What a REIT?
A real estate investment trust, or REIT, is a company that operates, finances, or owns income-producing real estate.
REITs help investors add real estate to their portfolio and benefit from diversification. They are known for their high dividend payouts, which provide consistent cash inflows to investors.
How Does a Real Estate Investment Trust Work?
REITs invest in a variety of real estate properties such as hotels, office buildings, shopping malls, warehouses, apartments, resorts, and more. Some focus on a particular type of real estate only, while others include several types of properties.
Like mutual funds, REITs create a large pool of capital from smaller investors. Generally, revenue is derived from leasing out the properties that it owns and collecting rent. For most real estate investment trusts, rent is the principal source of revenue.
Other REITs do not own properties at all but generate revenue by financing real estate transactions.
REITs are required to pay at least 90 percent of their taxable income to shareholders each year and must invest at least 75 percent of their total assets in real estate. Additionally, by law, they should earn at least 75 percent of their gross income from rents, real estate sales, or interest on mortgages targeted to financing real estate property.
Types of REITs
There are three types of REITs. The distinctions concern the type of business operations the trust uses to generate revenue.
Equity based – These real estate investment trusts own and manage income-producing real estate. Their primary source of revenue is the rent they collect. They are the most common type of REIT.
Mortgage based – These real estate investment trusts make money through interest earned on the financing of real estate properties. They lend money to real estate owners and operators directly through loans, or indirectly through investments made in mortgage-backed securities.
Hybrid REITs – As the name suggests, these real estate investment trusts use the operating strategies of both equity and mortgage REITs.
REITs can be further classified based on how they are traded and regulated:
Publicly traded – Shares of these REITs are listed on national securities exchanges, where they are traded like common stock by individual investors. They are regulated by the US Securities and Exchange Commission (SEC).
Public non-traded – These REITs are also regulated by the SEC, but they are not traded on securities exchanges. They are relatively less liquid than publicly traded REITs.
Private – These are not registered with the SEC and do not trade on securities exchanges—they can only be bought and sold by institutional investors.
How To Invest In Real Estate Investment Trusts
Any individual can invest in publicly traded REITs through brokerages, just like with stocks. Investors can also purchase shares in REIT exchange-traded funds and REIT mutual funds. These financial instruments often have a higher liquidity than the underlying individual real estate investments that make them up, which makes them more attractive to many investors.
Private REITs, out of reach of many individual investors, are limited to institutional investors and investors with high amounts of money at their disposal. Because these investments are not traded on public stock exchanges, investors must buy and sell them through private networks. Their liquidity risk is higher (meaning they are less liquid than other investments) and the minimum investment requirements are also considerably higher.
Investing in publicly traded REITs is generally recommended for individual investors who are interested in exposing their portfolios to the real estate sector. These investments trade on national stock exchanges, don’t have high investment minimums, have good relative liquidity, and are regulated by the SEC.
Benefits Of REIT Investing
One of the biggest advantages of investing in a REIT is the ability to add real estate exposure to a portfolio without making any direct investment in real estate properties.
Small-scale investors can escape the tedious due diligence process associated with actual real estate transactions, as well as the subsequent maintenance needs. It is easy to diversify portfolio risk through REIT investing without worrying about the low liquidity and sizeable capital commitments of direct real estate investing.
REITs have low correlation with traditional assets. Due to the laws that stipulate the percentage of revenues they must pass on to investors, they generally make huge dividend payments. Remember, REITs are required to pay at least 90% of their taxable income to shareholders annually.
This feature makes REITs an attractive alternative investment with the potential to provide revenue inflows during periods of economic downturn.
Limitations Of REIT Investing
One of the biggest drawbacks associated with REIT investing comes in the form of potential tax implications. The dividends derived from REIT investments are generally taxed at high rates compared to stock dividends. This can increase the tax bill associated with these investments that eats into overall investment returns.
The type of real estate property targeted by the trust can also profoundly affect potential returns. For example, a real estate investment trust that derives its revenue from leasing commercial space to retail tenants can be hit hard by outside factors that reduce foot traffic, encourage online shopping, or otherwise make the brick-and-mortar retail business difficult.
Despite these drawbacks, REIT investing—either directly in publicly traded REITs or in aggregated ETFs or mutual funds—is still one of the most popular alternative investment strategies used by investors to optimize their portfolio volatility and diversity. The overall stability of the real estate market, combined with the tremendous boost in liquidity compared to direct real estate investment, is a huge draw for everyday and institutional investors alike.