What is a Real Estate Investment Trust and How do you Invest in a REIT?

Want to invest in real estate without owning real estate?

Then a REIT is for you!

Real estate investment trusts (REITs) are businesses that financially back or own income-producing properties spanning a variety of sectors. Most REITs are traded on major stock exchanges just like stocks are.

They’re also secure in so far as they have to meet requirements in order to count as a REIT. Here’s everything you need to know!

What assets to REITs own?

Some properties that may find their way into your REIT include but are not limited to:

  • apartment complexes
  • data centers
  • hotels
  • infrastructure (cables, cell towers, etc)
  • medical facilities
  • offices
  • retail centers
  • self-storage
  • timberland
  • warehouses

How do REITS make money?

REITs tend to make their profits from a very simple plan of action: lease space and collect rent. The gains are then paid out to shareholders in the form of dividends, which are portions of a company’s profit owed to shareholders that get distributed at regular intervals.

Why should I invest in a REIT?

Everyone needs to live or work somewhere, so REITs are a pretty stable opportunity that provides a competitive return on investment. This is thanks to reliable dividend income and long-term capital appreciation. They’re great for diversifying your portfolio because of their low correlation with other investments.

How have REITs performed in the past?

Compared to the stock market, bonds, and other assets, REITs have been a good investment for much of the past 45 years. This is thanks to reliable and growing dividends as well as long term capital appreciation. Publicly traded REITs are professionally managed with the intent of maximizing profits, so they’re putting in the work to get their properties leased as well as buying and selling assets to grow value over the long term.

What are the different types of REITs?

REITs don’t just earn their money from owning income-generating property. And they’re also not all acquired in the same way. These differences merit varied REIT categorization.

Equity REITs

This is the most abundant form of REIT. They buy, own, and manage income-producing properties. Most of the income comes from rent as opposed to selling assets.

Mortgage REITs (mREITs)

Also known as mREITs, mortgage REITs provide loans for owners and operators. This can be done directly by issuing mortgages or loans or by buying mortgage-backed securities (MBS). An MBS is a financial instrument that’s made up of bundled mortgages that are issued by government-sponsored enterprises (GSEs). mREITs make their mone off the net interest margin, which is the difference between a loan’s interest and the cost of funding the loan. mREITS may be impacted by interest rate increases.

Hybrid REITs

These trusts make their money off physical rental properties and mortgages loans. Depending on the investing strategy of the REIT, these companies may lean more heavily toward property ownership or mortgage holdings.

Publicly Traded REITs

These REITs you can buy and sell on national security exchanges. They’re monitored by the U.S. Securities and Exchange Commission (SEC).

Public non-listed REITs

These REITs are registered with the SEC but aren’t traded. They have more stability since they’re not affected by the market’s volatility, but they’re also less liquid, meaning that they can’t be easily converted into cash.

Private REITs

These REITs are neither sold on national security exchanges nor are they registered with the SEC. They’re for private placements sold to a particular people.

How does a company qualify as a REIT?

To be a REIT you have to meet IRS criteria. These stipulations are meant to ensure that the REIT predominantly holds income-generating assets for the long-term and distributes income to shareholders. A REIT must:

  • Invest a minimum of 75% of its total contents in cash, real estate, or U.S. Treasurys.
  • Get a minimum of 75% of its gross income in the form of real property rents, interest on mortgages that support the real property, or from the selling of real estate.
  • Give back at least 90% of its taxable income as dividends to shareholders yearly.
  • After its first year, REITs must have at least 100 shareholders.
  • No greater than 50% of its shares can be held by five or fewer people during the last half of the taxable year.
  • The REIT also has to be taxable as a corporation and have a board of directors or trustees.

Real Estate Investment

What are the Pros of Investing in REITs

The stipulations that make a company a REIT, as well as the nature of real estate as an investment, make real estate investment trusts desirable money-making opportunities.

Guaranteed Dividends

By law, REITs have to pay out 90% of their income as dividends at a minimum. This stipulation is the most compelling reason why people invest in REITs. Additionally, REITs themselves don’t get taxed at the trust level, so the can offer greater returns than stocks since corporations have to pay taxes at the corporate level before calculating the dividend payout.

Hassle-Free Real Estate Investing

REITs are bought and sold on stock exchanges, which makes them an accessible investment as well as highly liquid.

Low Minimums

REITs are an affordable form of investment. A REIT index fund gives you access to real estate investment without requiring significant monetary commitment.

Passive Investment

All the work that the company that manages the REIT does would be very demanding for a single person or even a few people. So, you get to reap all the rewards of investing in real estate without dealing with real estate. This makes REITs as passive a form of investing like mutual funds, which are another form of investment that you buy into that’s managed by professionals.

Low Stock Market Correlation

REITs add diversity to your investment portfolio, making you a more resilient investor. REITs have a low correlation with other forms of investment, so they are particularly good at weathering economic downturns.

Better Performance

Interest rate increases may affect some REITs, but many others outperform other types of investment in spite of high interest rates. And when the economy’s slow, REITs often have a better return on investment than stocks.

Liquidity

Liquidity is a big deal! One shortcoming of investing in real estate directly is that it’s hard to convert your assets into cash and doing so may come at the expense of your profit. High liquidity, however, means that you can both have access to cash quickly and you can also make up for missteps by unloading your investment.

Mandatory Distribution to Investors

Since REITs are primarily made up of real estate holding they get favorable tax treatment. The cost of these benefits is that the REIT is required by law to payout at least 90% of its profits to shareholders. Again, this makes REITs a highly desirable investment.

What are the Cons of Investing in REITs

The downsides of investing in REITs are either the result of market forces or a direct result of the stipulations that also make an REIT so appealing. It’s important to have both perspectives in order to make the best investment decision you can, and so that you know the markers of a good vs bad REIT to invest in.

Declining Value Properties

Real estate doesn’t always go up in value. The housing crisis that began in 2007 is a great example of that. So, when deciding where to put your investment dollars, make sure to check out other assets as well as the particulars of the REIT you’re considering.

Fees and Markups

REITs are highly liquid but buying and selling them comes at a price. The majority of the fees associated with REITs are charged upfront, and they may run as high as 20 to 30% of the REIT’s value. Additionally, being traded in a public market means that REITs may trade at a cost that exceeds the value of the properties that make up the trust.

Potential Market Correlation

Not all REITs have a low correlation to other investment assets. For those that are correlated higher, their value may actually mimic that of corporate stocks. This may even happen if the value of the properties owned by the REIT don’t change. Keep this in mind when doing research on the REIT to invest in.

Gains Taxed at Ordinary Income Rate

REITs have desirable returns because at least 90% of their profits have to be distributed to shareholders. REITs, however, are taxed at the rate of ordinary income, as opposed to the 15% that corporate stock dividends get taxed at. To get around this, it’s wise to invest in REITs using accounts like IRAs and 401(K)s because they’re tax-deferred.

Inherent Potential Limited Growth

While getting a minimum of 90% of the REITs income in the form of dividends is very appealing, it also imposes a cap on growth since so little capital is left for purchasing or improving properties. But some REITs are able to get around this stipulation using debt.

What are the tax implications of REIT investing?

For those who own shares of REITs, profits are taxed as ordinary income at the shareholder’s top marginal tax rate. The exception is for REITs that payout qualified dividends, which are dividends that you pay capital gains taxes on.

A percentage of the income made from REITs may also qualify for a nontaxable return of capital, which lowers the shareholder’s taxable income in the year that the dividend is received while also deferring taxes on that portion until it’s sold.

Real Estate Investment

What is a real-world example of a REIT?

Before investing in a REIT, make sure to investigate how the real estate market is doing. If a particular arena is excelling, you can likely find a REIT that geared toward that sector. Health care, for example, is one of the fastest-growing fields in the U.S., so there’s a lot of demand for health centers, outpatient care buildings, retirement homes, and eldercare communities.

One REIT that focuses on the medical field is HCP Inc. (HCP). Its market value is $15 billion. It’s big enough of a REIT to trade on the S&P 500, 2,56 million shares are bought and sold every day at $33.99 as of Nov 14th, 2019. It offers a dividend yield of just over 4.25%. Recently, HCP Inc. restructured its assets to focus on life science facilities to meet demand: diagnostic centers, genomics, labs, medical office buildings, and senior housing.

How do I invest in REITs?

All you have to do is set up an account with a brokerage firm and you can buy REITs yourself. You can also invest in REITs using dedicated mutual funds; closed-end funds, which are mutual funds that allow a limited number of shares that can only be purchased from someone else selling the shares; and exchange-traded funds (ETFs), which are funds that invests in multiple types of assets and is bought and sold on an exchange just like stocks are.

Bottom Line

REITs are a great way to get the benefits of investing in real estate without doing the work of managing real estate.

Because of the stipulations, a company must meet in order to be a REIT, you can expect a consistent return. And since the real estate market has a low correlation to other assets, you end up with a resilient investment that can add diversity to a larger stock portfolio.

Do some research to see if now’s a particularly good time to invest in REITs in a particular sector or if there’s a particularly successful REIT that may, despite the fees and a tax rate that’s greater than stocks, will still provide you with a solid return on investment.

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