Real Estate Investment Trusts: Ultimate Guide to REITs (What, How, Why, Who)

Real Estate Investment Trusts: Ultimate Guide to REITs (What, How, Why, Who)

Real estate investment may be a viable alternative for those with an eye for the long term. Unfortunately, investing in property requires a sizable sum of money upfront. Zillow estimates that the national median value of a home is $357,544. Most lenders require a minimum deposit of 20%.

That comes to roughly $7,1509. In contrast, conventional loans allow for a down payment as small as 3%. You'll need around $10,726.33, which is still a significant sum for many. What are your options if you don't have the capital to make a down payment on a house? Buying shares of real estate investment trusts (REITs) is one way to start investing in real estate without putting up a sizable initial sum of money.

REITs allow every investment-minded person to make money off valuable real estate, giving them access to dividend-based income and total returns (that may otherwise be out of reach) without buying, managing, or paying for a property.

REITs Defined

Real estate investment trusts (REITs) are companies whose primary business is to generate profits for their investors and shareholders by managing diversified portfolios of real estate and mortgage assets. REIT assets include retail establishments, office buildings, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans. The capital of several investors funds REITs. 

Rental, leasing, and eventual sale of the properties are the means through which REITS generates revenue. A REIT is not in the business of building real estate and selling it. On the other hand, a REIT acquires and develops properties to operate them as part of its investment portfolio.

How Companies Qualify as REITs

To qualify as a REIT, a corporation must meet specific Internal Revenue Service (IRS) requirements. These conditions include:

  1. Real estate investment trusts (REITs) must be taxed like corporations, not partnerships or individuals.
  2. A diversified collection of investors must possess REITs, and no one person or entity may control above 50% of the company's outstanding shares.
  3. Real estate and assets associated with real estate, such as mortgages on real estate, must make up at least 75% of a REIT's assets.
  4. Rents from real estate, interest on mortgages securing real estate, or real estate sales must account for at least 75% of a REIT's gross income.
  5. REITs must pay out dividends to shareholders in the amount of at least 90% of their annual taxable income.
  6. REITs are subject to certain corporate governance requirements, such as having an independent board of directors.

The REIT Directory is a comprehensive list of Nareit-member REITs and publicly traded real estate corporations. The directory is searchable and sortable by sector, listing status, and stock performance. 

How to Invest in REITs

Anyone can buy listed shares of the REIT on the stock market by purchasing through a broker. For non-traded (REIT), you'll need to buy through a broker authorized to sell the REIT's shares. 

A non-traded REIT is a type of REIT not listed on a public stock exchange, so it can't be bought or sold on the open market like other publicly traded securities. Instead, non-traded REITs typically raise capital through private placements or direct investment programs that offer shares directly to investors. 

Alternatively, you can invest in a real estate investment trust by purchasing shares in a mutual fund or exchange-traded fund (ETF). You'll need a brokerage account to begin trading. You can also add some of your regular 401(k) contributions to a REIT. If you have a traditional 401k, a real estate investment trust (REIT) may be available in your investment options.

Other Types of REITs

  • Equity REITs 

Equity REITs acquire, manage, and hold commercial and rental assets. Most equity REITs deal in specific asset classes, like data centers, self-storage, shopping centers, or healthcare facilities. They will fund these properties in many situations, but their primary objective is to generate profits through acquisition and management. They allow you to own a share of a portfolio of different commercial real estate properties. In exchange, investors get a percentage of the cash flow and profit the underlying assets bring in.

  • Mortgage REITs

These REITs give money to real estate owners and developers in the form of loans, and the interest on those loans is how they make money. They help people get the cash they need to buy real estate assets. Most of the time, they invest in residential mortgages instead of commercial ones. Still, they can purchase loans for any property that brings in money.

  • Public Non-Listed REITs

REITs open to the public but not traded on public exchanges are registered with the Securities and Exchange Commission (SEC). They sometimes focus on certain types of assets, but they aren't very liquid because they can't be bought and sold on public exchanges.

How REITs Have Fared Over The Years

Real Estate Investment Trusts (REITs) have usually done well over the long term, but their performance can change from year to year. According to data from the National Association of Real Estate Investment Trusts (NAREIT), REITs have outpaced stocks for over two decades, including the most recent full year of data (2021). The NAREIT Equity REIT index has returned an average of 8.34% annually over the past decade as of June 2022. The index returned 9.05% during a quarter century, outperforming the S&P 500's 7.97% and the Russell 2000's 7.41%. It's important to remember that past performance doesn't always predict future performance and that investing in REITs comes with risks.

Drawbacks to investing in Real Estate Investment Trusts (REITs)

Market and Interest Risks

Like any security, the value of REITs might rise or fall according to market forces depending on various circumstances, including the state of the real estate market and the REIT's financial situation. To the extent that interest rate fluctuations affect the value of real estate assets, REITs may be more vulnerable to such volatility than other investment vehicles.

Management and Leverage Risks

The success of a real estate investment trust (REIT) might be hindered by incompetence on the part of the management firm hired to oversee it. Real estate investment trusts (REITs) frequently employ leverage or borrowing money to increase the amount of real estate in their portfolios. This is a factor that increases REIT risk by adding to costs and raising the fund's losses if underlying investments perform poorly.

Dividend and Valuation Risks

If a REIT's underlying real estate assets are not profitable enough, the company may have to reduce or terminate its dividend payments. When valuing real estate investment trusts (REITs), it's essential to consider whether the REIT is overvalued or undervalued, as this will affect the price an investor pays and the REIT's future performance.

Limited Control

As a shareholder in a REIT, you have limited control over the assets and decision-making of the REIT.

Double Taxation

Real Estate Investment Trusts (REITs) are subject to double taxation on their earnings. In other words, the REIT is taxed on its revenue before taxing the dividends paid to shareholders.

Benefits of investing in Real Estate Investment Trusts (REIT)

Potential for Appreciation

Investors may benefit from price appreciation of the REITs underlying real estate holdings. The value of a REIT and the income it generates from its underlying assets both rise in tandem with the growth in the value of those assets.

Tax Benefits

Investors can get tax benefits from REITs, like being able to put off paying taxes on dividend income.

Diversification

Investing in a real estate investment trust (REIT) is a cheap way to diversify your portfolio, provide a steady stream of income, and is very good as a means of passive income.

Professional Management

Professional real estate firms oversee REITs, meaning they run the properties it owns on a day-to-day basis. Since seasoned experts manage the properties with local knowledge, this may help mitigate risk for investors.

High liquidity 

Real estate investment trusts (REITs) are publicly traded companies available to any investor. This implies that your money is not tied up. You can sell whenever you wish to.

3 Things to Consider Before Investing in REITs

Sector and Geographical Diversification

REITs offer investors a way to diversify their portfolios and potentially reduce risk. However, it's essential to consider the specific types of properties that a REIT invests in and ensure that it aligns with your overall investment strategy. 

Over-dependence on one sector can be risky. Vacant spaces or non-payments will affect the REIT's performance. Therefore, while choosing a REIT, ensure the asset portfolio is well-diversified across different sectors. 

Likewise, investing in real estate investment trusts (REITs) that own properties in multiple locations or countries helps you diversify your portfolio and reduce your exposure to the effects of adverse economic or market conditions in any one area.

Management

An important factor in a real estate investment trust's (REIT) performance is the caliber of its management. Look into the company's background and the experience of its management to gauge their expertise and experience. 

Fees

Management costs are frequently associated with REITs, which might reduce your returns. Understanding a REIT's fees and assessing their reasonableness in light of the projected returns are crucial.

Bottomline

Real estate investment trusts (REITs) and outright real estate ownership (REPOs) are two distinct investment vehicles with varying appeal and applicability. More profit is possible through direct ownership of real estate, but it also carries more risk and management duties. 

However, while REITs provide diversification and ease of access to capital, their returns and dividends typically fall short of those of outright real estate ownership.

Consequently, to choose the best investment strategy that fits your needs, goals, and risk tolerance, it is highly advised that you speak with a financial advisor or real estate professional.

Amaka Chukwuma is a freelance content writer with a BA in linguistics. As a result of her insatiable curiosity, she writes in various B2C and B2B niches. Her favorite subject matter, however, is in the financial, health, and technological niches. She has contributed to publications like Buttonwood Tree, FinanceBuzz, and Wealth of Geeks.