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A Primer on How to Invest in REITs

It isn't hard to buy real estate investment trusts (REITs). Most trade on the stock exchange, so like other stocks they can be bought and sold through a licensed broker. REITs are well suited to income investors, since they must pay out at least 90% of their net taxable income in the form of dividends to maintain their status as REITs. These dividends often have relatively high yields.

For those interested in REITs, here's a brief primer on what to look for in a potential investment.

Which REIT is Right For You?

In choosing a REIT, investors should first determine whether they are interested in an equity REIT (one that invests directly into property), or a mortgage REIT (which puts its money in mortgages and mortgage-backed securities). Several REITs combine the two flavors.

Equity REITs are by far the more numerous type on the stock exchange. Some of the most high-profile REITs, period, take this form. Realty Income (NYSE: O) is a good example, as is Ventas (NYSE: SPG). Examples of prominent mREITs include Annaly Capital Management (NYSE: NLY) and Two Harbors (NYSE: TWO).

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Both types typically specialize in one particular type of property (or mortgage), such as commercial, residential, industrial, healthcare facilities, data centers, etc. Potential investors that might be more familiar with one or more of these should consider putting their money in a REIT that focuses on their area(s) of expertise. The same goes for those who simply believe a certain category has better potential going forward.

Rating the REITs

As with any other stock, there are several key metrics that must be taken into account when rating REITS. Arguably the most critical of these is funds from operations, which is essentially net profit with depreciation, in addition to several smaller line items, added back. This is done with equity REITs because, since much or all of their assets are in property, depreciation can be very high and as such heavily skew "real" profitability. 

Traditional companies almost always proffer GAAP and non-GAAP (aka "adjusted") net profit figures, the former being the current accounting standard, and the latter the company's own adjustments for extraordinary and one-time items it deems important. It's the same for standard FFO and adjusted FFO. The standard variety is good for comparing a REIT to its peers, while the latter could present a more accurate picture of profitability.

Either way, FFO in both flavors should be tracked over time to gauge the quality and performance of the REIT's management.

Like traditional companies, classic line items such as revenue and indebtedness should always be considered. For equity REITs, occupancy is always a concern (the more tenants, naturally, the higher the take from rent). The best REITs on the market -- Realty Income leaps immediately to mind -- boast collective occupancy rates close to 100% across their many properties.

But perhaps the most important figure for REIT investors -- who are often drawn to them because of the income they produce -- is the dividend and its yield. Due to the aforementioned 90% payout requirement, REITs boast yields that are well above those of more traditional stocks.

At the moment, the average dividend yield of stocks on the S&P 500 index is just shy of 1.9%. Realty Income pays out more than double that, at 4.3%, while Ventas is a touch higher at 4.5%. mREITs, which tend to be more volatile in terms of performance and stock price, boast much higher figures -- Annaly's is currently approaching 10%, and Two Harbors betters that at almost 10.1%. But, beware, as always higher dividends come with more risks, which means you need to pick your buys carefully and keep a close eye on your purchases.

TWO Dividend Yield (TTM) data by YCharts

Real returns

As mentioned, REITs are good targets for investment for those who are seeking a steady source of dividend income (a few, such as Realty Income, even pay on a monthly basis). The downside to this is that the stock prices of REITs -- well, equity REITs anyway -- don't usually shoot drastically higher in the short- to medium-term. As such, they are relatively conservative and unexciting investments.

Their returns can be compelling, though. So in times when the real estate market in general is doing well, owning a REIT or several can be an excellent way for investors to get a piece of it.

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Eric Volkman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.