REIT Definition: What Is a REIT?
Real estate investing is a proven method of generating wealth over the long term. This type of investing generates both a capital gain and a steady income that is protected from inflation. The one thing that keeps investors away from this great investment opportunity, however, is the large amount of time and effort required.
One way to get exposure to the real estate sector without the hassle is by owning a real estate investment trust (REIT). This involves investing in a public or private company that owns a portfolio of real estate properties or, in some cases, mortgage assets.
This article will focus on answering many questions you may have about this type of investment, including: “What are REITs and how do they work?,” “What are REIT investments’ pros and cons?,” and “How are REITs taxed?”
What Is a REIT?
A real estate investment trust is a company that owns or finances real estate properties that generate an income. Most REITs trade on the major trading exchanges and can be purchased as easily as a stock. That said, a smaller REIT may trade as a private entity until it grows enough to trade on the exchanges.
A REIT contains many properties, which are financed by a professional management team that will make the decisions with the goal of benefiting unitholders over the long term. And the great thing about owning a REIT is that you end up having a portion of capital allocated towards real estate without needing to be or manage tenants.
Depending on the goals of the REIT, the properties within the portfolio could be focused on a certain geographic area or spread across a few countries around the world. The properties also often need to fit a certain criteria; for instance, a REIT may focus solely on investing in office buildings in large cities or owning industrial properties. Common market segments for REITs include hotels, hospitals, student housing, mortgages, and apartments, giving investors a lot of options.
A REIT gives investors the ability to invest in large-scale properties that would otherwise be unavailable. They also provide access to a diversified portfolio of properties that generate a capital gain through price appreciation.
Here are the criteria that a REIT must follow:
- Pay at least 90% of its taxable income to shareholders as a dividend
- Invest at least 75% of the total assets in real estate
- At least 75% of the gross income must come from rents on properties, interest from mortgages, and/or the sale of real estate
- Be taxable as a corporation
- Have a board of directors or trustee in place
- Have a minimum of 10 shareholders
- Have no more than 50% of the company held by five or fewer investors
REITs are generally sorted into two major categories, equity REITs and mortgage REITs. There is more information on each below.
What Are Mortgage REITs?
A mortgage REIT’s investments are designed to provide financing for real estate by either purchasing or starting mortgages. Some companies may also invest in mortgage-backed securities. Revenue is earned from the difference in the borrowing cost and what the borrower is paying; the spreads in the interest rate are known as net interest margins. The dividend is based on the net interest margins of the REIT.
Mortgage REITs invest in both residential and commercial mortgages. Most the time, the investment is in one or the other, but in rare cases, it will be in both.
What Are Equity REITs?
Equity REITs contain commercial properties such as office buildings, apartments, shopping malls, and industrial units. Revenue is generated by leasing out the space to tenants. Whatever is left over after operating expenses is given to investors.
A great management team would generate more income for holders of a REIT by simply refinancing a mortgage. This would be done when the interest rates of mortgages are lower than the current existing mortgage rate. And income is not the only way to generate profit, as there is also capital gain appreciation when a property is sold.
What Are Publicly Traded REITs?
Publicly traded REITs are large companies that appear on trading exchanges. Shares of these companies can be purchased and sold at any time as long as the markets are open for trading.
Purchasing shares of publicly traded REITs requires completing the appropriate paperwork through the U.S. Securities and Exchange Commission (SEC). This paperwork is part of the regulatory process to keep the REIT listed.
What Are Public Non-Traded REITs?
For a REIT to trade on the exchanges, it must be registered with the SEC. The registration and release of all financial information is to ensure the company is following regulations. The same thing is applied to a REIT that is not traded on the public trading exchanges.
A non-traded REIT has some rules in place when it comes to buying or selling a position. For starters, there is a minimum time period that the REIT must be held for and a sell order can only be placed on certain dates. There are also times that a minimum dollar amount must be invested, which will be determined by the company.
Keep in mind that every non-traded public REIT will have its own set of rules. For instance, a company may only let holders of the REIT dispose of their position on the 15th of the month. This info is provided ahead of time so investors are aware of these rules before buying in. The goal of the REIT is to one day be large enough to appear on the trading exchanges.
What Are Private REITS?
Private REITs are not required to complete any administrative work with the SEC and the shares do not trade on any exchanges.
These REITs do not trade on the public markets for a few reasons. One is that the products are geared towards large pension funds, institutional investors, and wealthy retail investors. There is also a minimum payment required to be an owner of a private REIT, and it is difficult for investors to liquidate their position.
As a result, private REITs are generally preferred by investors that want to park their money and won’t need the funds for some time.
REIT Investment Risk
There are various types of REITs available in the marketplace. Here is a list of them, along with the associated risks of each.
1. Mortgage REITs
- Credit Risk: There is always the chance that a borrower’s credit rating could change, possibly because they took on more debt. This means the payback obligation could eventually become quite large and unaffordable for the borrower, potentially harming the business’s harm cash flow.
- Prepayment Risk: When interest rates are lower, there is a higher chance of the borrower paying back the loan sooner than expected. Why? Because there will be less money going towards the interest payment and there is more of a principal payment. This could also harm the cash flow of the business due to the lack of a steady stream of income.
- Rollover Risk: When interest rates are lower, there is a higher probability of the borrower refinancing the mortgage. This would result the borrower paying a higher interest rate and a lower rate on the borrowed money. Again, this negatively affects cash flow.
- Interest Rate Risk: When interest rates are higher, net interest margins are normally higher as well. When interest rates head lower or are at a very low rate already, the margins are small. If the direction of interest rates are on a downtrend, this hurts the company’s margins.
2. Equity REITs
- Debt Out of Control: A company’s administration could decide to go on a spending spree, purchasing properties and adding more debt. Unfortunately, there is a possibility of the debt not being covered if it becomes too large, impacting share price and income.
- Vacancy Risk: There could be a change in demand for the properties. For instance, an industrial REIT may have a contract in place that is up for renewal but it is unable to find a tenant. Even if it is vacant, there is still carrying cost that is associated with carrying the property.
3. Non-Traded REITs
- Liquidity Risk: A non-traded REIT cannot be traded at any time as per the company’s rules when selling a position. There could be a blackout period in which shares must be held for a certain period of time, which in turn may work against you.
- Pricing Risk: Since the company does not trade on the markets, the price that the shares are bought and sold at could be inefficient and not what you were expecting.
4. Private REITs
- Regularity Risk: There is no requirement to complete any paperwork for the SEC. This means the company could take advantage of this by over-promoting the company—and eventually under-delivering.
- Liquidity Risk: Selling the shares is quite difficult to do since there is no public market. There will also be very few holders of the REIT, so it may be difficult to find a buyer.
When Do REITs Pay Dividends?
A REIT pays out its dividend at its leisure. Some companies will make a monthly payment, while others are quarterly. In addition, investment decisions are based on how much cash flow can be generated.
The reason a dividend exists at all is that at least 90% of its disposable income must be paid to investors. This is because REITs don’t have to pay any tax on profits; rather, the tax burden falls on investors.
How Are REIT Dividends Taxed?
Receiving the dividend from a REIT is quite unique, and each payment could be different. I don’t mean that the payment amount will change; rather, I am referring to taxes and how the payment is broken down.
For example, let’s say a company’s dividend is $2.00 per share. This could be broken down as $0.50 from capital gain, $0.25 from the return of capital, and $1.25 from interest income. Each of which affects tax liabilities in a different way.
Now, let’s say a property was sold and cash was paid to shareholders from the sale; these proceeds would make it a capital gain. This could be considered a qualified dividend as long as all the criteria are met. If they aren’t, then it would be a non-qualified dividend payment.
Interest income would be paid when there is income generated from an interest-formed investment. This would be taxed as ordinary income at the investor’s marginal tax rate.
Return of capital is the money being returned to investors when the shares were invested in. Occasionally, this has been returned in the form of the dividend. There are no taxes due on the return of capital because the average cost basis of the shares will decrease.
For instance, let’s say a REIT was purchased for $10.00 per share and $1.00 was received as income as return on capital throughout the year. By the end of the year, the average cost per share would decrease to $9.00. If the shares were sold at a gain, it would be based on the $9.00 trading price.
Why Are REITs Good Investments?
For income investors, REITs are a great investment vehicle to use because, as noted, 90% of the taxable income is given to shareholders as a dividend and they provide you with an income source through the real estate sector without having to manage a property. The money will simply be added to either your bank account or broker account, or a check may be sent to you if shares were not purchased through a broker.
Real estate is an investment that is considered hedged to inflation. As economic inflation affects property prices, it should be reflected in the REIT’s trading price as well. Inflation is also seen in the income earned via contracts and renegotiations. This adds to the total return since it is accounted for by the shares’ capital gain and the income that is received, which is hopefully growing over time.
Another major reason to consider a REIT investment is because of the diversification of the portfolio of investments, since one REIT would hold many different properties. In the case of a mortgage REIT, there are many different borrowers, removing the credit risk of just one borrower.
Another reason to consider a REIT is the professional management team that makes decisions for the company, working in the best interests of the share price and income. They also live and breathe, and therefore fully understand the real estate market, so they make choices based on fundamentals rather than emotions.
How Do I Invest in REITs Stocks?
There are various methods that could be used to get exposure to the REIT sector. Here are the details.
If you have an online broker account, you can simply purchase the REIT through that, so long as the REIT trades on the public exchanges.
If you have an investment advisor, then a REIT could be purchased by simply placing a phone call to them.
2. Exchange-Traded Funds
If you are unaware of the exact REIT and want exposure to the sector, purchasing an exchange-traded fund (ETF) can be a great idea. Every ETF on the market will be different with the number of positions and the strategy that is used. Just like how a REIT has a variety properties in its portfolio, an ETF will have investments in many different REITs.
Depending on your investment requirements, there should be an ETF that that suits your needs. For instance, if you only want exposure to equity REITs or mortgage REITs, it will be possible to find one such ETF. Or if you are smaller investor and want some exposure to non-traded public REITs or private REITs and don’t have the access to the minimum requirements, you can still invest in them through an ETF.
Also, investing in an ETF will remove the liquidity concerns that come into play with non-traded public and private REITs.
3. Through the Company
If you are purchasing a non-traded or private REIT, then it must be done through the company themselves. This can be done with public REITs that are trading on the trading exchanges as well, but not all companies offer this method. Therefore, a broker might have to be used.
The Bottom Line on REITs
Investing in a REIT can be a great way to get exposure to the real estate segment, which would otherwise be difficult. There are many advantages of investing in this market segment, such as protection from inflation, a steady income, and a professional management team that takes care of the portfolio of assets. Whatever you may be looking for as an real estate investor, it most likely can be found via a REIT.
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