How safe are REITs? Do they only buy and sell properties, or can REITs invest in government securities and other safer instruments? We look at the answers below.
About REITs
A real estate investment trust (REIT) owns, operates, or finances income-producing real estate.
These trusts can work in a wide variety of real estate property types, some of which include:
- Healthcare
- Office buildings
- Telecommunication towers
- Commercial real estate projects
- Hospitality
- Apartment buildings
- Malls (and more)
Like mutual funds, they bring together investor money and employ it in buying assets – in this case, real estate.
There are three types of real estate investment trusts: Equity, Mortgage (mREITs), and Hybrid.
The first one buys/builds properties. But unlike other real estate companies, they do not resell what they buy or build.
Instead, they develop and operate real estate assets as part of an investment portfolio, making money primarily through leases.
mREITs create mortgages and buy mortgage-backed securities, which help finance real estate buyers by providing them credit.
Hybrids operate using both models.
REITs are tradable securities, which means they can be bought and sold on stock markets.
One of their key attractions as an investment vehicle is that they are legally obligated to distribute 90% of their net earnings as dividends to shareholders.
Due to this reason, they are one of the best sources of regular, passive income.
However, their capital appreciation is moderate at best.
REITs are also considered an excellent inflation hedge and a good means to diversify an equity-heavy portfolio.
What Is a Government Security?
A government security is any investment product that is offered by the government of a country.
For example, in the US, the term normally refers to Treasury bonds, notes, and bills.
These financial instruments are usually issued to raise funds for ongoing government operations, infrastructure or defense projects, etc.
They are backed by the government that issued them, which promises to pay back the principal invested on maturity.
Due to this reason, government securities are considered one of the lowest-risk financial assets.
However, they normally do not offer very high returns either.
Apart from principal repayment, some of them also offer periodic interest or coupons.
Government securities are tradable in the secondary bond market.
Investors can also choose to hold them till maturity.
Can REITs Invest in Government Securities?
A real estate investment trust is designed to have a specific focus on the real estate industry. Therefore, if a government-issued bond or security is relevant to the real estate market, they can buy it.
For example, we talked earlier about mREITs and how they deal in mortgage-backed securities.
US government-sponsored entities (GSE) can also release guaranteed MBSs from time to time.
Apart from that, some agency securities, such as those backed by Freddie Mac, Fannie Mae, and Ginnie Mae, also fall under the same category.
Therefore, mREITs can deal in all of these.
In fact, some of them specialize in trading only government-backed mortgage securities.
These trusts can leverage the guaranteed interest generated from such instruments.
They use the assured earnings to raise money at low rates from lenders and invest it elsewhere.
In fact, they might end up raising seven to eight times the money they get from investors.
Due to this reason, these firms often offer an excellent return on investment.
Such mREITs are amongst the highest dividend payers in the market, with yields even going above 10% at times.
In Which Securities Can REITs not Invest In?
There are certain legal obligations that all REITs must comply with.
For example, a minimum of 75% of their total assets must be in either cash, US Treasuries, or real estate.
Also, 75% or more of their gross income has to come from rents, property sales, or interest from mortgages that have been used to finance properties.
Another stipulation is that 90% or more of their taxable net income has to go to shareholders as dividends.
If they meet the above criteria, REITs can invest in other securities.
For example, mREITs can deal in commercial mortgages, non-agency mortgages, or ones that are guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.
Are REITs a Good Investment?
REITs can be a good addition to an investment portfolio. However, like all financial instruments, they have their pros and cons.
On the positive side, publicly traded equity REITs are very easy to buy and sell.
This allows retail investors to enter a market that is otherwise limited only to corporates and high-net-worth individuals due to the huge sums involved.
Moreover, they are an excellent source of passive dividend income and can offer decent capital appreciation.
Long-term total returns on these real estate funds are even better than the S&P 500.
REITs are allowed by the government to “pass-through” their dividends.
In other words, they are not taxed on income distributed to shareholders.
This process increases the amount available to distribute, hence making their yields even higher.
In fact, they are among the highest dividend payers in the market.
On the flip side, capital appreciation in REITs is nowhere near what can be achieved through equities.
This is partly because 90% of their earnings are returned to shareholders. Hence, there is little that can be reinvested.
Another problem is that investors receive dividends from regular taxable income, not capital gains.
Hence having them in your portfolio increases tax liability.
Unlike stocks, they might also have high management fees and transaction charges.
Lastly, private REITs are a very different cup of tea compared to publicly traded ones.
They don’t need to follow the disclosure requirements of the SEC.
Some use this to deceive investors with false data or misrepresent facts.
This is known as REIT fraud; unfortunately, it is not uncommon.
Investors should look at all facts and data very carefully before putting their money in them.
Final Thought
Henry Ford once said that his customers could get cars in any color as long as it is black.
In the same vein – REITs can invest in anything – just that it has to be related to real estate!
Government-guaranteed mortgage bonds and agency securities meant for the property sector are fair game for them.
In fact, a certain class of mortgage REITs specializes in working with these assets.
They leverage the assured returns on such securities to raise money and reinvest it in other mortgage opportunities.
This lets them offer very high returns to investors, with yields going over 10% at times.
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