For most people, the idea of investing in real estate holdings directly is out of reach, belonging only to those with the means to pay massive sums of money in order to purchase properties and development projects. This was indeed the case until 1960, when the U.S. created a law that made it possible for every investor to place monies in diversified real estate portfolios via the purchase of liquid securities. The concept of the REIT (rhymes with “neat“) was born, and over the past six decades this investment vehicle has become an important player in the financial landscape.
Read on to learn about the basics of this investment vehicle and whether it can be a good fit for your portfolio.
What is a REIT?
A REIT stands for a real estate investment trust. A REIT is a company that pools investor monies for the purposes of engaging in real estate activity. To qualify as a REIT, the company cannot have just a nominal interest in real estate, but rather the vast majority of the monies under management must be involved in real estate-related activities.
In practice, there are three main types of REITs.
The first consists of REITs that are property owners. These REITs own and operate properties, making their monies by charging their tenants rent. These can be residential, medical buildings, commercial properties, storage facilities or any number of other real estate holdings such as data centers and energy pipelines.
The second type of REIT are those who are involved in mortgages. These mortgage REITs (also known as mREITs) will finance real estate purchases, earning revenues from the interest paid on this debt. There are some REITs that originate and finance purchases directly, while others assume debts from the original issuer.
There is a third, hybrid approach which combines elements from both the property owning and mortgage-based models. By investing in both properties and mortgages, this REIT further diversifies its risks by investing in different types of assets.
How Do REITs Operate?
At their essence, REITs work by pooling monies from multiple sources in order to make larger investments. The fund will be divided up into numerous shares that individual investors can purchase.
Most REITs are publicly traded, and accessible for individual investors who have a brokerage account. However, some REITs are not publicly traded, and can only be bought and sold by institutional investors through a broker with access to the particular REIT.
All publicly-traded REITs must be registered with the U.S. Securities and Exchange Commission, even if they do not trade on stock exchanges. Privately-traded REITs are exempt from registering with the SEC.
There is a fairly large distinction between REITs that trade on stock exchanges and ones that do not. Whereas the valuation of REITs that are traded on stock exchanges is readily available, non-traded REITs may not have their valuations known for months, if not years. The liquidity of these two types of investments is therefore quite different as well, as REITs that trade on stock exchanges can be quickly bought and sold whereas there is no guarantee that non-traded REITs can be readily sold on the open market.
You can use TipRanks’ tools and data sets to review the historical performance and attributes of a number of REITs that are publicly traded on stock markets.
How Do REITs Differ From Other Pooled Investments?
REITs share many of the same qualities as other pooled investments such as Exchange Traded Funds (ETFs) and Mutual Funds. In fact, there are a number of Mutual Funds and ETFs that qualify as REITs due to their focus on the real estate sector.
However, there are a number of key criteria that these investment vehicles need to meet in order to be considered a REIT.
The first is that the majority of its work must revolve around the real estate sector. 75% of its total assets must be invested in real estate and 75% of its gross income must be generated from real estate activity.
Another requirement: REITs must pass along a minimum of 90% of its taxable income to its shareholders in the form of dividend payments. These dividends do not qualify as qualified dividends, and beneficiaries must pay ordinary income tax on these benefits. This passing along of revenues prevents the REIT from reinvesting these monies, making future growth incremental by nature (see below).
Additionally, there are other administrative requirements that must be met in order to be considered a REIT. REITs must be a taxable corporation, managed by a Board of Directors, have at least 100 shareholders one year after its establishment, and a majority share cannot be held by less than 5 investors.
What are the Pros and Cons of REITs?
There are a number of pros and cons that come along with investing in REITS. It is important to be aware of these features prior to investing.
Advantages
- Accessing new investments: By virtue of their size, real estate investments are outside the scope of what most individuals can afford. REITs allow anyone with a brokerage account to partake;
- Diversifying your holdings: REITs hold multiple assets and/or mortgages, lessening the risk that your portfolio can be sunk by one underperforming investment;
- Dividends: By law, REITs must pass along at least 90% of their taxable income to shareholders as dividends;
- Stable, relatively safe returns: Historically, real estate has shown strong and consistent growth;
- Liquidity (for publicly-listed REITs): Publicly-traded REITs can be easily bought and sold, making this asset highly liquid.
Disadvantages
- Slow growth: Because at least 90% of taxable income must be passed along to shareholders, there is little monies left over to invest in growth opportunities;
- Dividends cannot qualify to be taxed at the capital gains rate: Dividends from REITs do not qualify to be counted as “qualified dividends,” and are instead taxed at the beneficiaries’ marginal tax rate;
- Real estate risks: While there is diversification of the properties and mortgage debt, when the real estate market slows down this could cause a drop-off in returns;
- Actively managed: Many REITs are actively managed, leading to the possibility of higher management fees, which will take a cut out of your revenues.
Conclusion: Making the REIT Investment Decision
REITs can be a valuable option for investors, creating accessible opportunities for all to enjoy the robust real estate market. There are differences between the focus of REITs and their availability for individual investors, though there are a number of key criteria any fund must meet in order to qualify as a REIT.
REITs can offer a relatively safe, stable source of growth for your portfolio, and can serve as a good option for those seeking to invest in real estate but without the means to own, develop, or manage properties themselves.
Prior to acquiring shares of REITs, it is always a wise decision to take the time to research and understand the particulars of the investment vehicle you are considering. TipRanks has a comprehensive set of tools and data available to help you find the right investment for you.
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