Investing in Diversified REITs

Diversified real estate investment trusts (REITs) take a broad-based approach to investing in commercial real estate. Instead of focusing on a specific property type (e.g., retail, industrial, residential, or offices properties) like most REITs, these entities own a diversified portfolio across more than one property type.

Here's a closer look at why some REITs opt to diversify and the advantages and disadvantages of being a diversified REIT. We'll also look at some of the top diversified REITs for investors to consider.

Understanding diversified REITs

A diversified REIT owns a diversified portfolio of commercial real estate assets, which can include:

• Office buildings and business parks.
• Warehouses and other industrial buildings.
• Multifamily properties.
• Healthcare-related real estate like medical office buildings.
• Retail properties, including freestanding retail buildings and shopping centers.
• Hotels and resorts.
• Gas stations and travel centers.
• Self-storage facilities.
• Mixed-use properties that include offices, retail, and multifamily units.

Many diversified REITs focus on owning single-tenant net lease real estate. These are properties secured by long-term triple-net (NNN) leases with the occupying tenant. This lease structure makes the tenant responsible for maintenance, building insurance, and real estate taxes, enabling the REIT to collect steady rental income.

However, some diversified REITs will own multi-tenant properties with some rental income variability due to a shorter-term lease structure or variable expenses. In addition, some diversified REITs own properties they operate alongside a third-party manager (e.g., hotels and self-storage facilities). These properties can have even more income variability since occupancy and rates can decline quickly during a recession.

Diversified REITs don't buy properties at random. They develop an investment strategy that focuses their efforts on a specific theme. For example, some diversified REITs concentrate on a particular type of property (e.g., global net lease real estate or service-related properties). Meanwhile, others focus on owning a diversified real estate portfolio in a specific city.  

Advantages of investing in diversified REITs

Diversified REITs make it easy to invest in real estate. These REITs typically own a diversified portfolio providing investors with reasonably broad exposure to several types of commercial real estate, often with offsetting risk profiles. In some ways, owning a diversified REIT is similar to investing in a REIT ETF. They both can provide instant diversification across several property types.   

Risks of investing in diversified REITs

While diversified REITs can help reduce an investor's risk profile, they aren't without risk. Because of their diversified operations, many diversified REITs have chosen to pay out the bulk of their cash flow via dividend and therefore have high dividend payout ratios. While that typically means they are high dividend REITs, it increases the risk of a dividend reduction if a property segment runs into trouble. The strategy can also limit the REIT's ability to grow since it's not retaining as much cash to make acquisitions, forcing it to heavily rely on debt and issuing stock to expand.

Diversified REITs can also face risks specific to the property types they hold. For example, office and retail properties have experienced headwinds in recent years. Reduced occupancy and traffic have weighed on the stock prices and cash flows of diversified REITs that hold these types of properties. This issue has led several formerly diversified REITs to shift their strategies by narrowing their investment focus on a specific property type.

Diversified REITs also face interest rate risks common to all REITs. As interest rates rise, it's more expensive for these REITs to borrow money and refinance debt. In addition, higher interest rates make lower-risk, yield-focused investments such as government and corporate bonds more attractive to income investors. As a result, REIT stock prices tend to fall, pushing up dividend yields to compensate investors for their higher risk profiles.

3 top diversified REITs

There were 17 publicly traded diversified REITs in early 2022, according to the National Association of Real Estate Investment Trusts (NAREIT). This number has been shrinking in recent years. Several formerly diversified REITs have chosen to focus on a specific property type after years of underperformance in some of their other property segments.

Despite the shrinkage, investors still have several interesting diversified REITs to consider. Three that stand out are:

Here's a closer look at these diversified REITs.

W.P. Carey

W.P. Carey is one of the largest and most diversified REITs. It focuses on owning operationally critical properties net leased to high-quality tenants. This REIT entered 2022 with more than 1,300 properties, with about 156 million square feet of rentable space leased to more than 350 tenants across more than a dozen industries. Its properties include single-tenant industrial (26% of its annual base rent), warehouse (24%), office (20%), retail (18%), and self-storage (5%). Other property types (education facilities, hotels, fitness facilities, theaters, student housing, restaurants, and land) make up the remainder of its portfolio. W.P. Carey owns most of its properties in the U.S. (63% of its real estate assets) and Europe (35%). Other countries (Canada, Mexico, and Japan) make up the remaining 2%.

The REIT's focus on the global net lease market has enabled it to generate stable cash flow. That's allowed W.P. Carey to pay a consistently rising dividend. This REIT has increased its dividend every year since its initial public offering in 1998. It has historically produced an above-average dividend yield, making it an excellent option for those seeking to generate passive income backed by commercial real estate.

JBG SMITH Properties

JBG SMITH focuses on owning high-quality, mixed-use assets in Washington, D.C., that feature office, multifamily, and retail space. This REIT owns 17.1 million square feet of currently operational assets and has a pipeline of 16.6 million square feet of mixed-use development opportunities.

The crown jewel of its diversified portfolio is National Landing, where it's the exclusive developer of the new headquarters for e-commerce giant Amazon (NASDAQ:AMZN). It's also currently developing several multifamily assets that will feature some retail space and two new outdoor destinations that will include restaurants, parks, and other amenities at National Landing. This focus on Washington, D.C., makes JBG SMITH a way for real estate investors to participate in the growth of the capital region, driven by Amazon's expansion.

Service Properties Trust

Service Properties Trust is a diversified REIT focused on service-related properties. This REIT entered 2022 with almost 1,100 properties, including roughly 300 hotels and nearly 800 net lease service retail properties. Its hotels made up 57.5% of its portfolio. Meanwhile, its net lease properties included travel centers (27.8%), restaurants (4.1%), movie theaters (1.6%), health and fitness (1.5%), grocery stores (1.1%), home goods and leisure (1%), and other properties (5.4%). This REIT also owns interests in its two largest tenants: Sonesta Holdco Corporation (34%) and TravelCenters of America (NASDAQ:TA).

The net lease portfolio provides this REIT with steady cash flow, which helps offset the variability of its hotel portfolio. That volatility was on full display during the COVID-19 pandemic as its hotels suffered. However, occupancy and revenue per available room have started recovering as traveling has rebounded. The bounce back in travel also benefited its travel centers and other service-related properties. 

Still, the headwinds have forced the REIT to take steps to improve its financial situation in recent years, including selling off several hotels in deals slated to close in 2022. These deals will put Service Properties in a better financial position and reduce its exposure to the volatile hotel sector while still allowing it to participate in its recovery.

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Diversified REITs can be great options for real estate investors

Diversified REITs enable investors to own a diversified real estate portfolio through one investment, thereby reducing risk. However, it's essential to know what's in a diversified REIT's portfolio. That's because most of these companies develop a strategy around a particular theme, which has its pros and cons. While some of these strategies have worked well over the years, others have faced headwinds, leading the REIT to shift gears.