Summary: In this ultimate guide, learn all about real estate investment trusts. Topics include what is a REIT, the main types of REITs, property sectors to invest in, how to invest in a REIT, are REITs a good investment, plus taxes and more.
Since 1960, people have used REITs to buy into larger-scale real estate investments that generate income. Real estate investment trusts can help diversify and grow portfolios. REITs can invest in a variety of real estate sectors and either own real property or finance it. Investors can then earn ongoing income in the form of dividends.
Investing in real estate through REITs can be a great way to get your feet wet, without having to buy actual property. Instead, you can simply buy into a real estate investment and let the REIT handle the rest. This type of real estate investing also offers a lot more liquidity than owning a rental property yourself–more on that later.
For the most part, REITs are publicly traded and have produced historically higher returns compared to the stock market. Having said that, not all REITs are equal and it’s important to understand the difference. The REIT is responsible for doing the proper due diligence in order to find a good investment property, which makes picking the right one that much more important. This article should help you understand how REITs work and what to look for before investing.
What is a REIT?
A real estate investment trust is a company that owns or finances real estate. A REIT will invest in rental properties (known as equity REITs), or finance the mortgages (known as mREITs), or both.
If you know how a mutual fund works, REITs operate similarly. Investors pool their money to build enough capital to fund a real estate project. It’s the REITs job to buy, manage and finance income-producing real estate investments. Individuals who have invested in the REIT should then begin earning dividends from rents collected or mortgage interest.
Real estate investment trusts can invest in all different types of property. Some REITs invest in commercial buildings like warehouses, retail centers, office buildings, or medical facilities. While others might specialize in buying residential real estate. There are benefits to every sector of real estate, it just depends on what you’re looking for.
How Do REITs Make Money?
Real estate investment trusts essentially make money through buying, owning, and selling property long-term. As real estate values increase, so do shareholders investments. As mentioned above, investors earn money from REITs in a couple different ways: through rents or mortgage interest.
The Difference Between Publicly Traded REITs vs Non-Traded REITs
REITs are classified by how they are bought, held and sold. Publicly Traded REITs are available to buy and sell on a national securities exchange. While public Non-Traded REITs are not traded, making them less liquid. However, they aren’t impacted by changes in the market, which brings additional stability to non-traded REITs. The SEC regulates publicly traded and non-traded REITs, while Private REITs are not.
2 Main Types of REITs
Equity and mortgage are the two main types of REITs. Equity REITs buy and own actual rental property. Mortgage REITs invest in mortgage-backed securities and mortgage-related assets.
Equity REITs are often referred to as just REITs because they’re the most common. This type of REIT owns and manages real estate and earns money primarily through rents. The bulk of equity REITs are publicly traded and vary across real estate sectors, i.e. commercial, residential, health care, etc.
mREITs don’t directly own real estate and make up only about 10% of all REIT investments. Instead, mREITs finance real property and earn interest on the mortgage.
Here’s how it works: mREITs borrow money at lower, short-term interest rates to then buy 15 or 30-year mortgages with higher interest rates. Investors make their money from the interest on the mortgage minus borrowing costs. This type of REIT acts much like a bank or insurance company and are often considered a financial stock, rather than a real estate asset.
Bonus: Hybrid REITs
Remember when I mentioned earlier that REITs can invest in both equity and mortgages? Say hello to Hybrid REITs, who both own properties and hold mortgages. However, it’s rare to find a REIT that does both.
Sectors of REITs to Invest In
There are a number of market segments in real estate to invest in, each with its own nuances. Below are many of the real estate segments REITs choose to invest in:
Almost a quarter of REIT investments are in retail–specifically shopping malls and unattached retail buildings. Owning the largest share of the REIT industry, the retail sector can be a smart investment if the retail industry itself is healthy.
Let’s use COVID-19 as an example: The pandemic continues to impact retail sales, particularly for small, local businesses with physical storefronts. If sales are dropping, retailers may have a very difficult time paying monthly rent. Retail properties with the strongest staying power include grocery and home improvement stores. As with any real estate investment, finding tenants with strong staying power is critical to success.
Keep in mind that retail REITs are increasingly competing with the online retail sector. Property owners are having to come up with creative ways to find tenants, not necessarily retailers, to fill their space.
This subsector of REITs includes residential properties. They include multi-family apartment buildings, student housing, manufactured homes, and single-family homes. There are even REITs that invest in section 8 housing.
Residential REITs should determine where to invest based on property type. Strong multi-family rental markets are usually in areas where there isn’t a lot of affordable housing, at least compared to the rest of the U.S., (i.e. Los Angeles, New York, San Francisco).
The best residential real estate markets are experiencing job growth, population growth and relative affordability. Jobs are an indicator of a growing economy. As people move to a metro area, rental demand should keep going up and vacancy rates should remain low.
How well a healthcare REIT performs is directly correlated to the healthcare industry. Baby Boomers make up the second largest generation today (behind Millennials). Due to the huge population of aging Baby Boomers in American, healthcare REITs will be an interesting segment to watch in the future.
The biggest issue with these types of REITs, especially right now, are the questions surrounding healthcare costs. With the presidential election just weeks away, there’s a lot of uncertainty in regard to how healthcare will be funded.
Office REITs buy office buildings. Businesses occupying buildings will typically enter a long-term lease and investors of the REIT will receive income from monthly rents. The best office REITs invest in markets with strong economies and a lot of employers.
More types of real estate investment trusts to consider:
- Industrial REITs own properties such as warehouses, factories, and distribution centers.
- Infrastructure REITs invest in assets that require the use of land or buildings. These properties include pipelines, communications towers and fiber optic networks.
- Hospitality REITs invest in hotels and/or resort hotels. REITs who own resort hotels earn income from the hotel itself plus income from any restaurants and retail shops on property.
- Timberland REITs earn money by owning forest land and selling the lumber from that land.
What Qualifies a Company as a REIT?
There are several guidelines a company must meet in order to qualify as a reputable REIT. The company must:
- Invest at least 75% of its total assets in real estate
- Derive at least 75% of its gross income from rents, interest from financing a mortgage on real property, or real estate sales
- Distribute at least 90% of its taxable income every year to shareholders via dividends
- Be an entity that is taxed as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders
- Have 50% or less of its shares owned by five or fewer shareholders
How to Invest in a Real Estate Investment Trust?
According to Nareit, a research firm specializing in REITs said that around 87 million investors in the U.S. are shareholders in a REIT–either through their retirement savings account or other investing funds.
The safest and easiest way to invest in a REIT is to go through your broker, investment advisor or financial counselor. These professionals are aware of your financial goals and can offer recommendations for REITs with the best income-producing assets.
Are REITs a Good Investment?
For the past two decades, REITs have produced better returns than the S&P 500 Index and outpaced the rate of inflation. They can provide steady cash flow and long-term appreciation potential. With every investment, REITs come with their own benefits and drawbacks.
The benefits of REITS include the following:
- Cash flow
- Lower risk returns
The drawbacks to investing in REITs include:
- Lower appreciation
- Dividends may be taxed as ordinary income
- Subject to market fluctuations
- Potentially high management costs and transaction fees.
How REITs are Taxed
According to the IRS, qualifying dividends from investments are taxed as ordinary income (up to a max rate of 37% until 2025). Unfortunately, REIT dividends usually don’t meet the IRS’s requirements and are taxed differently.
REITs are pass-through businesses so non-qualifying dividends will get a 20% QBI (qualified business) deduction. Meaning only 80% of the income made from an REIT is taxable. Some distributions from REITs might be taxed as ordinary income, while a portion might qualify as a return of capital, making it non taxable income.
The not-so-good news is that understanding how REITs are taxed can be a bit complicated. The great news is that your REIT brokerage should send tax forms with everything already broken down for you.
Real estate investment trusts or REITs are just another way individuals can invest in real estate. Adding a physical asset, like rental property to your portfolio is an excellent way to minimize overall risk through diversification. REITs allow investors to buy income-generating real estate, without having to actually own and manage the investment property themselves.
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