Real estate as an asset class has been admired by investors for many years due to the benefits it brings to your financial plan. However, dealing with traditional, physical real estate is more challenging than simply owning stocks – and acquiring the capital to purchase entire properties is difficult for small-time investors. That’s where real estate investment trusts (REITs) come into play.
Real estate investment trusts allow investors to own real estate without purchasing it, per se. This in turn keeps their investment much more liquid than owning property. This helps investors small and large reap many of the benefits of real estate investment, such as:
- Passive income
- Hedging against inflation
- Portfolio diversification
- Acquiring leverage
- Tax benefits
This quick guide will cover the basics of REITs. We will address topics such as what an REIT is, how it’s sold, and basic classifications.
So, What is an REIT?
A real estate investment trust is a company that owns and operates income-producing real estate and properties. There are difference classifications of REITs from which you can choose as an investor. Some REITs specialize in specific types of properties, such as:
- Commercial properties
- Industrial complexes
- Healthcare facilities
In most cases, you can own shares of a REIT, just like you can own shares of a publicly traded company. Because the majority of REITs are publicly traded on exchanges, they are much more liquid than traditional real estate, which can take longer to sell.
As a shareholder of an REIT, you can participate in the appreciation in value of the property owned by the REIT. Just as shares of stock become more valuable as a company increases in value, so, too, do shares of REITs.
What people tend to know REITs for, however, is the income that they can provide their shareholders.
To qualify as a real estate investment trust under the Internal Revenue Code, an REIT must pay out at least 90% of its taxable income to its shareholders. This is especially attractive for income-oriented investors.
There are other regulations that REITs must follow to remain compliant with the tax code. You can find all of these on IRS.gov.
Another bonus of real estate investment trusts is the fact that professionals manage them for you. Just like you don’t have to physically run the day to day operations of a firm whose stock you hold, you don’t have to make any management decisions as an REIT shareholder. This is a plus for investors who don’t want to deal with tenants or the many major operational decisions involved with traditional real estate.
Public vs. Private
An REIT that is public can be purchased an owned by the general population. These types of REITs must file with the Securities and Exchange Commission (SEC), the organization responsible for regulating the industry. Public REITs can be either traded or non-traded.
If an REIT is traded, that means that the fund is listed on an exchange, like the NYSE. Therefore, shares of the REIT can be traded freely. Publicly traded REITs are marked to market. This means that their share values update frequently. These REITs must also meet the requirements of the exchange they are on in order to remain listed.
Public non-traded REITs are also regulated by the SEC. However, they aren’t listed on an exchange, which means they are more illiquid than publicly traded REITs. Non-traded REITs are not marked to market, which means their share values update less frequently.
By contrast, a private REIT does not have to register with the Securities and Exchange Commission. This means that they have much less regulation when it comes to things like reporting requirements. On the whole, only sophisticated investors tend be to offered private REITs, as they are typically available via private placement – thus the name.
Fundamentally, there are three classes of REITs:
- Equity REITs
- Mortgage REITs
- Hybrid REITs
Each class of REIT has its own pros and cons, which we’ll cover next.
Equity REITs are what most people tend to think about when it comes to real estate investment trusts. They purchase, manage, and hold cash flow-producing properties.
As discussed previously, real estate investment trusts can specialize in specific types of properties, just like certain fund managers specialize in specific types of investments. Prior to purchasing shares of an equity REIT, it’s wide to research what types of properties the company manages. You’ll also want to look into the risks associated with owning such properties.
As an equity REIT shareholder, you can participate in the cash flow generated by the underlying properties, typically rental income. You can also participate in the potential appreciation in value of the company’s real estate portfolio.
Unlike equity REITs and owning physical properties, mortgage REITs deal with the mortgages on those properties. There are two ways a mortgage REIT can do this:
- Directly lending the funds to build and operate properties
- Investing in Mortgage Backed Securities (MBS)
These companies make their money off of the interest associated with the mortgages they handle. If the REIT does not lend the money directly, it profits off of the spread between the interest on the loan to the borrower and the interest on the original loan. The term for this is the net interest margin.
Hybrid real estate investment trusts are a combination of both equity and mortgage REITs. Prior to purchasing shares of a hybrid REIT, make sure you research what the primary line of business of the REIT is.
For example, does it primarily deal with holding property or lending funds for mortgages? Does the business prefer an equal split of holding and lending? Just like you want to know what an ETF or mutual fund owns, you need to know what an REIT holds – and how it makes its money.
Real estate investment trusts offer many of the same benefits as a traditional real estate investment, namely:
- Portfolio income
- Portfolio diversification
- Participation in the growth of the real estate market
- Hedging against inflation
However, it’s important to note that you aren’t comparing apples to apples. In other words, you can’t look at REITs and physical real estate in the same light, because they aren’t the same thing.
While REITs are more liquid as a rule, publicly traded REITs don’t offer some of the benefits of traditional real estate. Chief among these are the tax benefits that follow property depreciation and the ability to leverage your property against purchasing more property.
It’s also important account for costs such as management fees when researching an REIT. High fees can silently eat away at your portfolio’s long-term gains.
Also, consider the track record of the REIT’s manager. What type of properties have they owned previously? What do they own currently? How have they performed throughout various market cycles? How did they bounce back after the coronavirus pandemic? In fact, a lot of the due diligence you owe to other investment research such as mutual funds applies to REITs as well.
The 90% Rule
One of the major critiques of REITs is how difficult it is to scale operations. This is due to the high minimum payout required. Remember, REITs must pay at least 90% of their income to their shareholders to remain compliant with the tax code.
Imagine a stock with a 90% dividend payout ratio. The company offering the stock would have little capital remaining to reinvest in their projects, which would make upscaling operations difficult.
In the same vein, the 90% minimum payout for REITs can be a hindrance. While it’s possible to mix in some leverage to increase the trust’s ability to upscale, this is a potentially risky maneuver.
Real Estate Investment Trusts: Recap
While REITs are not the same as traditional real estate holdings, they can still provide many of the same benefits of the asset class in a much more liquid fashion. Publicly traded REITs can even fit nicely in your IRA or brokerage account.
Nareit is a fantastic resource for North American REITs. Their site has plenty of information on different types of REITs and can help you find the next REIT addition to your portfolio.
As always, carefully consider your portfolio and investment needs prior to purchasing a real estate investment trust. Do your research to understand what’s going on under the hood of companies of interest. You always want to be attune to the risks and upsides offered by any type of asset you add to your portfolio.
Leverage the great free tools available to you as a modern investor. Do as much digging as you need before making the leap. Also, keep in mind that REITs will be subject to fluctuations in the general real estate market and economic conditions as a whole. If you need to study up on either of those subjects first, we highly recommend you do so. It’s what a true Financial Professional would do.
Have questions on REITs? Let us know!