REITs are often said to be a hedge against inflation and a good asset when markets are down.
But how do REITs make money? How do they perform well when everything else is going down? We explain REITs and how they work in detail below.
What Is A Real Estate Investment Trust (REIT)?
A real estate investment trust is a firm that acquires, funds, and/or manages income-producing real estate.
These trusts might operate a staggering variety of properties.
For example, they might run the show at apartment buildings, data centers, office buildings, retail shops, warehouses, and more.
The idea behind REITs is to pool investor money and employ it in the real estate market to generate income.
This makes the mammoth task of identifying and investing in this industry a lot easier for small investors.
In this sense, these trusts operate very much like a mutual fund or an ETF.
However, one unique feature of REITs sets them apart from other types of financial assets.
These trusts must give back more than 90% of their net taxable income as shareholder dividends by law.
This attribute makes them an excellent opportunity for investors looking for a steady, passive income.
Most REITs are traded on the stock market, just like other securities.
However, unlike shares, they are usually not considered a tool for capital appreciation.
How Do They Work?
Up until the 1960s, only large corporates and wealthy individuals could think of investing in real estate portfolios.
Congress changed all that by adding an amendment to the Cigar Excise Tax Extension.
This move ushered in the concept of real estate investment trusts.
Today, REITs operate in various sectors and are involved in almost every type of real estate.
This could include energy pipelines and cellphone towers to housing apartments and malls.
Most REITs choose to specialize in a specific segment of the real estate market.
For example, one may only focus on corporate offices, while another would build housing projects.
As mentioned earlier, the shares in these trusts are traded on major stock markets.
They are usually among the most liquid assets because of their high trading volumes.
What Qualifies as a REIT?
A firm can qualify as a REIT if most of its income and assets are related to real estate investing.
Moreover, it must distribute a minimum of 90 percent of its taxable earnings in shareholder dividends yearly.
REITs are allowed to deduct dividends paid in this way from their taxable income.
This is why some of them distribute nearly 100 percent of their earnings. In this way, they completely remove the need to pay corporate income tax.
Apart from this, here are a few other conditions that they must satisfy, as per law:
- They must follow all other rules of being a corporation apart from the exemption that we just mentioned.
- There should be trustees or a board of directors to manage their operations.
- Their stocks must be fully transferable.
- The REIT must have at least 100 shareholders at the end of its first year.
- More than 50% of the firm’s stocks cannot be held by five or lesser individuals in the second half of any taxable year.
- 75% of the company’s total asset must be in either cash or real estate assets.
- At the minimum, 75% of the business’s gross income must come from activities such as rentals, real estate sales, or mortgage interest.
- 95% or more of the firm’s gross income must come from real estate, interest, and dividends.
- No more than 25% of the company’s assets can be non-qualifying securities or taxable REIT subsidiary stocks.
How Do REITs Make Money?
Most REITs generate income by acquiring real estate assets and leasing out the space for rental income.
Most of the money they earn in this way is distributed back to shareholders.
There is one type that operates slightly differently, which is mREITs.
These trusts create mortgage loans instead of dealing in physical property.
REIT profits are based on the difference between the rate at which they raise funds and that at which they lend money.
Lastly, in either case, REITs also build long-term value due to appreciation in their underlying assets.
The eventual sale of such properties adds to their profits.
How Do You Invest In REITs
REITs can either be public or private.
For a publicly traded REIT, investors can buy them from the stock exchanges by opening a trading account with a broker.
Investors can also buy REIT mutual funds and ETFs instead of directly buying the security itself.
For private REITs, interested traders need to find a specialized broker who deals in their offering.
Types of REITs
REITs can be classified in two ways: mode of operation and means of buying and selling. Below, we explain both categories.
Mode of Operation
There are three broad classifications of these trusts based on the source of income:
- Equity REITs
- Mortgage REITs
The first one is the most common variety. These are trusts that own and operate real estate directly.
For example, they might buy office buildings, malls, hotels, hospitals, houses, etc.
As mentioned earlier, they earn their money through rental income and the resale of properties.
The second variety doesn’t deal in real estate directly. Instead, they fund real estate buyers and operators.
This can be done through loans and mortgages or by buying mortgage-backed securities.
Since their source of income depends on the rate at which they borrow and lend out funds, their earnings are deeply impacted by prevailing interest rates.
Hybrid REITs own property and loan money to real estate buyers and sellers.
Means of Buying and Selling
Another way to look at these trusts is how their shares are traded.
While most are publicly traded equity REITs, some are privately held.
In all, there are three broad categories:
- Publicly Traded REITs
- Public Non-Traded REITs
- Private REITs
The first one is the garden variety, which we have been discussing so far.
Their shares are listed on stock exchanges and are regulated by the U.S. Securities and Exchange Commission (SEC).
They need to meet the same stringent disclosure requirements as other shares.
Public non-traded REITs are also under the jurisdiction of the SEC but cannot be bought or sold on the markets.
Due to this reason, their liquidity is not as high as the publicly traded ones.
The last type is an entirely unregulated segment.
Neither do they follow the regulations of the SEC, nor can traders buy their units from stock markets.
There are different ground rules for these trusts, especially concerning minimum investment levels.
This makes them available only for institutional buyers and high-net-worth individuals.
Are There Fraudulent REITs?
Yes, there are fraudulent REITs.
While frauds can happen anywhere, in most cases non, private REITs are the culprits.
Since they are not governed by the SEC and do not follow the same disclosure norms as others, they can sometimes be very risky investments.
Some examples of REIT frauds include New York City REIT, Northstar Healthcare Income REIT, Cole Credit Property Trust, and more.
There are two ways in which these frauds happen:
Through REIT Managers
This could either be a case of intentional fraud or mismanagement.
For example, the REIT might have started in earnest, but speculation, greed, and risky trades could end up causing losses.
On the other hand, fund managers sometimes hide information or even misinterpret facts to attract more investors.
Brokers and Advisors
Brokers are usually motivated to fraud due to the extremely high fees and commissions from these trusts.
They may recommend these risky investments purely to make a quick buck for themselves, despite knowing the shortcomings.
REITs aren’t suited for all types of investors, and it is the job of advisors to explain this to their clients.
But sometimes, they might take gullible folks for a ride by showing them a rosy picture and hiding the realities of the product.
Advantages and Disadvantages
Like all investment avenues, REITs have their pros and cons. We discuss some of them below.
REITs make it easy for retail investors to enter the property markets without needing enormous capital.
They also offer an excellent opportunity to create a diversified portfolio that can withstand interest rates and inflationary impacts.
Another benefit of REITs is their steady, passive dividend income.
In times of market downturns, this regular flow of cash can be very useful for investors.
In fact, due to how they are designed, these securities offer some of the highest dividend yields in the market.
They can pay out so much because the IRS does not tax them against this money.
REITs simply “pass through” dividend income directly to shareholders without paying any tax. Taxation happens at the investor’s end.
This increases that they have available to distribute.
Taxation is very different for other firms – they pay corporate tax and distribute dividends from any free cash flow left afterward.
Again, REITs are one of the most liquid assets on the market and are traded in huge numbers.
This makes them less volatile than stocks.
Even though their dividends are one of the strongest aspects of REITs, it is also true that they are highly taxed at the investor’s end.
The government treats these monies as part of regular income for retail investors and taxes them accordingly.
That’s not the case with stocks, where earnings get taxed at beneficial capital gains tax rates.
Another thing folks should be wary of is their dependence on the interest rate.
Their fortunes can fluctuate very quickly when the Fed decides to make changes in its monetary policy.
And while we are at it, rates aren’t the only thing that can influence REIT prices.
They are very much subject to the vagaries of the sector in which they work.
For example, REITs that make their money through malls and retail properties are impacted by the growth of online retail.
One last thing – these securities can be expensive compared to stocks or ETFs.
Like mutual funds, sales commissions and management fees are involved in trading REITs.
Are REITs a Good Investment?
Yes, they are a good investment, as long as you are the right investor for them!
What we mean is that REITs are best suited for a certain class of market participants. Folks who are looking for steady incomes but don’t care as much about capital appreciation.
They are also suitable for investors looking to hedge their largely equity-based portfolios.
REITs are also nice to have when inflation comes a-knockin’.
If you want to touch and feel what your money is buying you – these securities will give you satisfaction.
But they are not meant for traders who would love to see spectacular growth in capital.
Neither will they be suited for folks who feel that commissions and expense ratios are a waste of money.
Hence the question should really be – is your investment strategy and expectation in line with what REITs can offer?
In one sentence, REITs make their money from real estate. Most of them buy or build property, lease it out and get rent in return.
A few don’t own assets – they just help finance them for others. These are called mREITs.
In either case, once the money comes to them, these trusts must distribute most of it to shareholders.
And no, that’s not something they do out of the goodness of their heart – there is a legal obligation to distribute 90% of taxable earnings.
Those who like the concept can trade REITs through their regular brokerage account. They are available to trade just like any other stock.
But not all of them might be available this way – some are privately traded.
Investors should think twice before trading in private REITs because there is less regulatory oversight and hence scope for fraud.
Lastly – REITs are not for everyone.
If you love steady, passive incomes, these securities would be right up your alley.
But if big capital gains are attractive, then stocks or derivatives would be a better bet.