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REIT Investing Basics - What, Why, and How.

What and Why invest in REITs:

So REITs (Real Estate Investment Trusts) are a way to buy real estate like stocks (can buy at a brokerage like you do with stocks).  So the advantage is that you can buy a share of the real estate for as low as the REIT trades (example VNQ - Vanguard Real Estate ETF is just over $100 a share) and not have to save tens if not hundreds of thousands of dollars (or even millions of dollars) to invest in this asset class.  Also, because you can buy and sell them like stocks, you have much better liquidity.

Some negative aspects are because they are liquid, you might get to overwhelmed following the prices change tick by tick, whereas houses and other real estate the prices don't change that often.  Another negative aspect is that it isn't common to take leverage buying REITs whereas most home buyers get leverage from a bank by taking out a mortgage.

I believe there are 2 major aspects of understand real estate valuation.  1st is how much income does the asset generate.  This is basically the rent collected minus all the expense of the asset (including upkeep).  And the 2nd aspect is appreciation value.

Since REITs are generally a portfolio of diverse real estate it can be a good barometer to evaluate physical real estate.  For example, if VNQ offers around 3% annual dividend, then when you compare physical real estate, you can quickly asses if the property can yield more than the a portfolio of diverse real estate.  But even if the property has a lower yield, it still may be a good investment if you expect the property to appreciate higher than a portfolio of real estate across the US (e.g. the property might be in a booming tech area).  However, even if the yield is higher than a REIT, it could still be a bad investment if the property doesn't appreciate as much as a portfolio of real estate across the US (e.g. the property might be located near a nuclear plant).

There are many different approaches to REIT Investing, below I share the process using a market data driven approach.  To give a diverse exposure and no reliance on fundamental or technical analysis as it is difficult to determine if the market has efficiently priced that in or not.

 

Finding the 5 largest REIT ETFs: (https://etfdb.com/etfdb-category/real-estate/ as of 4/20/22)

SymbolETF NameTotal Assets*Avg VolumeExpenseInceptionPrev Close
VNQVanguard Real Estate ETF$47,529,300.006,113,792.000.12%2004-09-23$110.66
SCHHSchwab US REIT ETF$7,014,070.002,718,482.000.07%2011-01-13$25.52
XLREReal Estate Select Sector SPDR Fund$5,890,600.006,507,745.000.10%2015-10-07$49.66
IYRiShares U.S. Real Estate ETF$5,306,510.009,138,876.000.41%2000-06-12$110.38
ICFiShares Cohen & Steers REIT ETF$2,895,760.00251,383.000.33%2001-01-29$73.16

From the above table, you can see that VNQ is by far the largest ETF. SCHH is the second largest but also charges the smallest Expense Ratio.  While IYR has the highest average trading dollar volume.  The Expense Ratio difference for $10,000 investment is $12 for VNQ vs $7 for SCHH.

For investing buy and hold style:

VNQ would probably be a safer choice as the ETF has significantly more AUM than the others.  There is something to be said for the wisdom of crowds.  However, if every little penny counted, then SCHH would save you about $5 a year on a $10,000 investment.

For trading and strategic use of options:


Bid Ask SpreadOption VolumeOption Open Interest
VNQ$0.1580050000
SCHH$0.1522767
XLRE$0.10324048600
IYR$0.069400322000
ICF$0.55281640

IYR is clearly the most suitable for trading stocks (highest average volume) and trading options (largest open interest with smallest Bid Ask Spread).   

Tax treatment of REIT and REIT ETFs make them excellent for IRAs:

REITs are special investment trusts that don't get taxed on profits (unlike most other companys on the stock exchange).  They do this by having at least 90% of the taxable income distributed to shareholders annually.  In a normal brokerage account, these income distributions are passed straight to the investor so they get taxed at the personal tax rate (unlike qualified dividends of companies that get lower tax treatment).  However, IRAs in the US are tax-advantaged and REIT distributions are not subject to taxes in these types of accounts (unlike other investments like MLPs).  Therefore, as I understand the current tax laws (these are my findings, please do your own research and ask your own tax adviser as your situation may be unique), REITs in IRA allow you to make the most of the tax advantage account.  So if you have both regular and IRA accounts and want to invest in REITs, it would be to your advantage to consider using the IRA account for your REIT holdings.

Enhancing your REIT holding with a covered-call strategy:

A very popular option strategy to enhance income is to sell a covered-call (sell a call in an stock you own).  This is like renting your shares to someone as long as it stays below your strike price.  You get extra income if it stays below the strike price at expiration but loss your share if the price is above the strike at expiration (but you still get all the gains up to the strike).

Takeaways:

  • REITs and REIT ETFs are an easy way to get exposure to Real Estate and can start with a very small amount
  • If you have qualified tax advantaged accounts, REITs and REIT ETFs could be excellent candidates
  • Since REITs trade like stocks, you can use options to enhance your returns or even hedge your position

Other Facts:

  • REIT ETF holdings are not just residential real estate (AVB, EQR).  Other large holdings include, industrial/factors (PLD), cellphone towers (AMT, CCI, SBAC), data centers (EQIX), public storage (PSA), healthcare facilities (WELL), retail(SPG,O), offices (DLR, ARE) and even timberland (WY). 

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