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What are REITs - Real Estate Investment Trusts?
When a company owns, operates, or finances income-generating real estate then it is called a real estate investment trust (REITs).
REITs pool the capital of many investors, making it possible for individual investors to earn dividends from real estate investments, without needing to buy, manage, or finance any properties themselves.
How REITs Work
In 1960 REITs was established by Congress as an amendment to the Cigar Excise Tax Extension.
Investors were allowed to buy shares in commercial real estate portfolios by the provision, which was earlier available only to wealthy individuals and through large financial intermediaries.
Even if REITs specializes in specific real estate sectors, the diversified and specialty REITs hold different types of properties in their portfolios, so it comprises both office and retail properties.
Apartment complexes, data centers, healthcare facilities, hotels, infrastructure are the properties included in a REIT portfolio, also fiber cables, cell towers, energy pipelines, office buildings, retail centers, self-storage, timberland, and warehouses can all be a form of properties.
Major securities exchanges have public trading of many REITs, and they can be bought and sold like stocks throughout the trading session by investors.
These REITs typically trade under big volume and are considered very liquid instruments.
What Qualifies as a REIT?
The business model of most REITs is quite straightforward. Space is leased and rents are collected on the properties, then that income is distributed as dividends to shareholders by REIT.
Mortgage REITs instead of owning real estate, finance real estate. Income is earned from the interest on their investments by these REITs.
A company must comply with certain provisions in the Internal Revenue Code (IRC) to qualify as a REIT.
These requirements being to primarily own income-generating real estate for the long term and distribute income to shareholders.
If a company wants to qualify as a REIT then it must meet the following requirements:
- At least 75% of total assets to be invested in real estate, cash, or U.S. Treasuries.
- At least 75% of gross income to be obtained from rents, interest on mortgages that finance real property, or real estate sales.
- Each year a minimum of 90% of taxable income to be paid in the form of shareholder dividends.
- The company should be an entity that’s taxable as a corporation
- A board of directors or trustees to manage the company
- After its first year of existence, the company must have at least 100 shareholders
- Five or fewer individuals cannot hold more than 50% of its shares
As in the current scenario, REITs collectively own about $3 trillion in gross assets, publicly traded equity REITs account for $2 trillion.
Different types of REITs
- Equity REITs: That owns and manages income-producing real estate. Income is generated mainly through rents and not by reselling properties.
- Mortgage REITs: The real estate owners and operators are lent money by these REITs either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. The spread between the interest they earn on mortgage loans and the cost of funding these loans is how their earnings are generated. Making them sensitive to interest rate increases.
- Hybrid REITs: It is a combination, where the investment strategies of both equity and mortgage REITs are used.
- Publicly Traded REITs: They are regulated by the U.S. Securities and Exchange Commission (SEC). Here individual investors buy and sell the shares of publicly traded REITs that are listed on a national securities exchange.
- Public Non-Traded REITs: These REITs don’t trade on national securities exchanges but are registered with the SEC. So they are less liquid than publicly traded REITs. Yet they are more stable as they do not face market fluctuations.
- Private REITs: These REITs neither are registered with the SEC nor do they trade on national securities exchanges. They can be sold only to institutional investors.
Ways to Invest in REITs
Just by purchasing shares through a broker, you can invest in publicly traded REITs, REIT mutual funds, and REIT exchange-traded funds (ETFs).
Shares of a non-traded REIT can be bought through a broker or financial advisor who is participating in the non-traded REIT’s offering.
Many defined benefits and defined contribution investment plans include REITs.
According to Nareit, a Washington, D.C.-based REIT research firm, approximately 87 million investors in America own REITs through their retirement savings and other investment funds.
In the United States, there are more than 225 publicly-traded REITs. So before buying consider the REIT’s management team and track record to know of compensation.
If it’s performance-based compensation, then they’ll be working hard to pick the right investments and choose the best strategies.
Also look at the numbers, like anticipated growth in earnings per share and current dividend yields. REIT’s Fund from Operations (FFO) is a useful metric.
Advantages and disadvantages of investing in REITs
As REITs offer a strong, stable annual dividend and the potential for long-term capital appreciation they play a vital role in an investment portfolio.
for the last 20 years, REIT’s total return performance has outperformed the S&P 500 Index, other indices, and the rate of inflation.
The advantages of REITs
- Liquidity: As most trade on public exchanges, REITs are easy to buy and sell.
- Stable cash flow through dividends: REITs offer very good risk-adjusted returns and stable cash flow.
- Diversification: Because a real estate presence provides diversification and dividend-based income it can be good for a portfolio.
- Attractive risk-adjusted returns: Quite often the dividends are higher than what you can get with other investments.
The disadvantages of REITs
- Low growth: REITs don’t offer much in terms of capital appreciation, because as part of their structure, they have to pay back 90% of income to investors. Which leaves only 10% of taxable income to be reinvested into the REIT to buy new holdings.
- Dividends are taxed as regular income: REIT dividends are taxed as regular income.
- They are subject to market risk.
- High management and transaction fees: some REITs have high management and transaction fees.
REIT Fraud
The Securities and Exchange Commission (SEC) warns investors to be careful of buying REITs that aren’t registered with the SEC.
They warn investors to verify the registration of both publicly traded and non-traded REITs through the SEC’s EDGAR system.
EDGAR can be used to review a REIT’s annual and quarterly reports.
Conclusion
Income-producing properties are owned, operated, or financed by a company called the real estate investment trust (REITs).
A steady income stream for investors is generated by REITs but very little is offered in the way of capital appreciation.
Unlike physical real estate investments, most REITs are publicly traded like, stocks which makes them highly liquid.
Most real estate property types have investment by REITs, like apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, warehouses, etc.
