The abundance of investment vehicles out there creates a challenge for the average investor trying to grasp what they're all about. Stocks are the mainstay of investing, bonds have always been the safe place to park your money, options have increased leverage for speculators, and mutual funds are considered one of the easiest vehicles for investors. One type of investment that doesn't quite fall into these categories and is often overlooked is the real estate investment trust, or REIT.
- A real estate investment trust (REIT) is a company that owns, operates or finances income-producing properties.
- Equity REITs own and manage real estate properties.
- Mortgage REITs hold or trade mortgages and mortgage-backed securities.
- REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
- Most REITs are publicly traded like stocks, making them highly liquid—unlike most real estate investments.
What Is a REIT?
A REIT trust company that accumulates a pool of money, through an initial public offering (IPO), which is then used to buy, develop, manage and sell assets in real estate. The IPO is identical to any other security offering with many of the same rules regarding prospectuses, reporting requirements and regulations; however, instead of purchasing stock in a single company, the owner of one REIT unit is buying a portion of a managed pool of real estate. This pool of real estate then generates income through renting, leasing and selling of property and distributes it directly to the REIT holder on a regular basis. (For further explanation, read our article: What Are REITs?)
Types of REITs
REITs, like most investments, come in a variety of flavors. These funds have classifications that indicate the type of business they do and can be further classified depending on how their shares are bought and sold.
Equity REITs is the most common form of enterprise. These entities buy, own and manage income-producing real estate. Revenues come primarily through rents and not from the reselling of the portfolio properties.
Mortgage REITs, also known as mREITs, lend money to real estate owners and operators. The lending may be either directly through mortgages and loans or indirectly through the acquisition of mortgage-backed securities (MBS). MBS are investments holding pools of mortgages issued by government-sponsored enterprises (GSEs). Their earnings come primarily from the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. Due to the mortgage-centric focus of this REIT, they are potentially sensitive to interest rate increases.
Hybrid REITs enterprises hold both physical rental property and mortgage loans in their portfolios. Depending on the stated investing focus of the entity, they may weigh the portfolio to more property or more mortgage holdings.
When you buy a share of a REIT, you are essentially buying a physical asset with a long expected life span and potential for income through rent and property appreciation. This contrasts with common stocks where investors are buying the right to participate in the profitability of the company through ownership. When purchasing a REIT, one is not only taking a real stake in the ownership of property via increases and decreases in value, but one is also participating in the income generated by the property. This creates a bit of a safety net for investors as they will always have rights to the property underlying the trust while enjoying the benefits of their income.
Another advantage that this product provides to the average investor is the ability to invest in real estate without the normally associated large capital and labor requirements. Furthermore, as the funds of this trust are pooled together, a greater amount of diversification is generated as the trust companies are able to buy numerous properties and reduce the negative effects of problems with a single asset. Individual investors trying to mimic a REIT would need to buy and maintain a large number of investment properties, and this generally entails a substantial amount of time and money in an investment that is not easily liquidated. When buying a REIT, the capital investment is limited to the price of the unit, the amount of labor invested is constrained to the amount of research needed to make the right investment, and the shares are liquid on regular stock exchanges.
The final, and probably the most important, advantage that REITs provide is their requirement to distribute nearly 90% of their yearly taxable income, created by income-producing real estate, to their shareholders. This amount is deductible on a corporate level and generally taxed at the personal level. So, unlike with dividends, there is only one level of taxation for the distributions paid to investors. This high rate of distribution means that the holder of a REIT is greatly participating in the profitability of management and property within the trust, unlike in common stock ownership where the corporation and its board decide whether or not excess cash is distributed to the shareholder.
Picking the Right REIT
As with any investment, you should do your homework before deciding upon which REIT to purchase. There are some obvious signs you should look at before making the decision:
It's always important when buying into a trust or managed pool of assets to understand and know the track record of the managers and their team. Profitability and asset appreciation are closely associated to the manager's ability to pick the right investments and decide upon the best strategies. When choosing what REIT to invest in, make sure you know the management team and their track record. Check to see how they are compensated. If it's based upon performance, chances are that they are looking out for your best interests as well.
REITs are trusts focused upon the ownership of property. As real estate markets fluctuate by location and property type, it's crucial that the REIT you decide to buy is properly diversified. If the REIT is heavily invested in commercial real estate and there is a drop in occupancy rates, then you will experience major problems. Diversification also means the trust has sufficient access to capital to fund future growth initiatives and properly leverage itself for the increased returns.
The final item that you should consider before buying into a specific REIT is its funds from operations and cash available for distribution. These numbers are important as they measure the overall performance of the REIT, which in turn translates to the money being transferred to investors. Be careful that you don't use the regular income numbers generated by the REIT as they will include any property depreciation and thus alter the numbers. These numbers are only useful if you have already looked carefully at the other two signs, since it's possible that the REIT may be experiencing anomalous returns due to real estate market conditions or management's luck in picking investments. (For more, check out How To Assess A REIT.)
The Bottom Line
With so many different ways to invest your money, it's important that any decision you make is well informed. This applies to stocks, bonds, mutual funds, REITs, or any other investment. Nevertheless, REITs have some interesting features that might make a good fit in your portfolio.