Real Estate Investment Trusts or REITs are entities owned for finance income-generating real estate in various property sectors. To qualify as REITs, these real estate companies must meet a number of criteria. Investing in REITs has many benefits for investors, including trading on major stock exchanges.
Real estate investment trusts allow investors to invest in real estate in the same way they invest in other types of funds – by buying individual shares of companies or by investing through mutual funds or exchange-traded funds (ETF). A REIT’s stockholders receive a portion of the income generated – without having to buy, manage, or finance real estate. Approximately 145 million Americans have REIT investments in their 401(k), IRAs, pension plans, and other investment funds.
REITs- Highlights
- Real estate investment trusts (REITs) own, operate, or fund revenue-generating assets.
- REITs provide investors with a consistent income stream but little in the way of capital appreciation.
- The majority of REITs are traded on the stock exchange, making them extremely liquid (unlike physical real estate investments).
- Apartment complexes, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses are among the forms of real estate that REITs invest in.
REITs and How They Work
Congress created REITs in 1960 as part of the Cigar Excise Tax Extension. The provision permits investors to purchase shares in commercial real estate portfolios, which were previously exclusively available to the wealthy and through huge financial intermediaries.
Apartment complexes, data centers, healthcare facilities, hotels, infrastructure (fiber cables, cell towers, and energy pipelines), office buildings, retail centers, self-storage, timberland, and warehouses are examples of properties in a REIT portfolio.
Typically, REITs specialize in a specific sector of the real estate market. Diversified and specialty REITs, on the other hand, may have a portfolio of several sorts of assets, such as a REIT that owns both office and retail facilities. Investors can buy and sell REITs at any time during trading hours since many of them are traded on major stock exchanges. These REITs are often traded in large volumes and are considered liquid assets.
What Constitutes a REIT?
Most REITs have a simple business model: they lease properties and collect rent, then pay dividends to their shareholders. Unlike real estate REITs, mortgage REITs finance real estate, and the interest on their investments generates income for these REITs.
A company must follow specific provisions of the Internal Revenue Code to qualify as a REIT (IRC). These requirements include the long-term ownership of the income-generating real estate and income distribution to shareholders. These REITs are typically traded in large volumes and are considered very liquid instruments.
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasury bonds.
- Rents, interest on mortgages used to finance real estate, or real estate sales must account for at least 75% of gross income.
- Each year, pay a minimum of 90% of taxable income in shareholder dividends.
- Be a taxable entity such as a corporation.
- Be overseen by a board of directors or trustees.
- After its first year, it should have at least 100 shareholders.
- Have no more than five people owning more than half of the company’s stock.
REIT Different types
REITs are classified into three types:
REITs that own equities
The vast majority of REITs are equity REITs that own and manage income-producing real estate. The primary source of revenue is rent (not by reselling properties).
Mortgage REITs
Mortgage REITs lend money to property owners and operators directly through mortgages and loans or indirectly through purchasing mortgage-backed securities. Their earnings are primarily driven by the net interest margin, the difference between the interest they earn on mortgage loans and the cost of funding these loans. Because of this model, they are potentially sensitive to interest rate increases.
Hybrid REITs
These REITs employ both equity and mortgage REIT investment strategies.
- REITs that are publicly traded. Private investors can buy and sell REIT shares on a national securities market, where shares of publicly-traded REITs are traded. The Securities and Exchange Commission (SEC) of the United States regulates them.
- A non-traded REIT is one that is not listed on a stock exchange. Although they are not traded on national stock exchanges, these REITs are registered with the Securities and Exchange Commission (SEC). This makes them less liquid than REITs that are publicly traded. However, they are much more stable and are not affected by movements in the market.
- An individual owns a REIT
- There is no SEC registration for these REITs and they do not trade on national securities exchanges. Private REITs can often only be sold to institutional investors.
REITs: Types and How to Invest in Them
- Retail real estate investment trusts (REITs)
Shopping malls and freestanding retail account for about 24% of REIT investments. Any shopping center you visit is almost certainly owned by a REIT. One must first evaluate the retail industry before pursuing a retail real estate venture. Is it currently financially stable, and what are the long-term prospects?
It’s crucial to keep in mind that retail REITs make money by charging tenants rent. In case of low sales, businesses experiencing cash flow problems may become bankrupt if they do not make their monthly payments on time. A new tenant must be located at that moment, which is seldom simple. As a result, it’s critical that you invest in REITs that have the best anchor tenants. Grocery and home improvement stores are among them.
Focus on the REITs after assessing the industry. In order to make a successful investment, the company must have solid earnings and as little debt as possible, particularly short-term debt. Retail REITs with substantial cash holdings will be offered opportunities to purchase good real estate at distressed prices in a bad economy. This will be exploited by the most well-run businesses.
However, there are longer-term worries for the retail REIT sector, as shopping is increasingly moving online rather than through malls. Space owners have continued to innovate in order to fill their spaces with offices and other non-retail tenants, although the subsector is under strain.
- Healthcare REITs
Healthcare REITs will be a fascinating subsector to watch as the population ages and health care costs rise. Hospitals, retirement homes, medical centers, nursing homes among the properties that healthcare REITs invest in. This real estate prosperity is inextricably linked to the healthcare system. Occupancy fees, Medicaid payments, Medicare and private funds are used by most owners of these institutions. So long as healthcare funding is uncertain, the future of healthcare REITs remains uncertain.
A diversified collection of consumers are things to look for in a healthcare REIT. Focusing can be beneficial, but spreading your risks can also be beneficial. The healthcare real estate market benefits from an increase in healthcare demand (which should occur as the population ages). In addition to a variety of customers and properties, look for companies with considerable healthcare experience, strong balance sheets, and access to low-cost financing.
- REITs for residential properties
Real estate investment trusts (REITs) own and operate multifamily rental apartment buildings and manufactured homes. When investing in this type of REIT, there are a few things to consider. The finest apartment markets, for example, are those where housing affordability is low in comparison to the rest of the country. In states like Los Angeles or New York, the high cost of single-family residences forces more people to rent, raising landlords’ rents. Since they tend to concentrate in metropolitan areas, the largest REITs tend to invest in residential properties.
A market’s population and job growth should be considered by investors. An economy that is booming and jobs are plentiful typically results in net inflows of residents to a city. Rents are rising and vacancy rates are decreasing, indicating an improvement in the market. If apartment supply remains low in a particular market and demand increases, residential REITs should do well. Those with the most substantial balance sheets and the most available capital typically perform the best with all businesses.
- Office REITs
Investing in office buildings is what office REITs do. They are normally provided with rental income by tenants who have signed long-term leases. Four questions come to mind for anyone considering investing in an office REIT.
- What is the state of the economy, and what is the unemployment rate?
- What are the current vacancy rates?
- What is the state of the economy in the area where the REIT invests?
- What is the REIT’s acquisition budget?
- Look for REITs that invest in economic hotspots. Owning a few ordinary buildings in Washington, D.C. is preferable to owning good office space in Detroit, for example.
- REITs that hold mortgages
Mortgages account for approximately 10% of REIT investments, as opposed to the real estate itself.
It doesn’t mean that a REIT is risk-free just because it invests in mortgages rather than stocks. Stock prices of mortgage REITs would drop if interest rates increased. In addition to equity offerings, mortgage REITs raise a significant amount of capital with debt offerings. Future funding will be more expensive as interest rates rise, lowering the value of a loan portfolio. Most mortgage REITs trade at a discount to net asset value per share in a low-interest-rate environment with the possibility of increasing rates. Finding the correct one is the difficult part.
How Do Real Estate Investment Trusts (REITs) Make Money?
The basic business model of most REITs is straightforward: income is generated by leasing space and collecting rent on its properties, and dividends are distributed to shareholders. The majority of REITs must distribute 100% of their taxable income to shareholders. Dividends are taxed by shareholders.
mREITs (or mortgage REITs) do not own real estate; instead, they finance it and profit from the interest on their assets.
Why should you invest in REITs?
REITs have long noted total competitive returns through high, consistent dividend income and long-term capital appreciation. Because of their low correlation with other assets, they are an excellent portfolio diversifier that can help reduce overall portfolio risk while increasing returns.
Investing in Real Estate Investment Trusts(REITs)
People can invest in REITs through a variety of methods, including publicly listed REIT equities, mutual funds, and exchange-traded funds. REITs are also becoming more popular in defined contribution and defined benefit pension plans.
Individuals can purchase REIT shares, which are traded on major stock exchanges, in the same way, they would any other public stock. Shares in a REIT mutual fund or exchange-traded fund are also available to investors (ETF). In fact, REITs are used by nearly 145 million Americans, with many of them investing through mutual funds and ETFs in their 401(k)s, IRAs, the Thrift Savings Plan (TSP), and pension plans.
A broker, investment advisor, or financial planner can assist an investor in analyzing their financial goals and making appropriate REIT recommendations. Eighty-three percent of financial advisors promote REITs to their customers, according to a 2020 Chatham Partners report. Investors can also invest in public REITs that aren’t listed on a stock exchange and private REITs.
How is the value of real estate investment trust (REIT) shares typically determined?
- The expected increase in earnings per share; Expected total return from the stock, based on the expected price change and the current dividend yield;
- Current dividend yields in comparison to other yield-oriented investments (for example, bonds, utility stocks, and other high-income investments);
- Dividend payout ratios as a percentage of REIT FFO
- Quality of management and corporate structure; and
- The underlying asset values of real estate and/or mortgages, as well as other assets.
Is it necessary for REITs to pay dividends?
How do REITs assess their earnings and dividend-paying ability?
What are the most common elements that generate REIT earnings growth?
Advantages and Disadvantages of Investing in REITs
REITs can be an important part of an investment portfolio because they provide a strong, consistent annual dividend as well as the possibility of long-term capital appreciation. Over the last 20 years, REIT’s total return performance has outperformed the S&P 500 Index, other indices, and the rate of inflation. REITs, like any other investment, have some pros and cons.
On the plus side, because most REITs trade on public exchanges, they are simple to buy and sell—a feature that mitigates some of the traditional drawbacks of real estate. REITs provide attractive risk-adjusted returns and consistent cash flow. Furthermore, a real estate presence can be beneficial to a portfolio because it provides diversification and dividend-based income—and the dividends are frequently higher than those available from other investments.
On the negative side, REITs do not provide much in terms of capital appreciation. As part of their structure, they are required to return 90 percent of their income to investors. As a result, only 10% of taxable income can be reinvested back into the REIT to purchase new holdings.
Pros
- Liquidity
- Diversification
- Transparency
- Dividends provide consistent cash flow.
- Risk-adjusted returns are appealing.
Cons
- Slow growth
- Dividends are taxed in the same way as ordinary income.
- Market risk exists.
- High management and transaction fees are possible.
- REIT Scam
Fraudulent REITs
Investors are advised to be aware of anyone attempting to offer REITs that aren’t registered with the Securities and Exchange Commission (SEC). It suggests that “The SEC’s EDGAR system can be used to check the registration of both publicly listed and non-traded REITs. You can also use EDGAR to look over a REIT’s annual and quarterly reports, as well as any prospectus that may be available.”
Check out the broker or investment advisor that recommended the REIT. You can use the SEC’s free search tool to see if an investment professional is licensed and registered.
Dangers of Non-Traded REITs
Investors in non-traded REITs, also known as non-exchange traded REITs, face unique risks because they are not traded on a stock exchange.
Shareholder Value
Because non-traded REITs are not publicly traded, investors are unable to conduct research on them. As a result, determining the REIT’s value is challenging. Even though some non-traded REITs will publish all assets and value after 18 months, this isn’t reassuring.
Liquidity Issues
Non-traded REITs are also illiquid, which implies that when an investor wishes to trade, there may not be any buyers or sellers in the market. Non-traded REITs, in many situations, cannot be sold for at least seven years.
Distributions
Non-traded REITs must pool funds to purchase and operate properties, securing investor funds. This pooled money, however, may have a darker side. The darker side is when a property pays out dividends from other investors’ money rather than profits earned by the property. This approach reduces the REIT’s cash flow and lowers the value of its stock.
Fees
Upfront fees are another disadvantage of non-traded REITs. The majority demand an advance fee of between 9% and 10%, with others charging as much as 15%. There are instances where non-traded REITs have exceptional management and properties, resulting in stellar profits, but this is also true with publicly-traded REITs.
External manager fees are also possible in non-traded REITs. External management is paid by a non-traded REIT, which reduces investor returns. If you decide to invest in a non-traded REIT, make sure you ask all of the pertinent questions about the dangers listed above. The more openness there is, the better.
Risks of Publicly Traded REITs.
REITs that are publicly traded provide investors with an opportunity to add real estate to their portfolio while also earning a healthy dividend. Although publicly-traded REITs are safer than non-exchange REITs, there are always hazards.
Risk of Interest Rates
The largest threat to REITs is a rise in interest rates, which diminishes REIT demand. In a rising-rate environment, investors tend to gravitate toward safer income investments like U.S. Treasuries. Treasury bonds are government-backed and pay a set rate of interest. As a result, when interest rates rise, REITs fall off, while the bond market rallies as money pour into bonds.
Selecting the Wrong REIT
The other major danger is picking the wrong REIT, which may seem obvious, but it’s all about logic. Suburban malls, for example, have been on the decline. As a result, investors may be hesitant to participate in a REIT with a suburban mall exposure. Urban shopping centers may be a superior play for Millennials who prefer city living for convenience and cost savings.
Because trends vary, it’s critical to investigate the REIT’s properties or holdings to ensure that they’re still relevant and capable of generating rental income.
How does a business become a REIT?
A corporation must meet the following criteria to be classified as a REIT:- At least 75% of its total assets should be invested in real estate.
- Rents from real estate, interest on mortgages financing real estate, or sales of real estate must account for at least 75% of gross income.
- Each year, pay at least 90% of its taxable profits to shareholders in the form of dividends.
- As a corporation, you must be a taxable entity.
- A board of directors or trustees will oversee the operation.
- A minimum of 100 shareholders is required.
- Have no more than five people owning more than 50% of the company’s stock.
What is a Paper Clip Real Estate Investment Trust (REIT)?
A “paper clip REIT” maximizes a REIT’s tax benefits while also allowing it to operate properties that other trusts are unable to. The paper clip REIT has a tight fiduciary duty to stakeholders, which can lead to conflicts of interest. As a result, this type of REIT is uncommon, and when it does exist, it is subject to intense regulatory scrutiny. Its structure is comparable to that of a “stapled REIT,” but it is more flexible.