Real estate Investment Trusts or REITs are an emerging concept in the real estate market. A REIT is modeled after mutual funds and they channel investable capital into owning, operating, or financing commercial real estate assets. Hence, REITs enable real estate investors to diversify their investment portfolios without bearing any additional risks.
What is a REIT (Real Estate Investment Trust)?
A REIT or Real Estate Investment Trust is a legal entity that is created solely to own, operate or finance income-producing real estate. Investing in REITs enables investors to add real estate to their portfolios by purchasing units of assets across a wide range of property sectors.
A group of shareholders owns and operates a REIT fund. They contribute money to invest in commercial and residential real estate assets. These include shopping complexes, multifamily properties, hotels, resorts, warehouses, self-storage facilities, mortgages, loans, and so on.
So a REIT investor can invest in a wide variety of profitable income-generating assets.
However, each REIT specializes in different types of property types. For instance, one REIT may invest in industrial assets while another might focus only on commercial real estate properties.
In some cases, a REIT operates on multiple property types.
Unlike other real estate entities, real estate investment trusts do not develop properties only to resell them afterward. REIT finance or invests in Real estate assets to expand its portfolio.
Hence, REITs are similar to mutual funds. But, REITs own and operate real estate assets directly or indirectly as their underlying investments instead of securities.
A Real estate investment trust delivers high steady dividend income and long-term capital appreciation to its investors.
What are the requirements of a REIT?
Congress in 1960 established the REITs to enable all average and smaller American investors to access Income yielding commercial real estate.
The US securities and exchange commission (SEC) sets the following criteria for a real estate investment trust:
- A REIT must have at least 100 shareholders or investors.
- No more than 50% of its shares Can be held by five or fewer investors.
- The REIT must invest at least 75% of its total assets in real estate.
- 75% of its gross income must be derived from rents from real estate, interest on mortgage financing real estate, or from the sale proceeds of real estate.
- REITs must earn at least 95% of their overall gross income from dividends and interest from real estate sources and interest.
- Only 5% can come from sources other than real estate, dividends, and interest income.
- It must pay 90% of its taxable income to shareholders as dividends.
- It cannot have more than 25% of its assets in non-qualifying securities in taxable REIT subsidiaries.
- The REIT must be managed by a board of directors or trustees.
- The entity should be taxable as a corporation.
Who are the stakeholders involved in a REIT?
The sponsor forms the REIT While transferring the real estate assets they own to the trust. Hence, a real estate builder or developer who wants to raise funds through REIT is generally the sponsor.
The sponsor appoints the trustee Who is responsible for holding the assets on behalf of the unitholders.
A trustee appoints a manager who is responsible for the management of the REIT assets. Moreover, a manager is also in charge of making investment decisions and is hence generally a private company that is closely held by the sponsor.
4. Unit Holders
Unitholders are the beneficiaries of the trust. They can become indirect holders of REIT assets. For this, they need to subscribe to the REIT units.
5. Independent Valuer
Besides the sponsor manager and trustee, REIT appoints an independent valuer who is a credible entity that estimates the values of the REIT’s portfolio of assets at regular intervals.
What is the structure of a REIT?
A REIT can choose to directly own its assets or through a special purpose vehicle (SPV).
In some cases, they add EIT can on their assets through a holding company that in turn operates such SPVs.
SPV is an entity in which a REIT or a holding company (Holdco) holds an equity stake or interest of at least 50%. The SPV holds at least 80% of its assets in real estate. So, it is not allowed to invest in any other SPV. Furthermore, the SPVs are legally prohibited from engaging in any activity other than owning and developing real estate.
A Holdco is a company or a limited liability partnership in which the REIT holds or proposes to hold an equity stake or interest of at least 50%. In addition to this, a Holdco must make investments in other SPVs which in turn ultimately holds the portfolio of real estate investment assets.
Just like an SPV, a Holdco does not engage in any other activity other than its holding of the underlying SPV. Therefore the Holdco must concern itself with only the holding of real estate assets.
What are the types of REITs?
REITs can be classified, on the basis of their accessibility or how they are traded. These include:
1. Publicly traded REIT
Publicly traded REITs trade on major stock exchanges and anyone with a brokerage account can invest in them. These REITs must register with the US securities and exchange commission and provide audited financial reports.
2. Publicly non-traded REIT
As the name suggests, publicly non-traded REITs or non-exchange REITs are open to all investors but they don’t trade on stock exchanges. Therefore, investors can buy and sell these REITs through their financial advisors or online real estate crowdfunding platforms.
Therefore, publicly non-traded REITs must also register with the SEC and submit audited financial reports.
3. Private REIT
Unlike Publicly traded and non-traded REITs are not available to the common masses. High-net-worth individuals, sophisticated investors, and accredited investors can only access Private REITs. So, it is exempted from SEC registration.
Within these three types of REITs, there are three subcategories by asset type:
1. Mortgage REIT
Mortgage REITs or mREITs focus on financing real estate by purchasing mortgages and mortgage-backed securities. They produce income from interest on these investments.
2. Hybrid REITs
Hybrid REITs invest in a combination of properties and real-estate-backed mortgages. In some cases, they also extend loans to real estate investors. Hence, Hybrid REITs generate a dual income from rent as well as mortgage interests.
3. Equity REIT
These companies purchase, own, and produce income-producing real estate. So, Equity traded REITs are highly suitable for long-term investing as they generate dividend yields and capital gains.
Equity REITs are further categorized into various sub-industries depending on the sector or property types:
4. Diversified REIT
A diversified REIT owns and operates a diversified portfolio of commercial real estate. For instance, they can manage a portfolio that consists of retail properties and office real estate.
However, some diversified REITs manage real estate assets across two different sectors. Hence, they can manage a mix of residential and commercial real estate assets.
5. Industrial REIT
These entities acquire, develop, own, lease and manage industrial facilities. These include warehouses, distribution centers, cold storage, light manufacturing centers, and so on.
Some of the advantages of Industrial REITs include long-term leases and net leases which require the tenants to bear the operating expenses.
6. Retail REIT
These entities acquire, develop, own, lease and manage retail real estate. These include regional malls, shopping centers, and freestyle retail properties.
Retail REITs benefit from triple net leases and annual rent hikes.
7. Office REIT
These firms focus on acquiring, developing, owning, leasing, and managing office real estate such as skyscrapers and office parks. Furthermore, some Office REITs also focus on specific locations/regions or tenant types.
8. Healthcare REIT
Healthcare REITs invest in healthcare-related real estate. These include hospitals, nursing homes, medical offices, assisted living facilities, skilled nursing facilities, and so on.
9. Hotel and Resort REIT
Hotel/Lodging and Resort REITs own and manage hospitality real estates properties like hotels and resorts.
10. Infrastructure REIT
Such REITs invest in infrastructures like fiber cables, telecommunication towers, and energy pipelines for mobile carriers or energy companies.
11. Data Center REITs
They focus on real estate facilities for data storage for technological companies.
12. Timberland REITs
Timberland REITs operate real estate facilities that focus on harvesting and selling timber.
13. Residential REITs
Residential REITs focus on operating residential real estate like multifamily properties, single-family rentals, student housing, manufactured dwelling, and so on.
14. Specialized REITs
Specialized REITs or Speciality REIT entities own and manage real estate projects that do not fall under any of the aforementioned categories. For instance, ground leases, farmlands, outdoor advertising, and so on comprise the portfolio of Specialized REITs.
Although investing in Specialized REITs enables wider diversification of one’s portfolio, it requires sufficient due diligence and knowledge about the underlying investments.
Read Lilypads’ blog on the key differences between Equity and Debt REITs here.
The benefits and risks of REIT investments
1. Earn high returns
REITs are required by law to distribute 90% of their earnings as dividends to their investors and shareholders.
As mentioned earlier, REITs generate rental income from direct investments in properties and dividends from investments through SPVs. And, when a REIT invests in mortgage-backed securities are debt instruments, they earn interest income.
Therefore, investors can earn a stable stream of passive income from above-average dividends.
Read Lilypads’ blog on how to generate passive income in real estate here.
2. Portfolio diversification
REIT investments diversify an investment portfolio with their low correlation to the performance of asset classes. Also, unlike bonds, REITs have the potential for long-term appreciation.
Moreover, REITs invest in a wide range of properties across multiple asset classes. Therefore, if an investment fails, the investor can still generate income from a wide variety of REIT assets.
Furthermore, REIT investments are a natural hedge against inflation because inflation causes real estate prices to rise.
In REIT investments, investors can easily convert their assets into cash. So, it becomes easier to purchase and sell real estate investment shares.
Publicly traded REITs trade on major stock exchanges. So, they operate similarly to publicly listed securities.
Therefore, REIT investors can easily access transparent information regarding REIT prices and trade throughout the day.
Risks of REIT investments
1. Higher tax payments
REIT investments can result in Higher tax liabilities for investors. So, they have to pay non-qualified dividends.
Hence, it is ideal that investors hold REIT investments through self-directed IRA accounts.
2. Correlated with interest rates
REIT investments are sensitive to changes in interest rates. Thus, they can produce negative returns during periods of soaring interest rates.
3. No control over investments
Since REITs are operated by management professionals, investors do not retain control over operational decisions such as market trading strategies and property ownership.
4. Higher management fees
Some REIT funds charge higher management fees that include higher transaction and administration fees. As a result, the investors end up receiving lesser net payouts.
The Lilypads Bottomline
For real estate investors, REITs could be a great way to invest in real estate and generate passive income through higher dividends. Real estate offers greater advantages and profits than stocks and bonds. So, REITs enable interested investors to access real properties without a huge capital investment.
After conducting proper due diligence into the management of REITs and their track record of success, investors can invest in REITs if it aligns with their risk tolerance and return objectives. Plus, REITs provide a great channel for portfolio diversification and historical returns.