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What Is a REIT? | All About Real Estate Investment Trusts

reit Oct 21, 2019

Income-generating, commercial real estate investments can boost your net worth significantly.

Unfortunately, commercial real estate investments are out of reach for most individuals.

Luckily, real estate investment trusts (REITs) make venturing into commercial real estate investments possible for all levels of investors.

They enable individuals with even just a small amount of capital to invest in, own, and share the benefits of large-scale real estate holdings.

In this article, you will learn exactly what a REIT is and everything else you’ve wanted to know about real estate investment trusts.

 

What Is a REIT?

A Real Estate Investment Trust (“REIT”) is a corporation that owns, finances, and often operates, income-producing real estate. It’s essentially a securitized portfolio of properties enabling individual investors to own fractional shares of commercial, income-generating real estate and related assets.

Such real estate and assets can include shopping malls, office buildings, hotels, apartment buildings, self-storage facilities, resorts, loans or mortgages, and warehouses.

The portfolios of some REITs also include data centers, apartment complexes, timberland real estate, healthcare facilities, and infrastructure in the form of cell towers, energy pipelines, and fiber cables.

Most REITs concentrate their holdings in one category of property; however, some are diversified across several kinds of real estate.

Unlike many real estate companies, real estate investment trusts do not engage in property development strictly for resale. Instead, REITs purchase and develop properties intending to operate them for the long term in their investment portfolios.

This attractive business model provides REIT shareholders the opportunity to benefit from passive rental income in the form of dividends, long term capital appreciation, total investment returns, all while improving the very communities we live, work, and play in.

 

REIT

 

 

How Do REITs Work?

Real estate investment trusts specialize in managing real estate portfolios and mortgages. These companies generally have simple business models.

For instance, most REITs acquire income producing real estate, lease spaces and collect rents. The collected rents are the company’s income that is distributed to shareholders as dividends.

Mortgage REITS, also known as “mREITS”, profit from interest on mortgages that they hold in their portfolio. Property sales can also create income for the company, which is distributed to shareholders as dividend income.

Here's a quick whiteboard video explaining How Do REITs Work from www.reit.com:

 

 

Anybody can buy shares of publicly traded REITs on major stock exchanges. This enables main street investors to enjoy the benefits of owning real estate without the expense or hassles of managing properties as a landlord.

For a company to be considered a real estate investment trust, it must distribute at least 90 percent of the taxable income to its shareholders annually.

Despite this 90 percent requirement, most real estate investment trusts payout 100% of taxable income. This is likely because REITs are taxed on any retained earnings. To maintain the pass-through entity status, a real estate investment trust deducts dividends from its corporate taxable income.

Pass-through entities are not required to pay corporate state or federal income tax. As long as they stay compliant, the tax burden is “passed through” to shareholders.

This results in higher yields for REIT investors compared to investments in businesses that are taxed at the corporate level. However, real estate investment trusts can’t pass their tax losses to investors.

To qualify as a REIT, a company must comply with the Internal Revenue Code provisions.

For instance, it must operate income-producing real estate with a long-term horizon and distribute 90% or more of its taxable income to shareholders. This means a REIT cannot retain earnings to reinvest back in the business.

Other requirements include:

  • Investing a minimum of 75% of its overall assets in real estate.
  • Generate a minimum of 75% of its total gross income from rents, mortgage interest from financing real property, or real estate sales.
  • Having at least 100 shareholders (after one year of existence)
  • Having less than 50% of shares held by 5 or fewer investors
  • Must be managed by a board of trustees or directors

 

Why Were REITS Created?

REITs were created to allow all investors a chance to invest in diversified, large scale income-generating real estate portfolios, the same way they invest in other types of assets – by way of exchanging readily available securities.

REITs democratized commercial real estate investing, making it accessible and affordable for all investors.

Real estate investment trusts were established by the U.S Congress in 1960. This occurred just after the Cigar Exercise Tax Extension of 1960 was signed into law by President Dwight D. Eisenhower.

Thomas J. Broyhill founded the American Realty Trust, which was the first real estate investment trust.

Since that time, REITs have been established in dozens of countries all over the world. The way people approach real estate investment as a whole has changed due to the rise of these investment vehicles.

Acceptance and awareness of real estate investment trusts, as well as global real estate securities as an investment class, has gained substantial traction over the years.

  

How Have REITs Changed Over Time?

At the time of their inception, real estate investment trusts primarily comprised of mortgage REITs (“mREITs”). It wasn’t until the late 1960s and 70s that the industry expanded significantly.

This growth was primarily catalyzed by an increase in construction projects and use of mREITs in land developments. This led to the Tax Reform Act of 1976 that allowed the establishment of real estate trusts as corporations apart from being business trusts.

In 1986, another Tax Reform Act was signed into law by Ronald Reagan which eliminated many tax deductions and tax shelters, including those that favored REIT investors.

Specifically, the Act included new rules to prevent the use of partnerships by taxpayers to shelter earnings from different sources.

Investors could no longer use pass through losses from real estate partnerships to offset income earned elsewhere. This negatively impacted REIT share values in the following years and reduced mortgage REITs dominance in the 1990s.

Consequently, many real estate investment trusts altered their structure.

The tax reform lead companies to improve operations and management, in the direction of running a professional business versus simply managing a portfolio.

In 1989, there was a real estate downturn which hit a bottom in 1991.

In the following years, Equity REITs became increasingly popular and in 1991 New Plan became the first REIT to achieve $1 billion in equity market capitalization. A series of IPOs followed creating the modern era of REITs as we know it.

Since then, more and types of REITs have come into existence and vary across many types of properties around the globe, with the equity market capitalization of publicly traded REITs surpassing the $1 trillion mark in 2016 for the first time in history.  

types of REITs

Photo Credit

 

Are REITs a Safe Investment?

Real estate investment trusts attract millions of individual investors to buy shares for a variety of reasons.

For instance, shareholders can be sure to receive a minimum of 90% of the REITs’ taxable income as dividend income. That said, it is not a guarantee of receiving any dividend income whatsoever.

Fortunately for REIT investors, dividend yields from real estate investment trusts tend to be higher than those of other investments traded on public stock exchanges.

Individual investors have been able to simply buy shares and access the time, resources, and expertise of these professionally managed corporations to achieve above average rates of return.

They don’t have to invest time and money in purchasing properties and investing in real estate directly, which presents an entirely new set of risks and rewards.

Buying a property directly can lead to major headaches, surprise expenses, and a learning curve that many people aren’t willing to take on.

Investing in REITs is a “hands off” real estate investment so the risks and liability associated with owning and operating property yourself are virtually eliminated.

Provided you do your research and choose a real estate investment trust with a proven track record, exposure to great properties, and solid management, you’ll ideally relax and receive dividends while watching the growth of your investment.

As with any investment you make, it’s particularly important to do your due diligence before you invest in any REIT. Do as legendary investor Warren Buffet does – study the management team carefully, analyze its financial statements, and make sure the REIT owns good properties.

Quick Tip: Look to invest in REITs with a portfolio of desirable properties in locations that have solid fundamentals and a strong economic outlook.

Research the tenants that are leasing the properties and make sure they are in good financial shape. Make sure you understand the potential downsides of investing in real estate trusts.

Bear in mind the fact that though these corporations can generate a consistent stream of dividend income, they are still equities. That means investing in them can be as volatile as investing in stock exchanges.

For instance, from early 2007 through 2008, the real estate market collapse and the financial crisis led to the plummeting of real estate investment trust shares by almost 50%.

In 2011, real estate investment trusts had a value loss of 15% amid concerns that the Europe debt concerns could affect the U.S recovery.

Therefore, if you decide to invest in REITs, don’t rush. Don’t let the appeal of total returns and quarterly dividends sway you.

Instead, take time to identify a company with a good management team with a ton of experience, matched with the right properties aligned with current trends.

You may find it wise to start with publicly traded real estate investment trusts and REIT Exchange Traded Funds (“ETFs”) over public non-listed real estate investment trusts (“PLNRs”), as they are more liquid and easier to understand.

Additionally, pay attention to the debt and credit markets, as well as interest rates, for they impact the share price of REITs.

 

How Do You Make Money on a REIT?

REIT investing can make you money in two primary ways:

  1. dividend income from rents and property sales, and
  2. long-term share value appreciation.

Owning stock in a real estate investment trust means you own a fraction of the company’s real estate portfolio and are entitled a proportionate share of its rental income and profits.

Therefore, if you invest in a REIT, you’ll receive dividends from the company’s earnings. Dividend income is typically paid quarterly, although some REITs pay monthly dividends.

Therefore, REITs can be very attractive for investors seeking consistent, passive income.

Investors can also make money by selling their REIT shares for a profit when the company’s value increases.

 

make money REIT investing

 

The amount of the money you earn from your REIT investments depends largely on the company’s successful management and market conditions.

Experienced real estate investment trust managers know how to run large portfolios and know how maximize shareholder value.

You’re more likely to make money buying a REIT with these four components – the right properties, with the right tenants, with the right management, at the right time.

If the corporation faces problems with the properties it owns and manages, it can’t sell them quickly as a way out. Therefore, before you buy the shares of a real estate investment trust, review its portfolio of mortgaged properties and equity.

You’ll find that some of these corporations come with greater risks than others. Generally, REITs with less debt on their books are considered less risky.

However, some do have more stability.

Shares in real estate companies that invest in mortgage loans are more volatile than shares in corporations that specialize in equity investments. That’s because fluctuations in the interest rates for mortgage loans can affect their performances quickly.

 

Can You Lose Money on a REIT?

Yes, you can lose money on a REIT. REIT investing alleviates some of the hassles and risks of direct real estate investing, however, this does not mean you can’t lose money investing in a real estate investment trust.

If the REIT you invest with loses money, you may receive less or no dividend income.

If you sell your ownership stake when the REIT share price is lower than when you purchased it, you may lose money by selling your shares for a loss.

Therefore, before you invest in a real estate investment trust, understand the market dynamics and check the performance of the corporation before purchasing your shares. Look for REITs with a history of decent dividends and value appreciation.

 

What Are The Average Returns on a REIT?

Real estate investment trusts are regarded as performing better than many other traditional forms of investments.

Returns vary depending on the type of REIT, though it is common to see average yearly returns above 10%.

A major reason why real estate investment trusts have higher returns is diversification. These corporations can invest in properties, property management, mortgages, or combine these options. 

Certain tax advantages, such as “pass through” income, generates higher yields for investors. They also offer dividend reinvestment plans, which compounds your investment returns.

Real estate investment trusts have a reputation for providing investors liquidity, good overall total returns, and diversification.

Individuals can invest in these corporations directly by purchasing shares or access them via REIT Exchange Traded Funds (“ETFs”) or real estate mutual funds with portfolio holdings in the sector.

Here’s a chart comparing the 20-year annualized returns by asset class from 1998-2017 from J.P. Morgan’s Guide to the Markets presentation

REIT real estate 

 

Are REITs Better Than Stocks?

Both real estate investment trusts and stocks can be used as passive investments with long-term, gradual growth. They also can have greatly varying characteristics depending on the companies you choose.

Just like stocks, some real estate investment trusts are high-risk investments seeking ambitious gains. Others are low-risk picks seeking steady, modest returns.

Investors seeking consistent passive income in the form of dividends will be more inclined to buy shares of REITS. Share value appreciation is not the primary motivation for REIT investor.

Stocks pay little to no dividends but may appreciate in value significantly over time.  

When you hear about having a diversified investment portfolio, often it refers to holding both income-producing assets such as REITs, as well as growth-oriented stocks.

Overall, REIT returns are regarded as better than stocks because they are less volatile, produce income, and may appreciate.

Stock investing is a speculative strategy, while real estate investment trusts are seen as more predictable and secure. Many different economic factors can influence stock market prices, which is often independent of the real estate market.

It’s important to note that real estate investment trusts have historically beaten the returns of most asset classes including bonds, stocks, utilities, high yield bonds, growth stocks, and value stocks.

Unlike stocks, real estate investment trusts provide a consistent cash flow throughout the ownership of its shares.

Their dividend yield is generally higher, and investors don’t have to rely on the price appreciation and selling of their shares to see a return.

 

Can a REIT Be Private?

Yes. A private real estate investment trust is a real estate company or a real estate fund that is exempted from the Security and Exchange Commission (“SEC”) registration.

That means it does not trade its shares on the national stock exchanges.

Only institutional investors and accredited investors can buy private real estate investment trusts.

Since these entities are not registered with SEC or traded on the National Stock Exchange, they are not subject to similar disclosure requirements with the public not listed or stock exchange-listed REITs.

Their shares are issued according to the security laws’ exemptions outlined in the regulations enforced and declared by the SEC.

Such exemptions include the rules that permit the issuer to sell their security to accredited investors. They also exempt the securities that are issued to qualified institutional buyers.

 

How Are REITs Taxed in 2019?

Real estate investment trusts receive a unique tax treatment.

For purposes of the federal income tax, these corporations file the form 1120-REIT, U.S Income Tax Return for Real Estate Investment Trusts. This return form is similar to the form 1120-S for an S-corporation.

That’s because real estate investment trusts are "pass-through entities," as well. That means they don’t pay the federal income tax at a corporate level.

Instead, they pass income to shareholders who report it on individual returns and are taxed at the shareholder’s marginal tax rate.

These corporations were considered tax-favored already. However, Tax Cuts and Jobs Act of 2017 (TCJA) made several important changes to the taxation of REITs.

The most notable change is a new 20% tax reduction on REIT dividend income for shareholders, which results in significant savings.  

Once qualified, their dividends might be eligible for pass-through deductions as provided for under section 199A, which means investors pay less taxes on what they make.

When dividends are qualified, it means they are neither capital gain nor qualified dividend. Special rules that include the holding period can apply.

It’s important to note that real estate investment trusts are allowed to create Opportunity Zone funds for acquiring and developing properties to take advantage of their favorable tax treatment.

If an investment qualifies, the capital gains can be reduced and deferred to even zero when selling the asset.

As stated earlier, some real estate investment trusts have a higher risk. Therefore, do your due diligence before investing.

It’s crucial to talk to a tax professional to find out how investing in a specific REIT can affect your tax bill.

 

What Are The Best REITs To Invest In?

There are different types of REITs to consider before you decide on the one to invest in.

About 22% of real estate investment trusts are into freestanding retail and shopping malls. This represents the largest type of investment in America. 

With a slew of options, it is important to do your own research and find REITs that are aligned with your investment strategy.

Consider REIT Exchange Traded Funds (“REIT ETFs”), which have stakes in a variety of other REITs or are tied to a REIT market index. This further diversifies investors exposure to the real estate market, while providing the same benefits of a REIT.

ETFs essentially provide a low-cost, liquid way of investing in the broad asset class of real estate. The diversification of REITs and REIT ETFs mitigates investors from exposure.

 

Here some of the best REITs to invest in:

1. Vanguard Real Estate ETF (VNQ)

This is the best option for novice investors that want to focus on the U.S or buy into a large public company that has ties with the real estate market.

VQN tops the list for having a broad and diversified portfolio and a reasonable ratio for the expense. The primary goal of this real estate investment trust is high income.

However, investors can see the overall value appreciation. Its top holdings include the American Tower Corp, Vanguard Real Estate II Index Fund, and Simon Property Group.

2. Schwab U.S REIT ETF (SCHH)

Schwab is a fund provider and a popular brokerage that offers lower fees than Vanguard. Charles Schwab manages this trust.

It follows the Dow Jones U.S Select index while charging fees of 0.07% only. Currently, this ETF holds 116 assets in the United States.

That means investing in this real estate investment trust eliminates the risk of venturing into the foreign market from your portfolio.

It’s an ideal trust to invest in if your goal is to focus on the U.S real estate industry. Its major holdings include Prologis, Simon Property Group, and Public Storage.

3. iShares Global REIT (REET)

This is the best real estate investment trust to invest in when you want to spread your investments globally.

The ETF outperformed the FTSE EPRA/NAREIT Global REIT Index benchmark in less than 4 years since its inception. It charges a management fee of 0.14%.

The major holdings of this fund include Prologis, Public Storage, Avalon Bay Communities, and Simon Property Group.

It has invested 5% in the United Kingdom, 6% in Australia, 7% in Japan, 65% in the United States, and the rest in Canada, France, South Africa, Singapore, and Hong Kong. Other communities make up 3% of its total assets.

4. iShares Cohen & Steers REIT ETF (ICF)

This fund aims at achieving similar results with the Cohen & Steers Realty Major Index.

It invests a minimum of 90% of all its assets in real estate investment trusts or depositary receipts that represent real estate investment trusts.

ICF particularly seeks companies that can be acquired or can acquire others as a way of consolidating the real estate sector.

5. Fidelity MSCI Real Estate Index ETF (FREL)

This is another top ETF provider that focuses on the U.S real estate. It also has one of the lowest management fees of around 0.084% expense ratio.

Its top holdings include Simon Property Group, American Tower Corp, Equinix, Prologis, and Crown Castle International.

 

List of REITs

If you want to invest in real estate investment trusts, here’s a list of companies to consider:

  • American Assets Trust, Inc. (AAT)
  • Arbor Realty Trust, Inc. (ABR)
  • Lamar Advertising Company (LAMR)
  • Outfront Media (OUT)
  • Aimco (AIV)
  • AvalonBay Communities (AVB)
  • American Campus Communities Inc. (ACC)
  • Ares Commercial Real Estate Corp. (ACRE)
  • Agree Realty Corp. (ADC)
  • Camden Property Trust (CPT)

 

REIT vs. Direct Real Estate Investing

Direct real estate investing involves acquiring and operating income producing property like a shopping center, apartment complex, or even private money lending on properties. 

REIT investing, on the other hand, gives investors fractional shares in the form of securities that reflect proportional ownership in a portfolio of real estate assets.

This enables individual investors to passively invest and share the income generated from commercial real estate without buying, financing or operating the properties themselves. Direct property ownership is typically more of an active investment, requiring more "hands on" management. 

Investing in REITs provides earnings from income-generating properties without taking out loans, dealing with tenants, contractors, or spending large sums of money buying real estate.

These trusts are beneficial to first-time investors because they provide an affordable way of venturing into the real estate market without the risk that comes with direct property ownership.

REIT shares are liquid, so there is less time, cost, and hassle if you need to sell.

Directly owning property requires substantial effort to sell, which can take weeks, months, and even years to liquidate certain properties.

Direct real estate investing can be more profitable and is allowed more tax breaks than investing in REITs.

Landlords have a substantial amount of control over most aspects of their business, such as in decisions in leasing, construction, and operations. Individual landlords decide their rental price, specific properties to buy, as the ability to screen for quality tenants.

 

The Bottom Line 

Investors don’t have to get into debt or raise large amounts of money to venture into the real estate industry.

Real estate investment trusts offer investors a chance to get in the game without down payments, debts, property management, rent collections, and other property ownership burdens.

These corporations have reasonable risk insulation due to their portfolio diversification and management expertise.

REITs have unique advantages, risks, and rewards that every investor should take time to research diligently.

 


 

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