If you’re new to the world of REITs, and you don’t know what a real estate investment trust is – Here is a simple definition to get you going:
A REIT is a particular company that enables investors to jointly pool their money to invest in different real estate assets. In other words, a REIT collects mutual funds from thousands of investors. Then, it uses the managed funds to invest in a variety of income-generating real estate properties. This is interesting because it allows everyday investors and Americans to invest their money in real estate.
REITs are one of the largest industries in the united states. In fact, this industry has witnessed constant growth since 1975 and reached a peaking growth in 2021 – with a market cap of 1.74 billion-dollar.
On top of that, REITs are an essential contributor in the U.S economy, especially when it comes to providing jobes. For instance, REITs alone offer the market 3 million jobs that generate 229 billion-dollar in labor income. This illustrates the great economic contribution of REITs in the U.S.
How does a real estate investment trust work?
Generally, a real estate investment trust works in three different ways:
- A REIT purchases real estate properties and sells them to tenants.
- Builds properties from scratch then sell/rent them to tenants.
- Manages the financial side & mortgages of properties (loans).
Most REITs specialize in one particular real estate sector. However, REITs can invest in variety of different real estate sectors, which allows for a more diversified portfolio. Moreover, the majority of REITs are publicly traded. This allows investors to buy/sell them in the form of stocks.
What does a company need to qualify as a REIT?
It is important to understand that buying & selling real estate properties doesn’t classify a company as a REIT.
In fact, there are certain conditions that must be met for a company to qualify as a REIT. And They include:
- A REIT must invest 75% of its assets in the real estate sector.
- REITs must be built and operate as a corporation with a minimum of 100 shareholders.
- Every real estate investment trust must generate 75% of its income from its invested assets in real estate.
- A REIT must limit investors to owning no more than 10% of its shares.
- Every REIT must pay at least 90% of its taxable income as dividends to its shareholders.
Why do some companies go REIT?
To qualify as a REIT, companies must go through a daunting process and meet strict requirements. This brings us to the question: Why do some companies choose to be REIT?
Well, the answer lies in taxes. Most companies that strive to be classified as REITs are motivated by tax advantages.
For instance, when a company is qualified as a REIT, it doesn’t pay any corporate taxes. And it doesn’t matter how much profit it earns.
What are the main types of REITs
REITs can be divided into three main types or categories:
- Equity REITs
- Mortgage REITs (mREITs)
- Hybrid REITs
This category of REITs owns & manages different types of real estate properties. This includes shopping centers, malls, houses, apartment buildings…, etc. Equity REITs generate income by selling properties or leasing space to tenants.
Mortgage REITs (mREITs)
By definition, mREITs invest in mortgages, mortgage-backed securities, and other mortgage-related assets. mREITs are different because they don’t own physical real estate properties. Instead, they generate their income from the interest on mortgages.
This real estate investment trust combines both of the above types of REITs. In other words, it invests both in equity REITs and mREITs. This option aims at reducing risks while providing more flexibility to investors.
That’s why it is an ideal choice for investors who are uncertain about which type to invest in. Another reason why investors choose hybrid REITs is that it allows them to have a diversified and adaptive portfolio. So, depending on the economic condition, they can easily switch from equity REITs to Mortgage REITs and vice versa. This helps investors minimize risks and adapt to economic fluctuations.
However, the main three types we’ve mentioned so far aren’t the only types. Interestingly, there are other common types that you can invest in. They include:
- This type of REIT specializes in residential properties like apartments, multifamily properties, and single-family homes.
- Office REITs invest in office buildings and self-storage properties.
- This real estate investment trust owns and manages industrial properties like distribution centers, warehouses, and factories.
- Healthcare REITs invest solely in medical properties. This includes hospitals, senior housing, medical centers…, etc.
Retail & hospitality REITs
- These REITs invest in hospitality and commercial properties such as hotels, malls, shopping centers, stores…, etc.
A cool fact:
What makes investing in REITs great is that it allows investors to invest in any type they want or all at once. So, as an investor, you’re not limited to one type. This is why REITs are effective if you seek to diversify your portfolio.
Pros & Cons
Like every other investment, investing in REITs has benefits & risks. So, in this section we will see some of the pros & cons of investing in a real estate investment trust:
Diversifies your portfolio
REITs are ideal for diversifying your overall portfolio into a different asset class like real estate. That’s because real estate is a distinct sector and not tied to other stock sectors. For example, tech stocks, such as Apple, or automotive stocks like Ford. So if we see other sectors tanking in the price for whatever reason, the price of your REITs might be unaffected… or not affected as much by other stock sectors.
Moreover, adding a REIT to your portfolio can protect some of your return…if other investments in your portfolio underperform during a certain period of time.
You can invest in real estate by either buying physical real estate or a REIT. Perhaps, you believe that physical real estate is the best option of the two. However, it is not very liquid, and it requires a larger amount of cash for a down payment.
You can’t just go sell your property tomorrow and have that cash show up in my account the same day. The process takes weeks or even months. But with a REIT, you can access your money as quickly as you can press that sell button – since they are traded on the stock market.
REITs are known for yielding high dividends on a consistent basis. This is a great way to get a steady passive income. But why do REITs pay off high dividends?
The main reason REITs pay such high dividends is that they’re legally required to pay 90% of their income after expenses to shareholders. This rule makes it easier for them to distribute a higher dividend.
Another reason why REITs pay high dividends is their access to a steady cash flow from tenants. This cash flow can be in the form of rent payments and other expenses.
Most REITs acquire more assets through debt. So when interest rates rise, it becomes more expensive to borrow that money to purchase additional properties. In other words, once interest rates rise the price per share for real estate investment trusts takes a hit. This means over the long term, the return on your REITs will be fine. But in the short term, it could be inconsistent.
Despite the fact that REITs are exempt from corporation taxes…REIT dividends are often taxed at a greater rate than other investments. Dividends are frequently taxed at the same rate as long-term capital gains, which is frequently less expensive for most people than the tax rate on their normal income. However, REIT dividend payments often aren’t eligible for the capital gains rate. Dividends from REITs are typically taxed at the same rate as an individual’s regular income.
Not a short-term investment
REITs are better suited for long-term investments, which are commonly defined as those lasting more than five years. Micro-changes in interest rates and other trends affect REITs, making them riskier for a short-term financial aim.
Despite the fact that REITs have some pros and can be risky, it doesn’t mean they’re bad. After all, as an investor, you should evaluate your investment based on clear metrics… while keeping the risks in mind.
By now, we hope you have understood what a real estate investment trust is. However, it is important to learn more about the world of REITs before investing your money in them. In the end, this article is only a brief introduction to REITs.