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What is an REIT?

definition

Real Estate Investment Trusts (REIT) own and manage different types of property (commercial, residential, infrastructure, medical, etc.) — that gives REIT shareholders access to real estate without buying real estate.

🤔 Understanding an REIT

What are REITs? In their most basic form, they are companies that own property on behalf of shareholders/investors. Strangely enough, REITs were born out of an excise tax on cigars in 1960. President Eisenhower signed off some additions to a federal law, which paved the way for the creation of the industry that now manages real estate investments. REITs are attractive to investors because they offer a diversified approach to property ownership, without the REIT shareholder actually owning a specific property themselves. However, REITs are quite different from other investments in that they are subject to some strict rules.

example

Two time-poor college friends decide to invest in commercial property. They have limited experience and bankroll, so they choose a small real estate investment trust company over purchasing commercial property directly themselves. They invest $100k each, and the company buys a factory in a neighboring town. The friends begin receiving rent from the property. By investing in a REIT, they gain exposure to the real estate market without the risk of buying a single individual building themselves.

Takeaway

Houses can be complicated...

REITs try to simplify that. By bundling properties together and packaging them into a single investment, REITs allow investors access to the real estate market that can be more complicated to take on alone. There are unique tax-related issues and liquidity elements that make REITs different than buying an individual house or building, but their purpose is to simplify that type of investment.

Tell me more...

What are the different REIT structures?
How do investments qualify as a REIT?
What are the Pros and Cons of REITs?
Timeline
How do you invest in REITs?
Owning a House vs. Owning a REIT

What are the different REIT structures?

There are four types of REITs: 1. Equity 2. Mortgage 3. Private 4. Public non-listed

Many real estate investment trusts fall into the equity category as they are usually listed on a stock exchange and generate income from rental returns.

Mortgage REITs, on the other hand, make their money from the financing and debt side of the property. Income for these trusts will come in the form of interest payments on mortgages. They can be higher risk as bad mortgages can lead to write-downs. The global financial crisis unearthed some systematic issues in the sector, particularly when it came to mortgage-backed securities.

Private real estate investment trusts are focused on institutional space. They do not require SEC registration/approval as they are targeting accredited investors (people or businesses who have the green light to trade certain securities that might not be regulated.).

Public non-listed REITs are similar to equity REITs; however, they are not publicly traded. Investors usually access these types of trusts through either a financial advisor or another intermediary.

How do investments qualify as a REIT?

Several criteria must be met before the property manager can qualify for a REIT

  • Shareholder base: The company must have a broad base of over 100 shareholders, with 50% of shares not controlled by five or fewer parties. To qualify as a REIT, a company must have a limited number of controlling parties.
  • Fully invested: 75% of the total investment pool needs to go into the property, while the same percentage of income must come from rentals.
  • Dividend happy: 90% of the income generated by the REIT must be distributed to shareholders.
  • Structure: Only taxable companies and corporations qualify as a REIT.
  • Board: The company must have an active board with a prescribed number of directors.

(Source: SEC, 2012)

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What are the Pros and Cons of REITs?

The sector has grown over the last few years — significantly. There are now estimates putting the total property assets owned by REITs at the $3T mark. (Source: NAREIT, 2019). According to the industry representative body NAREIT, 80Mpeople in the US alone invest in REITs.

Why are the benefits of REITs? Let’s take a look at some of the obvious and not so obvious benefits of investing in REITs.

  • Flexible: Unlike traditional property, some REITs can be bought and sold within an afternoon on the stock market and the cash available in three days. When we refer to flexibility, we really mean liquidity.
  • High Dividend Pay-out Ratio: For a company to qualify as a REIT, they must adhere to the pay-out rule, which states that 90% of income must be distributed to shareholders.
  • Diversified: REITs can offer true property diversification. A shareholder can get access to different types of property, including commercial, medical, and infrastructure. These would have been inaccessible to most direct property investors due to the very nature and size of investment required.

Some of the drawbacks of investing in REITs include:

  • Limited Tax Benefits: Income that is paid out to investors via a dividend is taxed at as income. For most, long-term capital gains are taxed at a rate lower than income.
  • The 90% rule: Although a positive aspect, it can also be a drawback and stunt growth. As REITs are required to redistribute most of their income, there is a limited amount of cash available for new projects or investments.
  • Underlying Valuation: REITs are at the mercy of the properties in their portfolio. In the event of a financial crisis, and write-downs on property values, REITs may be susceptible to heightened volatility and poor market performance especially during periods of increasing interest rates.
  • Fees: They’re an important part of the REIT ecosystem. Fees may be higher than some other investments.
  • Some REITs are not as liquid as those trading on an exchange resulting in longer wait times for proceeds and/or principal loss.

Timeline

1960 REITs are born.

1960 The first 6 REITs are created.

1961 NYSE saw its first REIT listing.

1969 International Adoption - Europe releases its first REITs.

1974 Foreclosure property laws come into effect, allowing REITs to hold foreclosure assets.

1976 Tax Reform Act comes into effect – REITs can be structured as corporates.

1989 Real Estate bubble bursts.

1993 “Five or Fewer Law” comes into effect, allowing pension funds access to the REIT market.

2000 First REIT exchange-traded fund is launched.

2001 Standard & Poor adds the first REIT to its S&P 500 index.

2008 REIT Investment Diversification Act opens the door to great REIT buying power.

2014 $3 trillion real estate investment trust asset mark is reached. This is the total amount owned and managed by REITs globally.

2019 Record $19.2 billion raised for REITs in 1st half of the year.

How do you invest in REITs?

Investing in listed equity or mortgage REIT can be a straightforward process — they’re typically listed on NYSE, Nasdaq, and other major stock exchanges. An investor will be eligible for the dividend in these companies if they are holding the shares on the record date. Publicly non-listed trusts, on the other hand, are not as easy to access and in most cases, the investor will need to apply through a financial advisor or intermediary. We have not touched upon Private REITs as they are only available to institutional and accredited investors (people or businesses that have the green light to trade certain securities that might not be regulated) and come up rarely in conversation.

Owning a House vs. Owning a REIT

They’re not the same thing. REITs are usually diversified when it comes to their property investments, as they don’t want to take on too much risk. Purchasing and owning a single property like a house is concentrated risk. This means the owner cannot offset any changes in market conditions.

A key differentiating factor between owning a house and a REIT is the number of available investing options. Investors who purchase REITs can get exposure to different property types, including commercial, infrastructure, healthcare, etc.

Liquidity is also another factor when comparing the two. If an investor wishes to exit a listed equity or mortgage REIT, they can sell their shares via their brokerage account. The whole process from start to settlement could be a matter of days. Selling a house, on the other hand, could take weeks if not months and could prove costly when you take into account agent commissions and other costs associated with preparing a house for sale.

There is also an emotional aspect to owning a house, which cannot be replicated by a REIT. The New York Times in 2018 wrote an article on this very subject, highlighting how an association can influence decision making, particularly when it comes time to sell. (Source: NY Times, 2018) 20191028-996026-3001801

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