REIT stands for Real Estate Investment Trust. A REIT is essentially a company that owns and operates income-producing properties and by law, it must develop and operate a property opposed to developing a property for sale. There are many types of REITs. (For more, read: 10 Biggest REITs and Key Tips for Investing in REITs.)
A Variety of REITs
The most common is an equity REIT, which is as previously described—it owns and operates income-producing properties.
A mortgage REIT is different in that it generates income via mortgages, real estate loans and/or mortgage-backed securities. Mortgage REITs are higher risk than equity REITs because they’re often highly leveraged and use derivatives to hedge interest rate and credit risk.
A hybrid REIT is self-explanatory: it has both equity REIT and mortgage REIT features.
There's another way to break down REITs: publicly-traded REITs and non-traded REITs. Publicly-traded REITs trade like stocks and most of them are registered with the SEC. They’re also highly liquid. Some investors prefer non-traded REITs with the notion that potential returns are higher. But according to a September 2014 article in The Wall Street Journal that cited a study by Green Street Advisors, non-traded REITs under perform publicly-traded REITs with the former delivering an average annualized return of 10.9% and the latter delivering an average annualized return of 14.5%. (For more, see: Overview of Non-Traded REITs.)
Non-traded REITs are illiquid. In many cases, you must hold that REIT for a minimum of six years prior to cashing out. In some cases, you can cash out early, but it will come with a steep penalty. Furthermore, front-end fees for non-traded REITs can run as high as 15%. You also won’t know the value of your position while holding the REIT. It’s possible to see a profit from non-traded REITs, but this information should serve as a warning of the risks associated with non-traded REITs.
Other types of REITs include mutual fund REITs and ETF REITs. If you’re looking for liquidity, then you might want to consider the latter. If you take this route, don't be swept away by high yield. Your first priority should be to look at the expense ratio. Anything about 0.75% should be approached with caution; an expense ratio below 0.50% would be ideal. Then look at the yield. (For more, read: REIT ETFs to Watch.)
Rules of REITs
Now you know the basics, but you should also know the rules (laws). The most important rule is that 90% of a REIT's taxable income must be distributed to shareholders in the form of dividends. This makes REITs highly appealing to investors because it’s a way to profit from real estate without the hassles of owning an actual property. And it can be just as lucrative, if not more so. Below are other SEC rules for REITs:
•Be an entity that would be taxable as a corporation but for its REIT status
•Be managed by a board of directors or trustees
•Have shares that are fully transferable
•Have a minimum of 100 shareholders after its first year as a REIT
•Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
•Invest at least 75% of its total assets in real estate assets and cash
•Derive at least 75% of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property
•Derive at least 95% of its gross income from such real estate sources and dividends or interest from any source
•Have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries
Most REITs are specialized. For example, a REIT will likely focus on one (not more than one) of the following areas:
- office buildings
- shopping malls
- apartment buildings
- self-storage facilities
- mortgage loans
- healthcare facilities
- industrial properties
The Bottom Line
REITs are a good way to gain exposure to real estate without the headaches that come from property ownership. It’s highly recommended that you consider publicly-traded REITs over non-traded REITs. If you invest in an ETF REIT, then it’s imperative that you look at the expense ratio before the yield. (For more, see: Real Estate Investment Trusts: Risks.)