What Is A Real Estate Investment Trust?
A real estate investment trust (REIT) is a company that owns, operates, finances income-generating real estate. These investment trusts have been modeled after mutual funds. A real estate investment trust gather the capital from numerous investors to enable purchases of stock of larger properties to generate dividends to pay to the individual investors.
How Do REITs Work?
Real estate investment trusts were first established in 1960 as an amendment to the “Cigar Excise Tax Extension”. This amendment allows investors to purchase shares in commercial real estate portfolios. Which previously was only an option for very wealthy individuals and through large financial intermediaries.
Properties in a REIT portfolio can include properties like apartments, data centers, healthcare facilities, infrastructure like cell phone towers and energy pipelines, office spaces, or warehouses. There are different types of REITs who may specialize in other types of real estate. However, most REITs operate within a specific sector of real estate.
Real estate investment trusts are usually traded on major security exchanges where investors can purchase or sell them like stocks. REITs are typically considered a very liquid instrument as they are usually traded in substantial volume.
Qualifications For REITs:
Most REITs operate under a fairly straightforward business model–to lease space and then collect rent on the properties. This income from the rent is then distributed to investors as dividends to the shareholders. To qualify as a REIT, the company must comply with provisions stated within the Internal Revenue Code (IRC) which include to primarily own income-generating real estate for the long-term and to distribute income among the shareholders. However, there are more specific requisites a company must meet to be considered a REIT:
The company must invest at least 75% of assets into real estate, cash, or U.S. Treasuries
Derive at least 75% of gross income from rents, interest on mortgage that finance on properties, or real estate sales
Pay at least 90% of taxable income in the form of shareholder dividends each year
Be an entity that is taxable as a corporation
Be managed by a board of directors or trustees
Have at least a 100 shareholders by the end of its first year of operation
Have no more than 50% of its shares held by five or fewer individuals
The Different Types of REITs:
There are three main types of REITs:
Equity: This is the most common type of REIT. These type of REITs own and operate income-generating real estate. The income for equity REITs are typically earned through rent rather than the reselling of properties.
Mortgage: This type of REIT lends money to real estate owners and operators through two means– either through direct loans or indirectly through the acquiring of mortgage-backed securities. This type of REIT makes its money by the net-interest margin. This income method leaves these types of REITs susceptible to interest rate changes.
Hybrid: As the name may imply, this type of REIT uses both equity and mortgage REIT methods of generating income.
However, the different types of real estate investment trusts can be further classified by how the shares are purchased and held:
Publicly Traded: Shares of these REITs are listed on a national securities exchange where they can be purchased and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
Public Non-Traded: These REITs are also registered with the SEC but are not traded on the national securities exchange. Its because they are not traded on the national securities exchange that non-traded REITs are considered less liquid than publicly traded REITs but in exchange are considered to be more stable since they are not subject to market changes
Private: This type isn’t registered with the SEC and is not traded on the national securities exchange. Typically, private REITs can only be sold to institutional investors.
Pros & Cons Of REITs:
Real estate investment trusts can play a vital role in your investment portfolio due to the strong and stable annual dividends as well as the possibility for long-term capital appreciation. This can be seen as REITs’ total return performance over the last twenty years has outperformed the S&P 500 Index, other indices, and the rate of inflation. Additionally, REITs are easy to buy and sell considering most trade on public exchanges. This feature mitigates the normal risk that real estate investment provides.
On the downside, REITs do not offer the most in the case of capital appreciation. This down side exhibits itself because of a part of their general structure. Since REITs have to pay 90% of income back to investors, it only leaves 10% of the taxable income to reinvest to buy new holdings.
As with any investment, there are up and down sides and REITs are no different:
Pros:
Liquidity
Diversification
Stable Cash Flow
Risk-adjusted returns
Cons:
Low growth
Dividends are taxed as regular income
Subject to market risk
Potential for high management and transaction fees