What is Real Estate Investment Trust (REIT) & how do they work?

What Is a Real Estate Investment Trust (REIT)?

A Real Estate Investment Trust, often called a REIT, represents a corporation that holds, manages, or supports income-producing real estate.

Taking inspiration from mutual funds, REITs amalgamate the resources of many investors. This structure facilitates individual investors to gain income through real estate investments - eliminating the need to purchase, administer, or bankroll any properties themselves directly.

REITs were conceived by the U.S. Congress in 1960 through an amendment to the Cigar Excise Tax Extension. This legislative development made it feasible for investors to acquire shares in portfolios of commercial real estate, a privilege that was hitherto exclusively accessible to affluent individuals and sizeable financial institutions.

A REIT portfolio can encompass various types of real estate assets, including residential buildings, data storage facilities, medical centers, hotels, infrastructural elements like fiber optics, cell towers, energy conduits, office spaces, shopping centers, self-storage units, timber estates, and storage facilities.

Usually, REITs concentrate on a particular sector of real estate. However, there are diversified and specialty REITs that manage a mix of different property types within their portfolio, such as a REIT that incorporates both office spaces and retail properties.

A significant number of REITs are publicly traded on leading securities exchanges, where investors can easily purchase or sell them just like regular stocks during trading hours. These REITs are often characterized by high trading volume and are regarded as highly liquid assets.

What Does REIT Stand for?

REIT stands for "Real Estate Investment Trust". A REIT is organized as a partnership, corporation, trust, or association that invests directly in real estate through the purchase of properties or by buying up mortgages. REITs issue shares that trade stock exchange and are bought and sold like ordinary stocks.?In order to be considered a REIT, the company must invest at least 75% of its assets in real estate and derive at least 75% of its revenues from real estate-related activities.

What are the Criteria to be Recognized as a REIT?

Most REITs operate with a simple business strategy: They lease properties and collect rent, then distribute the income as dividends to the shareholders. On the other hand, Mortgage REITs don't possess real estate but rather finance it. Their income is derived from the interest on these investments.

For a company to be classified as a REIT, it must adhere to specific stipulations laid out in the Internal Revenue Code (IRC). These provisions primarily involve owning income-producing real estate for an extended period and distributing the generated income to shareholders.

More specifically, a company must fulfill the following criteria to be acknowledged as a REIT:

• Allocate at least 75% of total assets to real estate, cash, or U.S. Treasuries
• Generate a minimum of 75% of gross income from rents, interest on mortgages financing real property, or from real estate sales
• Disburse at least 90% of taxable income as shareholder dividends annually
• Be an organization taxable as a corporation
• Be governed by a board of directors or trustees
• Accumulate a minimum of 100 shareholders following its first year of operation
• Ensure that no more than 50% of its shares are owned by five or fewer individuals

Categories of REITs

There exist three principal classifications of REITs:

1. Equity REITs: These constitute the majority of REITs. They own and administrate income-producing real estate. Their primary source of revenue comes from collecting rent, rather than the sale of properties.
2. Mortgage REITs: These REITs provide financing to real estate owners and operators either directly via mortgages and loans or indirectly by purchasing mortgage-backed securities. They primarily derive income from the net interest margin, which is the difference between the interest they earn on mortgage loans and the cost of funding these loans. This structure makes them potentially susceptible to interest rate fluctuations.
3. Hybrid REITs: These types of REITs combine the investment approaches of both equity and mortgage REITs.
4. Publicly Traded REITs.?Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
5. Public Non-Traded REITs.?These REITs are also registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs.?Still, they tend to be more stable because they’re not?subject to market
6. Private REITs.?These REITs aren’t registered with the SEC and don’t trade on national securities exchanges.?In general, private REITs can be sold only to institutional investors.

How to invest in REITS?

Investing in publicly traded REITs, as well as REIT mutual funds and REIT exchange-traded funds (ETFs), can be done by acquiring shares via a broker. Non-traded REIT shares can be bought through a broker or a financial advisor who is involved in the non-traded REIT's offering.

REITs are increasingly becoming part of many defined-benefit and defined-contribution investment plans. As per Nareit, a REIT research organization based in Washington, D.C., it's estimated that about 145 million U.S. investors have REITs in their portfolios, either directly or through their retirement savings and other investment funds.

Advantages and Disadvantages of Investing in REITs

REITs can be a valuable component of an investment portfolio due to their capacity to provide robust, consistent annual dividends, as well as potential for long-term capital growth. Over the past two decades, the total return performance of REITs has surpassed the S&P 500 Index, other indices, and the inflation rate. However, like any investment, REITs come with their own set of pros and cons.

On the upside, REITs are easily bought and sold, given that most of them are traded on public exchanges, thus reducing some of the typical constraints of real estate. From a performance perspective, REITs present attractive risk-adjusted returns and stable cash inflow. In addition, having a stake in real estate can benefit a portfolio as it offers diversification and income from dividends, often higher than what other investments can provide.

An additional advantage comes from the Tax Cuts and Jobs Act of 2017, which permits taxpayers to benefit from the qualified business income (QBI) deduction. This deduction constitutes the QBI plus 20% of eligible REIT dividends or 20% of taxable income minus net capital gains, depending on which amount is smaller.

On the downside, REITs offer limited capital appreciation. Due to their structure, they are required to distribute 90% of their income back to investors, meaning only 10% of taxable income can be reinvested back into the REIT for acquiring new properties. Other drawbacks include REIT dividends being taxed as regular income and some REITs charging high management and transaction fees.

Potential Pitfalls with REITs

The U.S. Securities and Exchange Commission (SEC) suggests that investors exercise caution with individuals attempting to sell REITs that are not registered with the SEC. It indicates that "The SEC's EDGAR system allows you to confirm the registration of both publicly traded and non-traded REITs. In addition, EDGAR enables you to scrutinize a REIT's annual and quarterly reports, along with any offering prospectus."

Furthermore, it's advisable to investigate the broker or investment advisor promoting the REIT. The SEC provides a free search tool for investors to determine if an investment professional is duly licensed and registered. U.S. Securities and Exchange Commission. "Investigate Your Investment Professional."

Do REITs Have to Pay Dividends?

By law and IRS regulation, REITs must pay out 90% or more of their taxable profits (to shareholders in the form of dividends. As a result, REIT companies are often?exempt from most corporate income tax. Shareholders of REITs who receive dividends are taxed as if they are ordinary dividends.14

U.S. Securities and Exchange Commission. "Investor Bulletin: Real Estate Investment Trusts (REITs)," Page 1-4.

What Is a Paper Clip REIT?

A "paper clip REIT" increases the tax advantages afforded to a REIT while also allowing it to operate properties that such trusts normally cannot run. It is so-named because it involves two different entities that are "clipped" together via an agreement where one entity owns the properties and the other manages them.15

?The paper clip REIT entails stricter regulatory oversight since there can be conflicts of interest and, as a result, this form of REIT is uncommon. It is similar but more flexible in structure to a "stapled REIT".

Best-performing REIT stocks: August 2023