If you have ever wanted to dip your toes into commercial real estate, without the purchasing and management responsibilities, Real Estate Investment Trusts (REITs) are the way to go. This increasingly popular investment is a great way to expand your portfolio beyond traditional stock and bonds.
A REIT allows individual investors to put capital into large-scale real estate like hotels, shopping malls, apartments, office buildings, warehouses, and more. Typical commercial real estate companies develop properties to resell. However, with a REIT, properties are developed to be operated as part of an investment portfolio.
How Do REITs Work?
In 1960, Congress created REITS to provide individuals the opportunity to earn returns on investing in real estate. Similar to how you purchase stock for other industries, real estate investment trusts are purchased through stock, mutual funds, or exchange traded funds (ETF). You then become a shareholder of the REIT. As a shareholder, you earn a portion of the income produced through the investment, without having to own or operate the property yourself.
The IRS then set standards that REITS are required to meet. The one that has the biggest draw for investors is that REITS are required to provide shareholder dividends yearly, based on a minimum of 90% of the taxable income.
REITS earn returns from the income generated from property, typically from tenant rental payments.
What Qualifies as a REIT?
There are two main types of REITS – publicly traded REITS and non-traded REITS. Publicly traded REITs can be purchased on the stock exchange. They are registered with the SEC. Non-traded REITs are also registered with the SEC, but are not traded publicly.
While these REITs are required to be registered with the SEC, non-traded REITs come with added risks, like lack of liquidity and higher fees.
As mentioned above, the IRS has set rules that REITS are required to meet in order to qualify. Besides providing a minimum of 90% taxable income as dividends, REITS must also:
- Invest 75% or more of total assets in cash or real estate
- Have a minimum of 100 shareholders after the first year
- Receive 75% or more of gross income from real estate, including property rents, interest on mortgages, or sales of real estate
- During the last half of the taxable year, have less than 50% of shares held by fewer than five individuals
- Be a taxable corporation
- Be managed by a board of directors or trustees
When REITs are qualified and follow the rules outlined by the IRS they do not have to pay tax at the corporate level. This allows them to grow and pay out larger dividends than other companies can.
What Is a Real World Example of a REIT?
Before investing in a REIT, you should do your research to look at the current real estate market. Determine which sectors are booming. This will help provide a reliable return.
Since healthcare is an ever-growing industry, in fact it is one of the fastest in the United States, there are several REITs that you could choose to tap into this growth. Eldercare facilities, retirement communities, medical buildings, and medical facilities can all be found in REITs.
A prime example of this is Sabra Healthcare REIT (SBRA). This REIT invests in over 430 properties in the US and Canada. As one of the highest-yielding health care REITs, the current dividend is 8.13% (as of early 2021).
How Can I Invest in REITs?
Currently, there are over 225 publicly traded REITs within the United States. When you have done your research and are ready to invest, you can purchase shares through your brokerage account. Your broker or financial advisor can also help you buy shares of non-traded REITs, if it is something they offer.
What Is the Average Return on REITs?
When considering your long-term investment strategy, REITs are a fantastic option. They are a favorable choice and tend to outperform the stock market more often than not. Although it should be mentioned, past performance cannot guarantee the same return on investment.
Depending upon which sector your REIT is in, you can often see a reasonable return of 5-10 percent, sometimes even more.
Types of REITS
There are multiple categories that REITs can fall into. They all have their own characteristics, so before you invest you should do your research to understand the investment.
Equity REITs are the most common. They own and manage real estate that produces income, typically from tenant rent. The income is then passed on to investors through annual dividends. They do not buy and resell properties.
A mortgage REIT does not own the property, similar to equity REITs. However with mortgage REITs, they do own the debt backed by the property. For example, if you take out a mortgage to purchase a property, you typically pay your lender the monthly payment. However, your lender might sell the mortgage to a REIT. You would continue to own and operate your property but pay your mortgage to the REIT. The REIT then collects all the monthly payments from these mortgages over time, passing the dividends on to investors.
This type of REIT is quite risky, although the risk tends to come with higher dividends.
Hybrid REITs are just that – a hybrid of equity and mortgage REITs. Their portfolios include both properties that they own and operate, and mortgages for commercial properties.
Publicly Traded REITs
As aforementioned, publicly traded REITs are traded on an exchange. They can be purchased through your brokerage account and tend to have higher transparency than non-traded REITs. Publicly traded REITs are also more liquid, meaning you can buy and sell them easily.
Public Non-Traded REITs
On the flip side, non-traded REITs are not available on exchanges. They have to be purchased through a broker that takes part in non-publicly traded offerings. These REITs are hard to value and highly illiquid.
Last but not least are private REITs. These REITs are typically exempt from SEC registration, which makes them hard to value and trade. They also have fewer disclosure requirements, which make them riskier than the other REIT options.
What Is REIT Fraud?
You should be aware that REIT fraud is possible. That is why the SEC recommends that you should avoid investing in REITs that are not registered. Both publicly traded and non-traded REITs can be found through the EDGAR system. This system allows you to review the REITs quarterly and annual reports, and any offering prospectus.
If a broker or financial advisor recommends you purchase a REIT that is not registered with the SEC, you should be wary and proceed with caution.
Benefits & Disadvantages of REITs
With all investments, no matter which vehicle you choose, there will be some form of advantages and disadvantages. REITs are no different.
Benefits of REITs
- Liquidity – publicly traded REITs are highly liquid, making them easy to buy and sell on public exchanges.
- Diversification – adding real estate to your portfolio is a great way to diversify and add dividend-based income.
- Transparency – Because REITs are registered with the SEC, you have access to all the pertinent information you need before investing.
- Regular cash through dividends – REITs pay out annual dividends to shareholders.
Disadvantages of REITs
- Illiquidity – If you invest in non-traded REITs, they are very illiquid.
- Taxes – Your dividends will be taxed as regular income.
- Higher fees – REITs have the potential to have higher transaction and management fees.
- Low Growth – Because REITs provide 90% of income to shareholders through dividends, they have only a small percentage to be reinvested to buy new holdings.
Adding REITs to Your Portfolio
It only takes minutes to add a REIT to your portfolio if you already have a brokerage account. But before you do, do your due diligence to make sure you understand the risks and reward with the REIT you are looking to invest in.
You should also consider working with your financial advisor. They can provide you with tips about investing in REITs. For example, it might make sense for you to keep REITs inside an account like an IRA, that is tax advantaged. Since REITS pay such large dividends, you will be able to defer the distributions.
No matter what you decide, REITs are a fantastic option to diversify your portfolio. Just be sure to not fall for any REIT scams and you should have a great long-term investment.