What is a REIT (Real Estate Investment Trust)
As we grow older, we realize how important it is to have investments while we are young. So when it is the right time, you will sow what you reap in your early years. But, we do not just invest anywhere and everywhere. The right time and type of investment must also be learned.
Have you done your research and are now looking for a way to invest on a commercial real estate property without actually buying and managing those properties yourself?
Then you must look for Real Estate Investment Trusts or REITS.
“Luckily for you, CORE Member, we’ve covered all the information you need to know about REITS. Remember, that while the first step is completing this amazing blog, the second and possibly more important step is taking action even if it’s an imperfect action.
REITs are a type of investment that provide greater diversification to any portfolio. They can provide investors either with higher total returns and/or a lower risk. By providing both dividend income and capital appreciation, they are an important counterbalance to stocks, bonds, and cash and should be considered when constructing equity or fixed income portfolios.
Investors interested in a variety of investments beyond publicly traded stocks or mutual funds have found a type of investment known as real estate investment trusts. REITs are companies that own income-producing real estate, such as apartments, warehouses, self-storage facilities and malls. Their appeal is simple: The most reliable REITS have a track record for paying large and increasing dividends. Still, the potential for growth carries risks that vary depending on the type of REIT.
Tracking back, Real estate investment trusts are historically one of the best performers available. The FTSE NAREIT Equity REIT Index is the most reliable gauge of the performance of the U.S. real estate market, with an annual return of 9.5% between 2010 and 2020.
The three-year average of returns for the real estate investment trust sector from November 2017 through November 2020 was well above both the S&P 500 and the Russell 2000, which respectively recorded a return of 9.07% and 6.45%. Historically, investors looking for yield have done better investing in real estate than fixed income, the traditional asset class for this purpose. A carefully constructed portfolio should consider both.
But, how do REITS work?
In 1960, Congress created REITs in order to help individual investors invest in large-scale real estate companies, just as they could own stakes in other businesses. This created an easy and scalable way for individuals to invest in a diverse portfolio of real estate.
Here are the certain standards set by the IRS that REITS should meet:
-A minimum of 90% of taxable income return in the form of shareholder dividends each year. This is a big draw for investor interest in REITs.
-At least 75% of total assets investment in real estate or cash.
-Receive at least 75% of gross income from real estate, such as real property rents, interest on mortgages financing the real property or from sales of real estate.
-A minimum of 100 shareholders after the first year of existence.
-Have no more than 50% of shares held by five or fewer individuals during the last half of the taxable year.
REITs don’t have to pay taxes on their profits, meaning they can invest in real estate more cheaply than non-REIT companies. This gives them a better chance at growing bigger over time and paying out even larger dividends.
Typically, REITs are divided into three categories: equity REITs, mortgage REITs and hybrid REITs. There are three further types of investment based on how one can purchase the investment: publicly traded REITs, private REITs, and public non-traded REITS.
Equity REITs are structures that allow investors to buy ownership of real estate, overseeing the property and collecting rent in exchange. The responsibilities you associate with owning a property are handled by the structure.
Unlike equity REITs, mortgage REITs do not own the underlying property. Instead, they hold on to a debt security backed by the property. For example, when someone takes out a mortgage on a house and collects their monthly payments, a financial institution like this one might buy that mortgage from the original lender and collect the monthly payments over time. In this case, someone else —the mortgagor in this example — owns and operates the property.
About 10% of REIT investments are in mortgage-backed securities, such as Fannie Mae and Freddie Mac — government-sponsored enterprises that purchase mortgages on the secondary market.
With most mortgage REITs, you need to be careful as they are often more risky and also more volatile than equity. A change in interest rates would mean that some of their future capital and even the value of their portfolio could decrease if they continued to rely on these loans. The trick is finding the right one.
Hybrid REITs own both real estate and commercial mortgage REITS. These REITS purchase real estate and collect loan payments on that property. While many hybrid REITs concentrate on one or the other, read the prospectus carefully to see which type of business is prevalent in a particular company.
Now let’s proceed to REITS type by trading status
Publicly Traded REITS
This term includes stocks and ETFs like publicly traded REITs, which are available for purchase through a regular brokerage account. There are more than 200 REITs on the market according to the National Association of Real Estate Investment Trusts.
For these reasons, publicly traded REITs have better governance standards and are more transparent than privately held properties. They also offer the quickest stock exchange―meaning that you can buy and sell a publically traded joint very easily.
Public non-traded REITS
These REITs are registered with the SEC and cannot be traded on an exchange, but can be purchased from a broker that participates in public non-traded offerings such as online real estate broker Fundrise. Because they aren’t publicly traded, these REITs are illiquid for periods of 8 years or more. This means you have to take your time investing in them.
As the SEC warns, non-traded REITs often don’t estimate their value for investors until 18 months after their offering closes. This can be years after you have invested in them.
REITs are companies that own, manage and develop properties. Several online trading platforms allow investors to purchase shares in public non-traded REITs, including Modiv, the Diversy Fund and Realty Mogul.
While private REITs create fewer disclosure requirements, they are also exempt from SEC registration, which makes them more difficult to value and trade — and are riskier. Some investors actively seek out nontraded REITs and may need to be encouraged that they carry additional risk.
Public non-traded REITs and private REITs also can have much higher account minimums, typically $25,000 or more, to begin trading and raise fees than publicly traded REITs. For that reason, private REITs and many non-traded REITs are open only to accredited investors with a net worth of $1M or more or an annual income in each of the past two years of at least $200,000 if single or $300,000 if married.
Aside from these categories, here are other other types of REITS.
While “investment” is not a synonym for “sale,” approximately 24% of real estate investments are shopping malls in America. This represents the single biggest investing type within America. Whatever mall you frequent, from the price point to the location to the tenants, it is likely owned by a REIT company (a real estate holding and investment trust).
When considering an investment in retail real estate, one first needs to examine the wider retail industry itself. Is it financially healthy at present, or what is its potential future?
Mentioning that retail REITs often charge rent, make it apparent that if the retailers in these REITs struggle financially due to poor sales, they may delay or even default on those monthly payments. This will eventually lead to bankruptcy of the REITs and could cause issues when finding new tenants. For these reasons, you should invest in well-anchored REITs with groceries and home improvement stores such as Whole Foods Market.
In a poor economy, REITs will perform well as they can buy distressed companies. Retail REITs that maintain strong balance sheets and have low levels of debt will be in the best position to purchase good real estate at distressed prices. To discern which companies are on the up-and-up and worth investing in, look for those with sound profits, great balance sheets and no use of short-term debt.
That said, long-term concerns threaten the retail investment in space, where shopping is focused more online rather than at actual physical locations. Owners of space have been innovating with their options, such as office building and non-retail oriented tenants to fill their load time, but there are still risks involved.
One of the most common types of REIT is the REIT that owns and operates apartment buildings, like making them offer to rent out to multiple families who might not be able to afford just one. This type of company tends to show up in places where home affordability is most low, such as in big urban centers like New York and Los Angeles. The cost for a single house can be too expensive for a lot of people, meaning that there are many more people who have to rent apartments. That drives up housing prices so much that these businesses make great investments.
For investors, the best indicator of success is whether a city or town is growing or not. Generally job growth and population changes in cities provide a good indication of company performance. As long as demand for housing remains high and rents are increasing, residential real estate could be a smart investment. Companies with strong balance sheets and those who have access to the most capital should tend to do the best, even if certain industries might do better at certain times based on individual indicators.
REITs in the healthcare sector will be interesting to watch as Americans age and healthcare costs continue to climb. REITs enter into agreements with operators of health facilities– hospitals, medical centers, nursing facilities as well as retirement homes– and invest in their real estate. Success of healthcare real estate is linked to the success of the healthcare system; a majority of these operators rely on occupancy fees and Medicare reimbursements, in addition to private pay. Due to this dependency, REITs are currently unstable due to funding questions concerning healthcare.
Here are factors to consider when choosing a healthcare REIT: companies with different customer types, experience and capital. The demand for this property type can benefit from the growing population of seniors who will require increased medical services. When analyzing the company’s balance sheet, look for a low-cost source of capital that can be used in operations.
Office REITs invest in office buildings. They receive rental income from tenants who have usually signed long-term leases. For investors, there are four critical considerations to think about before approaching an office REIT.
- What is the state of the economy and how high is the unemployment rate.
- What are vacancy rates like?
- How is the area in which the REIT invests doing economically?
- How much capital does it have for acquisitions?
Find REITs that invest in economic strongholds. For example, it’s better to own a bunch of average buildings in Washington, D.C., than it is to own prime office space in Detroit.
Now that we learned about the types of REITS, let’s proceed to its pros and cons
REITs offer dividend yields that are typically higher than those seen on extra-large companies on the S&P 500 index. REIT dividends must pay out 90% of annual taxable income and, as a result, often give investors a higher yield than most stock markets.
One of the many perks to owning a REIT is diversifying your portfolio through real estate. Not too many people have the ability to buy and sell commercial property, but this is possible with a REIT. Additionally, once you purchase shares of a REIT, chances are that it will be quick and easy to do so. Buying and selling property requires secured funds or cash gifts due to its liquidity—unlike with other investments.
There are some drawbacks to REITs that investors need to be aware of, most notably the significant tax liability that many REITs incur in some cases. Most REIT dividends don’t meet IRS qualified dividend criteria, so higher than average dividends from REITs are taxed at a higher rate than other income. For people who trade on IRAs and savers with standard brokerage accounts, it’s important to understand how the 20% pass-through deduction works with REITs.
Another issue with REITs is the sensitivity they have to interest rates. An attempt by the Federal Reserve to tighten up spending often causes REIT prices to fall and also creates property-specific risks (for example: Hotel REITs face strong performance decreases because of market downturns).
So, do you think you are ready to start with REITS?
Getting started is simple as opening an account with a brokerage, which typically takes under 10 minutes. Then you’ll be able to buy and sell REITs just like any other stock. Because REITs make so much money, it can be smart to keep them in a tax-advantaged retirement account like an IRA so the distributions are deferred.
If you don’t want to trade individual REIT stocks, it makes a lot of sense to simply buy an ETF or mutual fund that invests in a range of REITs. Getting diversified becomes less difficult and the inherent risk is reduced. With these funds, you get instant diversification and lower risk than researching individual REITs separately. Many brokerage firms offer these funds to investors and they require less legwork than researching them one by one.
So, what’s the bottom line?
With the federal government enabling individual investors to buy into large-scale commercial real estate projects as far back as 1960, it’s only been in the past decade that individual investors have embraced REITs.
Some reasons for the increase in demand of real estate investments are low interest rates, which forced investors to search for other places to put their money, the advent of exchange traded and mutual funds focusing on real estate, and Americans’ insatiable appetite of wanting to own property until the real estate market collapsed in 2008. REITs, like all investments, did not do well. Despite this, they still provide many benefits.
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