Stock Market Tips for Investing in Real Estate

By Markets Fool.com

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Real estate can be an excellent long-term investment, but buying and managing rental properties isn't for everyone. Fortunately, you can get exposure to all different kinds of real estate in your portfolio through stocks called real estate investment trusts, or REITs. Here are five tips for investing in real estate stocks that can produce excellent returns and protect you from downside risk.

1. There are two kinds of REITS -- and they are completely different investments
Under the broad category of REITs, there are some that own properties and some that invest in mortgages.

Mortgage REITs, or mREITS, are a much riskier type of investment. These companies use extremely high amounts of leverage to invest in mortgages. They tend to produce large dividend yields -- often 10% or more -- but they're susceptible to interest-rate fluctuations and can be rather volatile.

When I talk about "investing in real estate," I'm referring to REITs that own actual properties. These are usually more stable and conservative investments, especially from a long-term perspective. That's not to say that mortgage REITs don't have their place, but they're certainly less stable than property-owning REITs, and investors should be aware of the difference.

2. History tends to repeat itself
A common disclaimer in investing is that "past performance does not guarantee future results," and that's definitely true.

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However, stocks with a track record of a certain behavior tend to continue that pattern in the future. For example, stocks that have a strong track record of paying and increasing their dividends are likely to continue doing so.

Popular retail REIT Realty Income has not only paid a consistent monthly dividend since its 1994 IPO, but it has also increased its dividend 79 times since then. This kind of track record makes it likely that shareholders will continue to receive a growing stream of income from Realty Income stock for years to come.

3. Dividends are great, but focus on total return
When faced with the choice between two similar REITs, investors may naturally choose the one with the higher dividend yield, especially if they plan to use that regular income to pay for living expenses.

While this is not necessarily a bad idea, it's important to look at the big picture. Specifically, from a long-term perspective, you should be more concerned with a stock's total return, which refers to the stock's total annual appreciation, including both share price gains and reinvested dividends.

Some REITs with lower dividend yields have produced some of the best returns in the sector, so it's important not to exclude any REITs from consideration simply because they have lower dividends than you'd like.

Company Symbol Property Type Dividend Yield 20-Year Average Total Return
Realty Income O Retail (free-standing) 4.8% 14.5%
Simon Property Group SPG Retail (malls) 3% 15.3%
Health Care REIT HCN Healthcare facilities 4.6% 13.4%
Public Storage PSA Storage facilities 2.9% 16.1%
Equity Residential EQR Apartments 3% 13.3%
Average 3.7% 14.5%

Data current as of May 12, 2015.

For example, Simon Property Group has averaged a higher total return than Health Care REIT , although it pays a significantly lower dividend. And even though the REITs' annual returns look similar (15.3% versus 13.4%), consider that over the long that can be a huge difference. Compounded at 15.7% for 30 years, a $10,000 investment will produce $237,429 more than the same amount of money compounded at 13.7%.

4. Make sure you diversify
One potential drawback of REIT investing is that most REITs invest in one specific property type. For example, there are many great REITs that invest in:

  • Apartment complexes (Equity Residential, AvalonBay)
  • Student housing (American Campus Communities)
  • Office buildings (Boston Properties)
  • Retail properties (Realty Income, National Retail Properties)
  • Storage facilities (Public Storage)
  • Healthcare properties (HCP, Health Care REIT)
  • Specialized property types (Digital Realty Trust)

The problem is that any single REIT is vulnerable to weakness in that specific type of real estate. For example, if another recession hits and several retailers go out of business, retail-focused REITs, such as the aforementioned Realty Income, could see their income plummet. And if a wave of retailers were to go bankrupt, demand for this type of property could plunge, causing the property values to go down.

Or if a new first-time homebuyer incentive program is created, demand for rental housing could fall dramatically.

My point is that you should invest in REITs the same way you should invest in any stocks -- by not putting too many of your eggs in one basket. A portfolio that depends entirely on retail real estate is just as irresponsible as a portfolio that contains nothing but tech stocks.

5. Know the risks
Before you jump into any type of investment, it's important to be aware of the risks involved, and even though I think REITs as a whole are safer than most other stocks, there are a few risks worth mentioning.

I already mentioned the risk that comes with REITs' focus on a single type of property, and there is also some interest-rate risk. Most REITs finance a portion of their holdings, and this becomes more expensive when rates rise. When "safer" investments such as bonds are paying more, they become more appealing to income-seeking investors, which can create a lot of selling pressure on REITs.

The bottom line
A double-digit total return doesn't come without risk. Most of the larger property REITs performed just fine during the last crash, but there are some that didn't. The best way to minimize your risk is to diversify your REIT holdings.

So long as you take a diversified and conservative approach, investing in real estate could produce incredible long-term gains in your portfolio and limit your investment risk at the same time. While no stock's performance is guaranteed, REITs can offer some of the best risk/reward ratios in the market.

The article Stock Market Tips for Investing in Real Estate originally appeared on Fool.com.

Matthew Frankel owns shares of National Retail Properties, and Realty Income. The Motley Fool recommends Health Care REIT. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.