What Is a Real Estate Investment Trust?
Congress established real estate investment trusts (REITs) in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. The provision allows individual investors to buy shares in commercial real estate portfolios that receive income from a variety of properties. Properties included in a REIT portfolio may include apartment complexes, data centers, health care facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.
Most REITs specialize in a specific real estate sector, focusing their time, energy, and funding on that particular segment of the entire real estate horizon. However, diversified and specialty REITs often hold different types of properties in their portfolios.
Real Estate Investment Trust (REIT)
How a REIT Works
Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders.
To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code. These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a company must meet specific requirements including:
- Invest at least 75% of its total assets in real estate, cash or U.S. Treasurys
- Receive at least 75% of its gross income from real property rents, interest on mortgages financing the real property, or from sales of real estate
- Return a minimum of 90% percent of its taxable income in the form of shareholder dividends each year
- Have a minimum of 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
Other requirements including the REIT be an entity that is taxable as a corporation in the eyes of the IRS. Further, the enterprise must have the management of a board of directors or trustees.
- 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.
Types of REITs
There are several types of REITs. The 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.
Type of REIT
Own and operate income-producing real estate
Provide mortgages on real property
Own properties and make mortgages
Listing on a national exchange
Registered with the SEC bu not publically traded
Work only as private placement investments
Publicly Traded REITs offer shares of publicly traded REITs that list on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
Public Non-traded REITs also registered with the SEC, but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs but tend to be more stable because they’re not subject to market fluctuations.
Private REITs are not registered with the SEC and don’t trade on national securities exchanges. They work solely as private placements selling solely to a select list of investors.
Pros and Cons of Investing in REITs
REITs can play an important part in an investment portfolio. As with all investments, they have their advantages and disadvantages.
On the plus side, REITs are easy to buy and sell, as most trade on public exchanges. This marketable feature mitigates some of the traditional drawbacks of real estate. Traditionally, real estate is notoriously illiquidity—property can take a long time to sell or purchase—and its lack of transparency as not all markets offer reliable information on taxes, ownership, and zoning. REITs are regulated by the SEC and must file audited financial reports.
Performance-wise, REITs offer attractive risk-adjusted returns and stable cash flow. Also, a real estate presence can be good for a portfolio, diversifying it with a different asset class that can act as a counterweight to equities or bonds.
On the downside, REITs don't offer much in terms of capital appreciation. As part of their structure, they must pay 90% of income back to investors. So, only 10% of taxable income can be reinvested back into the enterprise to purchase new holdings.
Dividends received from REIT holdings are taxed as regular income. One primary risk for REITs is that they are subject to real-estate market fluctuations. Also, like most investments, don’t guarantee a profit or ensure against losses. Further, some REITs have high management and transaction fees.
Diversification/Counterweight to other assets
Low growth/Little capital appreciation
Subject to market risk
High management and transaction fees
How to Invest in REITs
You can invest in publicly traded REITs—as well as REIT mutual funds and REIT exchange-traded funds (ETFs)—by purchasing shares through a broker. You can buy shares of a non-traded REIT through a broker or financial advisor who participates in the non-traded REIT’s offering. REITs are also included in a growing number of defined-benefit and defined-contribution employer-sponsored retirement and investment plans. Naret, a Washington D.C. based research and advocacy firm for the U.S.-based REIT market, estimates 80 million U.S. investors own REITs through their retirement savings and other investment funds.
Nareit finds there are more than 225 publicly traded REITs in the U.S., which means you’ll have some homework to do before deciding which REIT will work best for your portfolio.
Be sure to consider the REIT’s management team and track record, and find out how they’re compensated. If it’s performance-based compensation, odds are they’ll be working hard to pick the right properties and choose the best strategies. Of course, it’s also a good idea to look at the numbers, such as anticipated growth in earnings per share (EPS) and current dividend yields. A particularly helpful metric is the REIT’s funds from operations (FFO), which measures the cash flow generated by the REIT's assets. Another metric commonly used with REITs is the Financial Management Rate of Return (FMRR).
Real World Example of a REIT
Another consideration when choosing REITs is to look at what sectors of the real estate market are hot. Consider what booming sectors of the economy, in general, can be tapped into via real estate. As an example, health care is one of the fastest-growing industries in the U.S.—especially in the growth of medical buildings, outpatient care centers, and elder care facilities and retirement communities.
Several REITs focus on this sector. HCP Inc. (HCP) is one such. With a market cap of nearly US$15 billion, it is a large company—large enough to be part of the S&P 500, in fact—and very liquid. Some 2.56 million shares trade daily. At $31.25 per share, as of April 5, 2019, it's trading near its 52-week high, and offering a dividend yield of 4.32%. Its recently restructured portfolio focuses on life sciences facilities—diagnostic centers, labs, genomics, and other facilities—medical office buildings, and senior housing.