REITs are gaining popularity among retired investors to maintain a diversified source of income in retirement. Real estate investment trusts (REITs) safeguard the financial stability of an investor irrespective of the size of their nest egg. Besides higher yields, REITs today allow investors to expand their landscape of retirement investment beyond stocks and bonds. Depending on their financial situation and long-term goals, REITs provide retirees with an alternative source of passive income. Primarily, there are two main types of REITs: Equity REITs and Debt or mortgage REITs. While both are categorized as REITs, there are certain fundamental differences between the two.
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What is a REIT?
Real Estate Investment Trusts or REITs are companies that own, operate or fund real estate properties across a range of asset classes. These include income-producing properties like multifamily, residential, industrial, retail etc.
REITs trade on major stock exchanges. They allow investors to buy real estate or mortgages using the combined pool of the money of several investors. By leasing these spaces and rents collected from the properties, REITs generate passive income. The REITs then pay back at least 90% of their taxable income to their shareholders as dividends. The shareholders, in turn, pay income taxes on those dividends.
This is a fairly straightforward business model which benefits individual investors. REITs mimic mutual funds in their operations. They allow large, small and mid-sized investors to earn dividends from real estate by retaining their passivity. This means that with REITs, investors can own shares of real estate without buying, operating or financing the property themselves.
To qualify as a REIT, a company must meet certain requirements in the Internal Revenue Code (IRC). The requirements are as follows:
- The entity needs to be modelled as a corporation or business trust
- It needs to be taxable as a corporation
- The entity should have trustees or a board of directors
- The company should have at least 100 shareholders in the first year of its existence
- Less than 5 individuals should not hold 50% of its shares during each taxable year
- The company must have full transferable shares
- The company must pay 90% of the income as dividend
- A minimum of 70% of its total assets must be in real estate
- The entity must derive at least 75% of its gross income from rents, interest on mortgages that finance or operate real estate properties
- A minimum of 95% of the total income of REITs must be invested
Types of REITs
Equity REITs are the most common types of REITs. They acquire, invest or operate commercial real estate properties. These include:
- Shopping complexes
- Hotels and resorts
- Healthcare facilities
- Office buildings
- Self-storage facilities etc
For instance, a company qualifies to be a REIT. It raises and combines the funds from a pool of investors to purchase, operate or finance a commercial real estate property. After it purchases the property, the company leases out space until the property is fully occupied. The company now owns and operates the property and collects monthly rent from its tenants. Hence, the company holds equity in that location and it is now considered an Equity REIT.
They collect revenue in the form of rents from the tenants and businesses that lease these spaces. In addition to this, the rental income tends to grow over time. However, it depends on the market value and occupancy rate of the property. In time, the value of the property will also increase due to price appreciation. Thus they produce a significant capital appreciation for the investors and provide them significant total returns over time.
The REIT incurs offering, the organisational and operational cost associated with the properties. After paying these expenses, the REIT pays at least 90% of the income to the shareholders. The REITs distribute the income to the shareholders in the form of dividends. These dividends may be distributed to the shareholders on a monthly or quarterly basis.
Equity REITs own more than $2.5 trillion of real estate assets in the US. This includes more than 500,000 properties and structures in all 50 states and the district of Columbia.
- High dividend income payout
- Portfolio Diversification
- Long-term Capital Appreciation
- Highly liquid
- Solo 401(k) and IRA friendly
Risks of investing in Equity REITs
Publicly traded REITs guarantee diversification, high yields and stable dividends. However, they are not without their risks. The foremost among them is the interest risks which when rise, decreases the demand for REITs. In addition to this, publicly-traded REITs generate dividends that are taxed as ordinary income. It also requires careful due diligence by the investors regarding a particular property’s market analysis and future demand.
Non-Traded REITs, on the other hand, can’t be sold for many indefinite years. This makes them illiquid. Moreover, the lack of information about the shares’ value in a non-traded REIT, jeopardises the investor’s decisions. Non traded REITs also involve high upfront fees ranging from anywhere between 9% to 15% and also external manager fees. This makes them expensive for non-accredited investors. It also reduces the returns on investment for the investors in turn.
Debt or Mortgage REITs
A debt REIT or Mortgage REIT (mREIT) lend money to real estate buyers in exchange for debt. Such debt-like instruments can be mortgages, preferred equity structures, and mezzanine loans etc. Unlike equity REITs, Debt REITS do not invest in real estate. Instead, they invest in mortgages. mREITS invest in commercial and residential mortgages. Furthermore, they also provide liquidity to residential mortgage in residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). Contrary to Equity trusts that generate their income from rents, Debt Equities earn their income from the interest earned on such debts or by acquiring Mortgage-backed securities (MBS).
For instance, if a company qualifies as a REIT, it is eligible to lend to a real estate buyer. Now, the company collects the interest on the loans. This makes the company a Debt or mortgage REIT.
Debt REITs earn primarily by the ‘net profit margin’. This means that mREITs borrow money at lower interest rates to acquire or purchase high paying mortgages. Hence, it ensures that Debt REITs provide excellent dividends to their shareholders. mREITS borrow funds from various sources. These include structured financing, common and preferred equity and repurchase agreements. Convertible and long term debt is also a credit facility from which Debt REITs borrow.
mREITs, like Equity trusts, need to distribute at least 90% of their taxable income to their shareholders. Although, here there is no increase in the profits for such companies with the rise in the property value.
Key features of Debt REITs
- Sensitive to Interest rate fluctuations
- Credit risk
Risks of investing in Debt or Mortgage REITs
Before investing in a REIT, investors should acquaint themselves with the risks of their investment. Debt REITs need to borrow at regular intervals. Hence, they use short term financing. Thus, they need to keep in mind the short and long term interest rates. This is because interests are the fundamental source of their income. However, changes in the interest rates can affect the net profit margin of the mREITs. In March 2020, with the onset of the pandemic in the US, the prices of the mortgage-bond prices fell. As a result, there were speculations that the repurchase agreements were seizing. This was a cause of growing concern among the Mortgage REITs. This is because they rely solely on wholesale funding for their operations. Thanks to the Federal-aid to the repo markets and mortgage-backed securities, the asset and liability sides took much of the burden of the mREITs.
Key differences between equity and debt REITs
- Equity REITs are a more common type of REITs in the US.
- Equity reits invest in income-generating properties, while Debt REITs own mortgage-backed securities.
- Debt REITs generate income through interests, while Equity trusts generate revenue through rental income.
- Investors receive significantly higher dividends in Debt REITs.
- Debt REITs have more frequent dividend cuts.
- Debt REITs are more leveraged.
It is important that investors understand and gauge the risks along with the benefits of REIT investments. Risk-tolerant investors who are keen on doubling their income with higher dividends, Debt or Mortgage REITs are smarter options. On the other hand, for investors who are looking for stable rental income and portfolio diversification, Equity trusts prove beneficial. Hence, proper knowledge of Real Estate Investment Trusts (REITs) is necessary to identify the investment type that suits the requirements and goals of investors.