For many, real estate is the gold standard of all investments. It has a great long-term track record, can provide a steady income, and is an investment that is tangible and usable. There is something satisfying in looking at a building you own, versus staring at shares of stock on a computer screen.
Unfortunately, real estate as an investment has barriers to entry, such as money for a down payment, the ability to get a sizable loan, the time and education to run a profitable enterprise, and the necessary cash for maintenance, repairs, property taxes, and insurance.
Fortunately, there is a way to invest in real estate without owning individual properties. It’s known as a Real Estate Investment Trust (REIT).
What Is a REIT?
A REIT exists to invest in income-producing properties. It does this directly through the purchase of real estate, or indirectly by providing loans or purchasing pre-existing mortgage contracts. To qualify as a REIT (and avoid corporate income tax), at least 90% of its profit must be disbursed to shareholders as dividends.
REITs are typically broken down into three categories:
1. Equity REITs
The most popular and well-known type of REIT, equity REITs focus on acquiring, managing, and developing investment properties. Since REIT restrictions require that properties are held and developed over a long period of time, their main source of revenue is rental income from their holdings. They typically invest in specific types of property, which generally fall into the following categories:
- Office and Industrial
- Hotel and Resort
- Health Care
- Raw Land
2. Mortgage REITs
Not as popular as equity REITs, these funds loan money to real estate investors or invest in existing mortgage loans on properties (rather than investing directly in the properties themselves). Their main source of revenue is interest from the loans they hold.
3. Hybrid REITs
A combination of both equity and mortgage REITs, hybrid REITs diversify between owning properties and making loans to real estate investors. Their revenue comes from both rental and interest income.
Advantages & Disadvantages of REITs
Like all investments, there are advantages and disadvantages to REITs that should be weighed before investing:
- Investors are able to diversify within the real estate market by holding an interest in multiple properties with minimal dollars.
- Risk is pooled among many investors versus a sole property owner.
- REITs pay high cash dividends.
- Many REITs offer high liquidity, relative to outright real estate ownership, by enabling investors to sell shares quickly.
- Investors share ownership in large properties, like major office buildings or hotels, that they would otherwise be difficult to afford.
- Properties are professionally managed.
- Foreign individuals, otherwise restricted from owning property, can have an interest in such property via a REIT.
- Depreciation expenses can minimize shareholder taxes on dividends.
Typically, dividends are taxed the year they’re received and as ordinary income. When depreciation expenses are passed down by the REIT, those expenses are viewed as a return of capital to the shareholder and offset an equal portion of shareholder dividends. This delays the payment of taxes on that portion of dividends until REIT shares are sold.
Moreover, when shares are sold, the amount is taxed as a capital gain and not as ordinary income. For example, if a shareholder was paid a $100 dividend, but could claim $10 of that as a depreciation expense, the shareholder would only pay income tax on $90 that year. However, the $10 subtracted would be taxed as a capital gain later, when the fund is sold.
Because ordinary income is taxed at a much higher rate than capital gains, this is a major advantage over the tax treatment of normal REIT dividends.
- REITs generally exhibit low growth since they must pay 90% of income back to investors. Thus, only 10% of income can be reinvested back into the business.
- REIT dividends are not treated under the tax-friendly 15% rule that most dividends fall under. They’re taxed as regular income at a much higher rate.
- Investment risk can be significant. Do your due diligence before investing and consider all factors in the real estate market (i.e. property values, interest rates, debt, geography, and changing tax laws).
- REIT investors cede control of all the operational decisions that an individual property owner would make.
- Some REITs will incur high management and transaction fees, leading to lower payouts for shareholders.
Publicly Traded vs. Non-Traded REITs
Now that we’ve explored how REITs work and the three main types, let’s delve into the important differentiation between publicly traded and non-traded REITs:
Publicly Traded REITs
Publicly traded REITs are registered with the SEC and listed on a national exchange.
- They can be bought and sold in a brokerage account.
- They offer almost instant liquidity since the fund can be sold at any time.
- The market instantly reflects an increase in share value.
- These funds tend to be very large and diversified.
- Share price can be heavily influenced by market conditions versus the actual value of the underlying properties. As a result, investors may experience volatility in a publicly traded REIT portfolio.
- The extra expense to run a publicly traded fund may lower an investor’s potential dividends.
Although a non-traded REIT is regulated by the SEC, it is not listed on an exchange. Investors must meet minimum net worth or liquidity guidelines in order to maintain the stability of the REIT and protect investor interests.
Currently, investors need to have a liquid net worth of $250,000 (exclusive of their homes), or income of $70,000 per year and $70,000 in assets. Shares in non-traded REITs are usually bought at a set price of $10 per share. They are designed to be held for a certain time period (usually five to seven years depending on the REIT strategy) and pay a pre-declared dividend.
This type of REIT will typically raise money for the first few years and then close its doors to new investors. There are 4 common ways the fund may be unwound, either before or after the holding period is over:
- The REIT could be acquired by a larger publicly traded REIT with the sale profits passed along to shareholders.
- The REIT could go public, in which case the investors would receive new shares that would be sold on an exchange for, theoretically, a much higher price.
- The REIT could sell individual properties and pass a pre-determined portion of the profits to the shareholders.
- If the economy dictates that none of these options are profitable, the REIT, by way of shareholder voting, could extend the normal operations until market conditions improve.
- A set share price eliminates the daily price fluctuations and volatility associated with publicly traded REITs.
- Dividends tend to be higher in non-traded REITs, and may be paid monthly or quarterly. These higher dividends are a result of lower expenses and a way to compensate the investor for low liquidity.
- There is potential for significant appreciation at the end of the holding period.
- Investors may hold foreign real estate that they’d otherwise be prohibited from owning. These properties are relatively immune to the volatility of foreign stock markets.
- The share price and dividends are not guaranteed, even though they are “set.” In fact, some REITs have had to cut dividends and reduce share values due to the economic downturn and increased vacancies in their properties.
- These products are not liquid. Due to minimum holding requirements, an investor needs to remain in the investment for a long period of time. Unlike their publicly traded counterparts, investors can’t sell shares upon major drops in share value. This substantially increases the risk of investing in a non-traded REIT.
- There is less financial transparency of fund operations. Because non-traded REITs are not publicly listed, they’re subject to less supervision.
- Major appreciation in the share price is not realized until the end of the period of operation (though dividends can be increased).
Tips for Investing in REITs
REITs can provide excellent income and growth opportunities for the right investor. If you’re considering making the leap, here are a few tips to consider before investing:
- Understand the types of properties you are investing in. Most REITs specialize in a certain sector which should be easy to find in the fund summary. Understand the risks of each sector. For example, REITs holding undeveloped land or retail shopping centers in a bad economy will carry more risk than high-end apartments in a major metropolis.
- Look at the numbers. It is important to see if dividends are being paid from operations or if the fund is being forced to use additional capital. A well-run REIT should rely on its operations to pay for expenses and dividends. Also, be wary of large, one-time real estate sales that might skew the financials upwards.
- Find out when the REIT began investing. If investments were made before a market downturn, the REIT could hold properties that are underperforming or need to be refinanced. In such cases, REITs may need to lower dividends or sell additional shares in order to raise cash in the near future. However, if the fund was created after a housing market recession, it could own and be buying valuable properties at low prices.
- Know your time horizon. Especially in a non-traded REIT, investors could hold shares for at least five years before seeing a return of principal. Make sure you can handle this potential lack of liquidity.
We have seen significant growth in many markets as our economy finds its way out of a deep recession. However, the real estate market has lagged behind.
The good news is that there are great long-term investment opportunities, especially in the form of real estate. REITs are a way to diversify in the real estate market and can be an attractive income producing investment in a low interest rate environment.
If you want to avoid stock market volatility and you meet minimum guidelines, non-traded REITs could play an important role in your personal investment portfolio. As with all investments, it is important to do your homework and understand where you are putting your money and why.
What is your experience with REITs? What percentage of your portfolio is in REITs?