Real Estate Investment Trusts (REITs): Understanding the Basics and Benefits

Thinking about investing in real estate? Real Estate Investment Trusts (REITs) can be a great option, but they can be confusing for beginners.

In this article, we'll explain the basics of REITs—what they are, how they work, and whether they are a good investment for you.

What are Real Estate Investment Trusts?

A REIT allows individual investors to buy shares in a company that owns and manages income-producing real estate. This can include office buildings, apartment complexes, warehouses, and storage facilities.

 

One of the requirements for REITs set by the Internal Revenue Code is that a primary goal of the company must be to own income-generating properties for the long term. That's different from many other real estate investing companies, in which the goal might be more focused on buying, developing, and reselling properties over the short term.

How do REITs Work?

Because real estate investment trusts have a special tax status, they operate a bit differently than other investment vehicles. To qualify as a REIT, a company must meet a number of specific requirements.

They must pay out a minimum of 90% of their income in the form of dividends, have at least 100 shareholders (with no more five shareholders owning more than 50% of the shares), and 75% of the company's gross income must be derived from real estate.

Types of REITs

Real estate investment trusts (REITs) come in various types, each with unique characteristics and benefits. Understanding these types is essential for anyone looking to invest in real estate through REITs.

Equity REITs

Equity REITs are the most common type. They own and manage income-producing properties. These properties include office buildings, shopping malls, apartments, and hotels. Equity REITs generate revenue primarily through leasing space and collecting rent. They are an excellent option for investors seeking regular dividend income from real estate.

Mortgage REITs (mREITs)

Mortgage REITs, or mREITs, do not own properties directly. Instead, they provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities. Their income comes from the interest earned on these financial assets. mREITs can be more sensitive to interest rate changes compared to equity REITs.

Hybrid REITs

Hybrid REITs combine the strategies of both equity and mortgage REITs. They own properties and invest in mortgages. This mix allows them to benefit from rental income and interest payments. However, hybrid REITs are less common and can be more complex than their pure equity or mortgage counterparts.

Public Non-listed REITs

Public non-listed REITs are registered with the Securities and Exchange Commission (SEC) but do not trade on major stock exchanges. They are less liquid than publicly traded REITs but offer more stability since they are not subject to market volatility. Investors can buy shares through brokers or financial advisors.

Private REITs

Private REITs are not registered with the SEC and do not trade on public exchanges. They are typically available only to institutional investors and accredited individuals. Private REITs can offer unique investment opportunities but come with higher risks due to less regulatory oversight and lower liquidity.

How REITs Make Money

Understanding how REITs generate income is crucial for evaluating their potential as an investment. Here's a detailed look at the business models of different types of REITs.

Equity REITs

Equity REITs make money primarily through leasing space in the properties they own. These properties can include office buildings, shopping centers, apartments, and hotels. Here’s how their business model works:

• Lease Agreements: Equity REITs enter into lease agreements with tenants, which can range from individuals to large corporations.
• Rent Collection: The REIT collects rent from these tenants on a regular basis, usually monthly.
• Dividend Payouts: By law, REITs must distribute at least 90% of their taxable income to shareholders as dividends. This provides investors with a steady income stream.

Mortgage REITs (mREITs)

Mortgage REITs (mREITs) generate income differently from equity REITs. Instead of owning properties, mREITs provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities. Here’s how mREITs operate:

• Interest on Mortgages: mREITs earn income from the interest on the mortgages they hold. This can include residential or commercial mortgages.
• Spread Income: The income is often derived from the spread between the interest they earn on mortgage assets and the cost of funding these assets.
• Dividend Payouts: Similar to equity REITs, mREITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends.

Hybrid REITs

Hybrid REITs combine the income strategies of both equity REITs and mREITs. They earn revenue from rental income and interest on mortgages. This dual approach allows them to diversify their income streams, though they are less common than pure equity or mortgage REITs.

By leveraging these business models, REITs can provide consistent income to investors, making them a popular choice for those seeking to invest in real estate without the hassle of direct property ownership.

How to Invest in REITs

Investing in REITs can be a smart way to gain exposure to real estate. Here's how you can get started with different types of REITs and the role of financial professionals in the process.

Publicly Traded REITs

Publicly traded REITs are listed on major stock exchanges and can be bought and sold like any other stock. Here's how to invest in them:

• Research: Look into the REIT's portfolio, management team, and financial health. Pay attention to their dividend history and debt levels.
• Buy Shares: Purchase shares through a brokerage account. This can be done online, through a financial advisor, or directly from the exchange.
• Monitor Investments: Keep an eye on market trends and the performance of your REIT investments. Publicly traded REITs offer liquidity, making it easy to buy or sell shares as needed.

Public Non-Traded REITs

Public non-traded REITs are registered with the SEC but do not trade on stock exchanges. They are less liquid but can offer more stability. Here’s how to invest in them:

• Consult a Financial Advisor: These REITs are typically sold by brokers or financial advisors. They can help you understand the investment and assess whether it fits your financial goals.
• Invest Through Offerings: Purchase shares through a broker or financial advisor who participates in the non-traded REIT’s offering. Be aware of the fees and the less liquid nature of these investments.

Private REITs

Private REITs are not registered with the SEC and do not trade on public exchanges. They are generally available only to accredited investors. Here’s how to invest in them:

• Accreditation: Ensure you meet the criteria to be an accredited investor, typically having a net worth of over $1 million or an annual income of over $200,000.
• Work with Financial Professionals: Private REITs are often accessed through private placements. A financial advisor or broker can help navigate these investments and ensure they align with your portfolio.
• Understand the Risks: Private REITs can be riskier and less transparent. Due diligence is crucial to avoid potential scams and ensure the investment's legitimacy.

Role of Brokers, Investment Advisors, and Financial Planners

Financial professionals play a crucial role in REIT investments. Here’s how they can help:

• Brokers: Facilitate the buying and selling of REIT shares, especially for publicly traded REITs. They can provide access to investment platforms and execute trades on your behalf.
• Investment Advisors: Offer personalized advice on selecting REITs that fit your investment strategy. They can help diversify your portfolio and manage your investments.
• Financial Planners: Assist in creating a comprehensive financial plan that includes REIT investments. They consider your overall financial goals, risk tolerance, and long-term objectives.

Tips for New Investors

Starting with REIT investments can be straightforward if you follow these tips:

• Start Small: Begin with a modest investment in publicly traded REITs to get a feel for the market.
• Diversify: Spread your investments across different types of REITs and property sectors to manage risk.
• Do Your Homework: Research each REIT thoroughly, considering factors like property types, geographic locations, and financial performance.
• Seek Professional Advice: Consult with financial advisors to ensure your REIT investments align with your financial goals and risk tolerance.

Benefits and Risks Associated with REITs

Many see value in the ability to buy and sell a REIT just like any other stock, making it relatively easy to get started. REITs are also regulated by the Security and Exchange Commission (SEC), which provides more transparency—at the close of the market each day, you will know the price. Finally, many equity REITs tend to see a lot of stability, producing consistent dividends in positive markets.

In a down market, however, the risks from REITs are just as evident. They are susceptible to losses over the short term, and even in up markets, the stability doesn't always translate into high growth potential. There are tax ramifications based on REIT dividends.

Real estate investment trusts can provide an attractive entry into real estate investing, but speak with your advisor or broker to make sure you understand how they work and if REITs will fit into your overall investment strategy.

This article was updated on 7/29/2024