A Beginner's Guide to Real Estate Investment Trusts (REIT)
April 10, 2022
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If investing in real estate seems impossible to you, consider learning about the real estate investment trust opportunity. You can invest in real estate and earn REIT dividends and capital appreciation with a small minimum investment and little to no work required.
What Is a REIT?
REITs or real estate investment trusts are shares of real estate companies investors can buy. By investing in REITs, investors indirectly invest in real estate. Since you own a fraction of the company, you own the real estate they invested in, but you don't have to do any of the work a landlord would do.
REITs sometimes invest in the equity side of commercial real estate, such as apartment buildings, office buildings, and retail real estate. They can also invest in the debt side of real estate investing, acting as the lender for real estate developers or builders, helping them finance real estate. These are called mortgage REITs.
Both equity REITs and mortgage REITs may pay dividend income. It depends on the type of investment and how the REIT handles them. Some REITs pay dividend income monthly, quarterly, or annually yet others reinvest the money back into the investment until maturity.
What Assets Do REITs Own?
REITs own a variety of income producing real estate. Many REITs have a niche, such as buying undervalued apartment buildings or retail real estate. Others, however, may diversify their investments in a variety of income producing real estate, including:
- Medical centers
- Shopping malls
- Apartment buildings
- Data centers
In the case of mortgage REITs, the asset is the mortgage the REIT funded. The real estate assets the funds paid for are the collateral. If the borrower defaults on the mortgage REIT, the company can take possession of the commercial real estate and sell it, distributing the proceeds to investors.
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How Do REITs Work?
REITs are required to pay out 90% of their profits to shareholders. They do this by making real estate investments that produce income, aka pay rental income. REITs then distribute the dividends to their shareholders. This is taxable income investors earn, but it's an easier way to invest in commercial real estate without requiring a lot of money or the responsibility of owning real estate yourself.
You pay a fraction of the total asset when investing in either equity REITS or mortgage REITs. You invest alongside other investors, and the REIT pools the funds to cover the cost of buying the real estate or funding the mortgage loan.
Why Invest in REITs?
Real estate properties are historically a good way to diversify a portfolio. While there's no guarantee of a positive return, diversifying your portfolio with publicly traded REITs can offset the risk of investing only in the stock market.
REITs historically perform well, and many pay shareholder dividends, giving you a regular income that you can withdraw and/or reinvest. Real estate assets have a long history of long term capital appreciation, which may provide a decent return on your investment.
Fees & Taxes
Understanding the taxes and fees of any investment is important to determine if it's a smart financial decision. While you can offset the taxable income produced by REITs by investing in them with your IRA or Roth IRA, any money invested with taxable funds are subject to ordinary income tax.
As far as fees, always read the fine print. Most companies owning income producing real estate and offering REITs charge a percentage of your assets under management per year, but there could also be early redemption fees and other miscellaneous fees you might owe.
Types of REITs
There are a few types of REITs that are handled differently. Understanding how they are funded, managed, and the real estate property types they invest in can help you determine which might be right for you.
Publicly traded equity REITs are traded on the national stock exchange, such as the NYSE. Shares trade during regular trading hours and are regulated by the SEC. They are the more liquid way to invest in the real estate market since you can buy and sell shares during trading hours.
mREITs or mortgage REITs invest in mortgages, financing real property. They provide the funds developers and builders need to buy or build income producing real estate. mREITs earn interest on the loans, which they payout to shareholders as dividends.
PNLRs are publicly traded REITS that are non-listed. They are registered with the Securities and Exchange Commission, but they are not traded on public exchanges, such as the NYSE. They are less liquid because they are not listed and/or publicly traded.
Private real estate investment trusts are also not publicly traded. They are also not regulated by the Securities and Exchange Commission. They are the least liquid investment funds among your REIT options.
Like any investment, REITs have their peaks and valleys, but over the last 45 years, they have had an attractive rate of return compared to the stock market. Long term capital appreciation and investing in real property that has the potential to attract tenants and earn rental income is what gives REITs the attractiveness that individual investors prefer.
How to Buy and Sell REITs
There are a few ways to buy and sell REITs, but you should know that most REITs have a required investment timeline. You might pay early redemption fees if you need to redeem early, so always read the fine print before investing.
To buy publicly traded REITs, you can purchase shares through a broker like you would purchase stock shares. If you are interested in private equity and mortgage REITs, you can buy shares through a broker affiliated with the REIT.
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- Low minimum investment requirements
You can invest in real estate with a small investment, sometimes as little as $10. This removes the barrier to entry that owning real estate usually has.
- Publicly traded REITs are liquid.
You can trade publicly traded REITs whenever the market is open, which means you can liquidate your investment in a pinch should it be necessary.
- You might earn dividend income.
Most REITs pay some sort of dividend. While there isn't a guarantee they will, there is a good chance that a publicly traded REIT or private REIT will pay dividends.
- A great way to diversify your portfolio
Your investment advisor likely recommends diversifying your portfolio, and including real estate investments in your portfolio can be the perfect way to do it.
- REITs have a long timeline
With the exception of publicly traded REITs, you might be tied up in the investment for the long term. Non traded REITs can tie up your funds for several years without an option for early redemption.
- Dividends can be taxable income.
Talk to your investment advisor about the tax liabilities you might incur if you invest in a real estate investment trust that pays dividends.
- There's no guarantee of appreciation.
Real estate has a history of long term capital appreciation, but there's no guarantee. The housing crisis of 2008 showed us that anything is possible, so you should always be prepared.
Like any investment, there is the risk of fraud when investing in REITs. To protect yourself, always check with the SEC. Even non traded REITs are registered with the SEC. If you're investing in private REITs, do your due diligence on the advisor recommending the investment and the REIT itself.
Using the SEC's Edgar system is the best way to start your research, but don't be afraid to do your own research on real estate companies offering REITs to make sure they are legit.
Popular, Best-Performing REITs
REIT performance can change in the blink of an eye, but here are the current top-performing REITs available.
- Preferred Apartment Communities has a share price of $24.93 with a one-year return of 150.90%
- Blue Rock Residential Growth REIT has a share price of $26.53 and a one-year return of 172.57%
- NexPoint Residential Trust has a share price of $90.14 and a one-year return of 96.64%
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How Does a Company Qualify as a REIT?
For a company to qualify as a REIT, it must go through a rigorous process to prove the following:
- The company invests at least 75% of its assets in real estate
- The company pays out at least 90% of its profits to its shareholders
- Be a taxable corporation
- Have at least 100 shareholders
- Five or less shareholders cannot own more than 50% of the shares
- At least 75% of the gross income must come from rental income, interest on mortgages, or capital appreciation
What Is a Paper Clip REIT?
A paper clip REIT is a combination of two entities, one that owns the real estate properties and the other that runs them. It's not a common form of a real estate investment trust because the SEC regulations are so strict because of the risk of a conflict of interest. Still, it does afford companies more flexibility for operations that aren't typical of a REIT.
Can You Lose Money on a REIT?
Like any investment, there is always the risk of losing money on a REIT. While real estate has a decent performance history, there's no guarantee that it will continue. Therefore, it's best to diversify your portfolio to reduce the risk of a total loss.
Are REITs Safe During a Recession?
REITs have historically protected investors during a recession because they don't have the same reaction to the market as the stock market. While real estate isn't 100% recession-proof, it can provide more protection in a diversified portfolio.
How Much of Your Portfolio Should Be In REITs?
How much of your portfolio should be in REITs depends on your situation. Talk with your financial advisor to determine the right allocation based on your financial goals and risk tolerance.
REITs can be a great way to get your foot in the door with real estate investing. Even if you think you don't have enough money to own real estate, REIT investments can be the way to diversify your portfolio. In addition, you'll enjoy long term capital appreciation, dividends, and the pride that comes with knowing that you own a piece of commercial real estate. Take a look at our website to get started investing today!
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