A Real Estate Investment Trust (REIT) is a company that owns, operates or finances income-generating real estate.
Sharing a similar model to mutual funds, an REIT pools the capital of numerous investors, this makes it possible for individual investors to earn dividends from real estate investments without having to finance or manage any properties on their own.
REITs have the potential to generate a good income for investors in the pool but offer very little in the way of capital appreciation. Publicly traded like stocks, REITs are highly liquid unlike physical real estate investments. Typical REIT investments include apartment complexes, hotels, data centers and retail centers.
How a REIT works
REITs allowed investors to buy shares in commercial real estate portfolios, something which was previously reserved for only wealthy individuals and through large financial intermediaries.
Hotels, healthcare facilities, energy pipelines, and warehouses are common property types that are often included in a REIT. Typically a REIT will specialize in a specific sector but some are more diversified and may hold both retail and office properties for example.
REITs were established by congress in the US in 1960. Their inception of REITs was as an amendment to the Cigar Excise Tax Extension.
The business model for REITs is usually straightforward, the REIT leases space and collects rent on the properties. The income is then distributed as dividends to shareholders. To qualify as a REIT, a company has to meet specific criteria set in the Internal Revenue Code (IRC), these include:
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 REIT
REITs can be ordered into three different types:
Equity REITs
The most common type of REIT, these are those who own and manage income-producing real estate. Revenue comes from rents and not by reselling properties.
Mortgage REITs
These lend money to real estate owners and operators either through mortgages and loans or by the acquisition of mortgage-backed securities. Earnings are generated by the net interest margin (the spread between the interest they earn on mortgage loans and the cost of funding these loans) Mortgage REITs are sensitive to interest rate increases.
Hybrid REITs
This type of REIT uses the investment strategies of equity and mortgage REITs, meaning they both own properties and hold mortgages.
The ways in which a REIT’s shares are bought and held can also be classified as either a publicly traded REIT, one that is listed on a nation securities exchange, is bought and sold by individual investors and is regulated by the U.S. Securities and Exchange Commission (SEC).
Or as a public non-traded REIT. Public non-traded REITs are registered with the SEC but are not traded on national securities exchanges. They are less liquid that publicly traded REITs but tend to be more stable as they are not sensitive to market fluctuations.
The final classification is private REITs, this type of REIT isn’t registered with the SEC and nor is it traded on national securities exchanges. Typically, private REITs can only be sold to institutional investors.
Advantages of a REIT
There are many advantages of a REIT, including:
High liquidity
REITs generally offer high liquidity, meaning they are easily converted into ready cash without affecting the market price. For this reason they are a popular choice with investors.
Stable cash flow
REITs often play an important role in an investment portfolio because they can provide strong annual dividends and stable cash flow. REITs can be a good way for investors to diversify their portfolio and provide attractive risk-adjusted returns.
Disadvantages of a REIT
The disadvantages of a REIT include:
Low capital appreciation
As part of their structure a REIT must pay 90% of its income back to investors in the form of dividends, meaning that only 10% of taxable income can be reinvested back into the REIT to buy new holdings.
Can have high costs
Dividends from REITs are taxed as regular income which can be costly for some investors. They are also often accompanied by high management and transaction fees, which may make them less profitable.