'll have to pay your ordinary income tax rate on your REIT dividends. Now, to further complicate matters, not all of a REIT's dividend is usually of the non-qualified kind.
A REIT will send you a breakdown of its dividend distributions at the end of each year. The vast majority will usually be non-qualified dividends meeting their tax at ordinary income rates. Some may be qualified dividends depending on how the REIT made the money, and some could even be considered a non-taxable return of capital depending on how the REIT made its money. For example, if it sold properties at a profit and it's passing that money on to shareholders, that could be considered a non-taxable return of capital in that situation, which serves just to reduce your cost basis in the shares. If that doesn't sound complicated enough already, REITs also qualify for the 20 percent qualified business income deduction, but only the portion that's considered ordinary income, which is a good tax benefit. It generally brings your tax rate down to a comparable level as if you had a qualified dividend, but it's a big more complicated calculation and get there. REIT dividends, two things you need to know, they're not qualified dividends and they're complicated, if I were to break all that down into two things. Correct. The REITs will send you a tax form at the end of the year with all these broken down for you. You can usually import it right into whatever tax software you're using like TurboTax, you can just import it right in there. It will do the calculation for you, but it is a more complicated tax situation. If you are in a higher income bracket especially, you could find your effective tax rate on REIT investments higher than on normal stock dividends.
So that's just something to keep in mind as you invest in REITs and in non-taxable accounts. Ideal candidates again for retirement accounts, but if you're going to invest in them in a standard brokerage account, just be aware that the tax treatment is a little bit different. That really just a more complicated tax structure and a lot of the analytical methods don't necessarily translate. But other than that, I wouldn't call anything about REITs really a big negative. Yeah, we're a little bias though. I actually checked the website. It's not nareit.com, it's just reit.com. It's the National Association of Real Estate Investment Trust. They have some fantastic educational resources. Like I said, there's a directory of all the different REITs that trade on the public, non-traded and private markets. There's a lot of educational: what is a REIT? How to look at REITs? REITs statistics, REIT historical performance. They have some great statistics there. I would recommend that as a great resource.
Your broker likely has a lot of educational resources. I use TD Ameritrade for example, they have a lot of third-party research reports on a lot of the major REITs. That could be a great way to learn more about the companies from an analytical point of view without really having to know too many analytical methods yourself. Those are the two big resources other than Millionacres, I would recommend that you try. Yeah. You can definitely check out your local market. I know right down the street there's a mall owned by a major REIT. There's an office building owned by a major REIT right here, and a hospital owned by a major REIT not far from where I'm sitting right now. That's one way of looking.
What I like to look for are unique and irreplaceable assets, or at least assets that you can't really find anywhere else. Like for example, if you're looking at a Hotel REIT, there's some good REITs that own these. Anybody can own an extended stay hotel, like a standard extended stay building. Not everyone can own a giant conference center or a hotel with a big entertainment venue attached to it or something to that effect. Not every Office REIT owns the Empire State Building or not every apartment REIT can buy urban high-rise apartment buildings. Those are unique assets that are very difficult to get into that business, high barriers to entry and are very irreplaceable or difficult to replace, or difficult to be competed against. Those are the things I really look for. But your local market is a great place to start if you want to start getting some ideas. You'd be surprised how many buildings you go into all the time, they are owned by publicly traded REITs. Right. Like I'm a part owner of the Empire State Building. It's neat. How many other people can say that? Well, I guess everyone else who own shares. But it's really a unique type of investment and that it's one that you can readily see. You could stand inside the building that you partially own. It's an engaging type of investment in that sense. I know you could buy Apple and use your iPhone and say, "I help put some profit in my pocket by buying this iPhone". But it's different when it's a physical building and a piece of real estate or especially like an iconic asset like the Empire State Building I keep talking about or your favorite shopping mall that you've been going to since you were a kid or something to that effect. There are a few good more REITs out there believe it or not. It's great to be here. I hope we do this again very soon.
Deidre Woollard: Thank you for tuning into the Millionacres podcast. I hope you like today's show. If you enjoyed this episode, please consider subscribing through your favorite podcast provider. If you have any questions, please feel free to drop us a line at email@example.com. Stay well and stay invested. People on this program may have an interest in the deals, offerings, or services they discuss at Millionacres or The Motley Fool may have a formal recommendation for or against. Always consult a Certified Tax Professional before acting on tax advice, and do not buy or sell assets based solely on what you hear.