What is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is an investment fund or security that invests in income-generating real estate properties. The fund is operated and owned by a company of shareholders who contribute money to invest in commercial properties, such as office and apartment buildings, warehouses, hospitals, shopping centers, student housing, hotels, and timberlands. A real estate investment trust will receive special tax considerations, offer high returns for investors, and can be publicly traded on the stock exchange.
What are the Requisites for Managing a REIT?
Like mutual funds, real estate investment trusts allow both small and big investors to acquire ownership in real estate ventures. It is governed by a law that intends to provide investment opportunities and strong income vehicles. In other words, it is similar to stocks traded in the market.
Reits have the following requirements:
- All REITs should at least have 100 shareholders or investors and none of them can hold more than 50% of the shares
- Must have at least 75% of its assets invested in real estate, cash, or treasuries
- Gross income of 75% must be obtained from real estate investments
- Must pay dividends equaling at least 90% of their taxable income to shareholders
- Must be managed by a Board of Directors or Trustees
What are the Three Types of REITs?
- Equity REIT – commonly used REITs that invest in properties. Income is generated in the form of rent, mainly from leasing office space, warehouses, and hotels, which is eventually distributed as dividends to shareholders.
- Mortgage REIT – earnings are generated from mortgages via lending money to real estate owners or buying existing mortgage-backed securities. The margin between the interest earned on mortgage loans and the cost of funding these loans is the income derived from this investing activity.
- Hybrid REIT – combination of investing in properties and mortgages by owning properties while extending loans to real estate investors. Revenue comes from both rent and interest income.
What are the Benefits of Investing in a REIT?
- Transparency – REITs traded on major stock exchanges operate under the same rules as other publicly listed securities for regulatory and reporting purposes.
- Liquidity – Shares can easily be sold and bought in the market.
- Dividends – provides a stable income stream for investors, as 90% or more of the profits are returned to them.
- Diversification – having a REIT in an investment portfolio is an advantage when other stocks or securities are down because it usually performs better than the rest. It has a low correlation to the performance of other asset classes.
- Performance – historically proven to perform well due to the steady long-term appreciation of commercial properties.
What are the Drawbacks of a REIT?
- Slow growth – since 90% of the profit is given back to investors, only 10% can be reinvested back into the business.
- Higher tax payment – dividends are taxed the same as regular income instead of the 15% rule that most dividends fall under.
- Investment risk – can be significant because of factors that may affect the real estate market, such as: property valuation, interest rates, debt, and geography and tax laws; therefore, due diligence must be exercised.
- Management fees – some REITs charge high transaction and administrative fees, which tend to lessen the net payout to investors.
- Minimal control – investors can’t control operational decisions, such as the ownership of properties and the strategies applied to market trading.
Learn more with the resources listed below and in EY’s 2016 REIT Report