A Real Estate Investment Trust (REIT) is a company or corporation that owns or finances income-generating real estate properties on behalf of shareholders. A REIT is like a holding company for real estate.
The portfolio of properties owned by REITs are often within a specific sector.
REITs use the money of investors to purchase properties that can generate income from rents or interest on the property and by law; they must payout 90% of their total annual profits in dividends to shareholders.
The tax on dividends received by shareholders is low.
REITs make it possible for any individual to earn income from real estate without being directly involved in the work and stress associated with owning real estate properties.
What is a REIT?
For a company to be regarded as a REIT it needs to make a REIT election by filling a Form 1120-REIT with the IRS, which excludes it from corporate tax and prevents the double taxation of shareholders’ income.
It must also meet the following requirements as stated by the SEC and IRS:
- The company must exist in any of the states as a corporation taxable for federal purposes except for its REIT status.
- A REIT must have at least 100 shareholders after the second year of operation.
- 5 or fewer individuals should not hold more than 50% of the company’s shares during the last half of the taxable year.
- The shares of REITs must be transferable and a board of trustees or directors must manage the company.
- At least 75% of the gross income of a REIT must be from real estate or real estate-related sources. This means that it should invest 75% of its total assets in real estate.
- A REIT cannot own more than 10% of the voting rights on any corporation except if it is another REIT, a Qualified REIT Subsidiary (QRS), or a Taxable REIT Subsidiary (TRS).
- Service fees or non-real estate businesses classified as non-qualifying sources should not constitute more than 5% of the company’s income.
- REITs by law must pay at least 90% of their taxable income as dividends to shareholders annually. If it retains its income, it will pay taxes like every other company.
REITs by law must mail letters to all its shareholders requesting details of beneficial ownership of shares annually. If the REIT fails to do this on time, it faces penalties.
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Types of REITs
There are two major REITs categories: Equity REITs and Mortgage REITs.
Equity REITs generate most of their revenue from rents on properties they own. About 90% of all REITs are equity REITs. Equity REITs can own either residential or commercial real estate properties.
Equity REITs appear more financially stable because they earn revenue from the monthly cash flow of rents that tenants pay.
The four major kinds of equity REITs are:
- Retail REITs: Retail REITs invest in freestanding retail locations and shopping malls. They earn income from the rent that the tenants of these properties pay. In fact, 24% of all REITs are retail REITs.
- Office REITs: This type of equity REIT invests in commercial office buildings and earns revenue from long-term tenants. The tenants sign a lease agreement that lasts between three to ten years. Office REITs are usually in urban centers where there is job growth.
- Residential REITs: Residential REITs own residential properties. Data shows that REITs own 2% of residential apartments in the U.S. They usually invest in apartment buildings that have nothing less than five units and multi-family properties with 2 to 4 units. Just like office REITs, residential REITs also focus on urban centers with increasing population and job growth. In 2018, residential REITs outperformed the broader REIT sector, with dividend yields averaging 3.97% in one year.
- Healthcare REITs: There are 33 health care REITs worldwide with a market capitalization that exceeds 127 billion dollars, and 90% of health care REITs are in the US. Healthcare REITs invest in health-related real estates such as nursing facilities, hospitals, retirement homes, and medical centers. The Healthcare sector accounts for about 17% of expenditure in the US GDP. They generate revenue from Medicare reimbursements and occupancy fees. The dividend yield paid by Healthcare REITs is higher than those of companies in the global real estate index.
Mortgage REITs purchase existing permanent mortgages with a high-interest rate and they make their money off interest payments.
They make a profit on the spread between the short- term and permanent interest rates.
Mortgage REITs can be either residential or commercial.
Investing in mortgage REITs is risky. Mortgage REITs only make up about 10% of all kinds of REITs; this is because mortgage REITs operate with high leverage and this makes them volatile. Before you invest in mortgage REITs you should definitely pursue more investor’s education.
How to Invest in REITs
REITs make their profits through Funds from Operating (FFO) and you can calculate this by adding the net income of the company plus the amortization and depreciation minus gain on sale of properties.
FFO = (net Income) + (depreciation and amortization) – (gain on sale of property).
Depreciation is included in the calculation because the annual depreciation expense of the many real estate assets of REITs distorts earnings negatives. Because the gains on the sales of properties are removed, REITs can reinvest them.
The best way to invest in REITs is to invest in an already existing REIT.
You can invest in REITs by directly buying its shares or by investing in a scheme like an authorized Unit Trust, which invests in REITs.
You can get REIT shares by investing in REIT mutual funds or REIT exchange-traded funds (ETFs). ETFs are regulated investment companies that raise investment capital by selling their shares to investors. They then invest the money received from the sale of the shares in specific investment objectives.
Publicly Traded REITs
These kinds of REITs are similar to stocks and ETF as you can buy and sell them on public exchanges like the Nasdaq or the New York Stock Exchange. There are over 225 publicly-traded REITs in the U. S.
There is no minimum or maximum amount for the purchase of publicly-traded REITs. For every trade made, an online brokerage fee of about $8 to $10 is charged.
Investors receive quarterly or monthly dividends that equals 90% of their profits. Assets of investors in public REITs constantly appreciate and grow in value depending on macroeconomic trends and the performance of the company.
A lot of people prefer to invest in publicly-traded REITs because they are highly liquid and have stable growth. They also do not have to pay upfront or annual service fees.
Publicly traded REITs by law must give quarterly financial reports and comply with other financial reporting requirements to increase transparency and accountability.
You can find good publicly-traded REITs to invest in on platforms like Dividends.com, where more than 200 publicly-traded REITs are listed on the website.
These companies meet IRS requirements but they’re listed with the SEC on an exchange. Private financial advisors or private brokers sell privately traded REITs.
Unlike Publicly traded REITs that are free, privately-held REITs charge about 10 to 16% upfront fees. Privately traded REITs can sell securities to accredited investors who have an annual salary of at least $200, 000 or a net worth of $1million.
Privately held REITs are not transparent because they do not need to adhere to the reporting standards that Publicly-traded REITs are subject to. They do not have to comply with the rules of public cooperation.
Also, investors can’t access their investment for the first 2 to 3 years after investing in privately-held REITs.
When this period is over, they can withdraw their investment. Withdrawals of privately-held REITs are known as redemptions. Despite the three-year period, the managers of private REITs can decide to indefinitely restrict redemptions.
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Advantages of Investing in REITs
There are many advantages REITs investments have over individual real estate investments:
- Yields tend to be quite high. According to Nareit, about 80 million investors in the U.S own REITs through investment funds and retirement savings and in 2018, REITs in the United States yielded more than other income-generating investments. Investing in REITs diversify your portfolio and helps in the preservation of the total value of your investment.
- Investing in REITs provides a reliable source of passive income for investors. Unlike individual real estate investments, REITs Investors do not have to bother with the buying and selling or renting and maintenance of real estate properties.
- REITs have professionals who handle every aspect of the properties (including the legal work) in a way that yields high profit. At the end of the quarter, investors get a share of the profit in the form of dividends.
- Most REITs are larger than individual real estates in terms of the properties they own. This makes them more solid and less volatile.
- Transparency. Publicly traded REITs by law must give a regular report to shareholders. This transparency subjects their activities to market scrutiny and enables investors to be in the know of all that goes on in the company.
- REITs enable individuals to invest in properties that are too expensive for them to own as individuals. REITs stocks are also liquid; you can easily buy and sell them.
Check out our post: Are REITs a Good Investment?
So, Is a REIT a Good Investment?
Investing in REITs is a great way to diversify any investment strategy and also a great way to invest in real estate without having to own any physical properties on your own.
While some people might enjoy being a landlord, the hands-off benefit of REITs make them attractive investments. If you want to learn more about investing in Real Estate, check out my top picks for Best Real Estate Investing Books!