Real Estate Investment Trust (REIT)

Real Estate Investment Trust (REIT): How They Work and How to Invest

What Is a Real Estate Investment Trust (REIT)? 

A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate.

Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.

KEY TAKEAWAYS

• A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties.
• REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
• Most REITs are publicly traded like stocks, which makes them highly liquid (unlike physical real estate investments).
• REITs invest in most real estate property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.

• How REITs Work 

  Congress established REITs in 1960 as an amendment to the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios—something that was previously available only to wealthy individuals and through large financial intermediaries.1

  Properties in a REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.

  In general, REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties. 

  Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks throughout the trading session.2 These REITs typically trade under substantial volume and are considered very liquid instruments. 

  How REITs Work 

  Congress established REITs in 1960 as an amendment to the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios—something that was previously available only to wealthy individuals and through large financial intermediaries.1

  Properties in a REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.

  In general, REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties. 

  Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks throughout the trading session.2 These REITs typically trade under substantial volume and are considered very liquid instruments. 

• What Qualifies as a REIT? 

  Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders. Mortgage REITs don't own real estate, but finance real estate, instead. These REITs earn income from the interest on their investments.

  To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (IRC). These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders.3 Specifically, a company must meet the following requirements to qualify as a REIT:

  • Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
  • Derive at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
  • Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
  • Be an entity that's taxable as a corporation
  • Be managed by a board of directors or trustees
  • Have at least 100 shareholders after its first year of existence 
  • Have no more than 50% of its shares held by five or fewer individuals

• Types of REITs 

  There are three types of REITs:

  • Equity REITs. Most REITs are equity REITs, which own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties).
  • Mortgage REITs. Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
  • Hybrid REITs. These REITs use the investment strategies of both equity and mortgage REITs. 

REITs can be further classified based on how their shares are bought and held:

• Publicly Traded REITs. Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).5
• Public Non-Traded REITs. These REITs are also registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs.5 Still, they tend to be more stable because they’re not subject to market fluctuations.
• Private REITs. These REITs aren’t registered with the SEC and don’t trade on national securities exchanges. In general, private REITs can be sold only to institutional investors.

Pros and Cons of Investing in REITs 

REITs can play an important part in an investment portfolio because they can offer a strong, stable annual dividend and the potential for long-term capital appreciation. REIT total return performance for the last 20 years has outperformed the S&P 500 Index, other indices, and the rate of inflation.6As with all investments, REITs have their advantages and disadvantages.

On the plus side, REITs are easy to buy and sell, as most trade on public exchanges—a feature that mitigates some of the traditional drawbacks of real estate. Performance-wise, REITs offer attractive risk-adjusted returns and stable cash flow. Also, a real estate presence can be good for a portfolio because it provides diversification and dividend-based income—and the dividends are often higher than you can achieve with other investments.

As a bonus, the Tax Cuts and Jobs Act of 2017 allows taxpayers to take advantage of the qualified business income (QBI) deduction. The deduction is the QBI plus 20% of qualified REIT dividends or 20% of the taxable income minus net capital gains, whichever is less.7

On the downside, REITs don't offer much in terms of capital appreciation. As part of their structure, they must pay 90% of income back to investors.1 So, only 10% of taxable income can be reinvested back into the REIT to buy new holdings. Other negatives are that REIT dividends are taxed as regular income, and some REITs have high management and transaction fees.

Pros

• Liquidity

• Diversification

• Transparency

• Stable cash flow through dividends

• Attractive risk-adjusted returns

Cons

• Low growth

• Dividends are taxed as regular income

• Subject to market risk

• Potential for high management and transaction fees

REIT Fraud 

The Securities and Exchange Commission (SEC) recommends that investors should be wary of anyone who tries to sell REITs that aren't registered with the SEC. It advises that "You can verify the registration of both publicly traded and non-traded REITs through the SEC's EDGAR system. You can also use EDGAR to review a REIT's annual and quarterly reports as well as any offering prospectus."

It's also a good idea to check out the broker or investment advisor who recommends the REIT. The SEC has a free search tool that allows you to look up if an investment professional is licensed and registered.8

Real-World Example of a REIT 

Another consideration when choosing REITs is to look at the sectors of the real estate market that are hot. Which booming sectors of the economy, in general, can be tapped into via real estate? As an example, healthcare is one of the fastest-growing industries in the U.S.9—especially in the growth of medical buildings, outpatient care centers, eldercare facilities, and retirement communities.

Several REITs focus on this sector. Healthpeak Properties (PEAK)—formerly HCP— is one example. As of April 2022, it had a market cap of nearly US $18.9 billion, with some 4 million shares traded daily.10 Its portfolio focuses on three core asset classes: life sciences facilities, medical offices, and senior housing, owning interests in more than 615 properties.1112

What Does REIT Stand for?

REIT stands for "Real Estate Investment Trust". A REIT is organized as a partnership, corporation, trust, or association that invests directly in real estate through the purchase of properties or by buying up mortgages. REITs issue shares that trade stock exchange and are bought and sold like ordinary stocks. In order to be considered a REIT, the company must invest at least 75% of its assets in real estate and derive at least 75% of its revenues from real estate-related activities.13

Do REITs Have to Pay Dividends?

By law and IRS regulation, REITs must pay out 90% or more of their taxable profits (to shareholders in the form of dividends. As a result, REIT companies are often exempt from most corporate income tax. Shareholders of REITs who receive dividends are taxed as if they are ordinary dividends.

What Is a Paper Clip REIT?

A "paper clip REIT" increases the tax advantages afforded to a REIT while also allowing it to operate properties that such trusts normally cannot run. It is so-named because it involves two different entities that are "clipped" together via an agreement where one entity owns the properties and the other manages them.15 The paper clip REIT entails stricter regulatory oversight since there can be conflicts of interest and, as a result, this form of REIT is uncommon. It is similar but more flexible in structure to a "stapled REIT".

Source : investopedia