Whether you’re new to investing, or a seasoned accredited investor, you may at some point have wondered, “What exactly is a REIT?” A REIT, or a real estate investment trust, is an organization that owns and operates income-generating real estate. There are a variety of commercial and residential properties that fall under the REIT umbrella, including apartment or condominium buildings, shopping centers, hotels, industrial warehouses, and even hospitals. It is a key component while constructing any equity or fixed-income portfolio since real estate typically provides greater diversification at a lower risk compared to stocks and their ability to generate predictable dividend income similar to bonds.

Choosing which REIT to invest in is a complex process as not all REITs as created equal. Real estate investing is littered with many different types of companies and investment strategies. The COVID-19 pandemic struck early and hard in 2020, with the FTSE Nareit All Equity REITs Index down 7.0% in February and down 18.7% by the end of March. However, the most recent months have shown modest increases, with total returns since March 2020 up 19.4%. Unpacking the REITs by their property sector paints a different picture of the pandemic’s impact on the industry. Sector with the most exposure to e-commerce outperforms the rest of the index. These includes infrastructure, data centers, and industrial and logistics REITS. On the other end of the spectrum, retail and lodging/resorts REIT are hardest hit by the pandemic. Office, healthcare and residential REIT are in the middle of the impact as their short-term impact is not as severe for these sectors.

1. Retail REITs

Approximately 24% of REIT investments are in shopping malls and freestanding retail.3 This represents the single biggest investment by type in America. Whatever shopping center you frequent, it’s likely owned by a REIT. When considering an investment in retail real estate, one first needs to examine the retail industry itself. Is it financially healthy at present and what is the outlook for the future?

It’s important to remember that retail REITs make money from the rent they charge tenants. If retailers are experiencing cash flow problems due to poor sales, it’s possible they could delay or even default on those monthly payments, eventually being forced into bankruptcy. At that point, a new tenant needs to be found, which is never easy. Therefore, it’s crucial that you invest in REITs with the strongest anchor tenants possible. These include grocery and home improvement stores.

Once you’ve made your industry assessment, your focus should turn to the REITs themselves. Like any investment, it’s important that they have good profits, strong balance sheets and as little debt as possible, especially the short-term kind. In a poor economy, retail REITs with significant cash positions will be presented with opportunities to buy good real estate at distressed prices. The best-run companies will take advantage of this.

That said, there are longer-term concerns for the retail REIT space in that shopping is increasingly shifting online as opposed to the mall model. Owners of space have continued to innovate to fill their space with offices and other non-retail oriented tenants, but the subsector is under pressure.

2. Residential REITs

These are REITs that own and operate multi-family rental apartment buildings as well as manufactured housing. When looking to invest in this type of REIT, one should consider several factors before jumping in. For instance, the best apartment markets tend to be where home affordability is low relative to the rest of the country. In places like New York and Los Angeles, the high cost of single homes forces more people to rent, which drives up the price landlords can charge each month. As a result, the biggest residential REITs tend to focus on large urban centers.3

Within each specific market, investors should look for population and job growth. Generally, when there is a net inflow of people to a city, it’s because jobs are readily available and the economy is growing. A falling vacancy rate coupled with rising rents is a sign that demand is improving. As long as the apartment supply in a particular market remains low and demand continues to rise, residential REITs should do well. As with all companies, those with the strongest balance sheets and the most available capital normally do the best.

3. Healthcare REITs

Healthcare REITs will be an interesting subsector to watch as Americans age and healthcare costs continue to climb. Healthcare REITs invest in the real estate of hospitals, medical centers, nursing facilities, and retirement homes. The success of this real estate is directly tied to the healthcare system. A majority of the operators of these facilities rely on occupancy fees, Medicare and Medicaid reimbursements as well as private pay. As long as the funding of healthcare is a question mark, so are healthcare REITs.

Things you should look for in a healthcare REIT include a diversified group of customers as well as investments in a number of different property types. Focus is good to an extent but so is spreading your risk. Generally, an increase in the demand for healthcare services (which should happen with an aging population) is good for healthcare real estate. Therefore, in addition to customer and property-type diversification, look for companies whose healthcare experience is significant, whose balance sheets are strong and whose access to low-cost capital is high.

4. Office REITs

Office REITs invest in office buildings. They receive rental income from tenants who have usually signed long-term leases. Four questions come to mind for anyone interested in investing in an office REIT

1. What is the state of the economy and how high is the unemployment rate?
2. What are vacancy rates like?
3. How is the area in which the REIT invests doing economically?
4. How much capital does it have for acquisitions?

Try to find REITs that invest in economic strongholds. It’s better to own a bunch of average buildings in Washington, D.C., than it is to own prime office space in Detroit, for example.

5. Mortgage REITs

Approximately 10% of REIT investments are in mortgages as opposed to the real estate itself.3 The best known but not necessarily the greatest investments are Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages on the secondary market.

But just because this type of REIT invests in mortgages instead of equity doesn’t mean it comes without risks. An increase in interest rates would translate into a decrease in mortgage REIT book values, driving stock prices lower. In addition, mortgage REITs get a considerable amount of their capital through secured and unsecured debt offerings. Should interest rates rise, future financing will be more expensive, reducing the value of a portfolio of loans. In a low-interest-rate environment with the prospect of rising rates, most mortgage REITs trade at a discount to net asset value per share. The trick is finding the right one.

Types of REIT

Beyond sectors, REITs come in a variety of classifications that are based on how shares are transacted and access to the public market:

Publicly Traded REITs issue shares that are listed on a national securities exchange. This form of REIT is regulated by the U.S. Securities and Exchange Commission (SEC) and shares are bought and sold by individual investors.

Public Non-traded REITs are not traded on the stock exchange, but are registered with the SEC. As they are not impacted by market fluctuations, they tend to be more stable than publicly-traded REITs. They do, however, have lower liquidity.

Private REITs, or private placement REITs are only available to an exclusive group of investors, are not publicly traded, and do not need to be registered with the SEC. These types of REITs are generally not liquid.

Why invest in REIT?

REIT provide access to real estate investment for you as an individual investor to help diversify your capital allocation and create steady income stream distributed from rental income produced by the commercial real estate without the hassle of managing the asset yourself.