What the heck is a…Real Estate Investment Trust (REIT)?

Plenty of people invest in real estate, even if it just involves buying the house they live in. Getting into large-scale, income producing properties can be difficult, though, because of the amount of needed to invest in real estate projects versus owning individual stocks, bonds, or shares of mutual funds. One of the most common investing tools to invest real estate projects without these high amounts of capital is the Real Estate Investment Trust, or REIT. A Real Estate Investment Trust is an investment vehicle that generates income through real estate, and can add diversity to a portfolio. REITs are required to have a minimum 75% of assets in real estate, derive 75% of their income from real estate, and pay at least 90% of their taxable income out as dividends. Some of the more common REITs are the Simon Property Group (SPG), Realty Income (O), Public Storage (PSA), Vornado (VNO), HCP (HCP), and Equity Residential (EQR).

REITs have been in the news, because they have been popular as an income-producing investment for the last couple of years due to high yields and poor bond rates.  Lately, REITs have been going through market volatility, largely due to the specter of rising interest rates. Interest rate hikes will make the cost of doing business for REITs higher. An interest rate hike would also make bonds more attractive by paying out higher rates, so the price of REIT holdings may drop due to investment market pressures.

There are two basic types of REITs. An equity REIT develops and manages income-producing properties, like shopping centers, apartment and office buildings, and hotels. Equity REITs generate most of their income through rents. This category makes up about 90% of all REITs. There are also mortgage REITS, that loan or purchase mortgages and earn interest. In addition, there are some hybrid REITS that do both. There are also a number of real estate mutual funds and ETFs that purchase shares of REITS and of management companies.

Key Factors in REITs

REITs pay little or no federal income tax, because they distribute most or all of their taxable income as dividends, so can create a steady income stream.

In addition to getting steady rental income, equity REITs benefit from asset appreciation as real estate prices rise. However, they also suffered greatly when real estate prices fell, as well as when real estate vacancies are high.

Because most of the cash is paid out to investors as dividends, it may be difficult for REITS to grow outside of this appreciation.

For the shareholders, the dividends are treated as ordinary income and are not eligible for the reduced dividend tax rates paid on most corporate dividends. This makes putting them in tax-advantaged accounts, like IRAs, a good idea.

Privately Traded REITs

Some REITS are publically traded and some are not. Privately offered REITS may offer high yields, but they can be difficult to trade, as there is no established market. Even when you find a buyer, assessing a fair price can be difficult. Nontraded REITS are often managed externally, and the manager’s interests may not coincide with the shareholders’. They may also have high transaction fees and commissions. Shares of publically traded REITS are easier to buy and sell,in terms of trade volume, the number of venues where an investor can make any transactions, and the amount of information available to investors. For this reason, most investors are advised to sticking with publically traded REITs.

Dipping into REITs

REITs can be a good tool for adding an income stream to your investment portfolio, particularly in a tax-deferred account. It is important to understand what the REIT does, and what the associated risks are. Common advice for examining REITS is to stick with REITs that have a good management track record, look at the growth of Funds from Operations (which adjusts for depreciation) or Adjusted Funds from Operations (which adjusts for depreciation and projected capital expenditures) instead of growth of net income, and avoid an overexposure to REITS (no more than 10% or so of your portfolio).

This article is for information purposes only and should not be constituted as advice. I am not a financial advisor, only an investor sharing my thoughts. Past performance does not determine future performance, and an investor interested in REITS or REIT mutual funds should proceed with caution and do lots of research before putting their money in any investment.

Image courtesy of ddpavumba at FreeDigitalPhotos.net

References and Further Reading:

3 Surprising Drawbacks of REIT Investing You Never Knew About-from Fool.com

4 Trusty Tips when Investing in REITs-from Bankrate

Add Some Real Estate To Your Portfolio, How To Assess A Real Estate Investment Trust (REIT) and 5 Types Of REITs And How To Invest In Them-from Investopedia

Behind the Great REIT Sale-from Market Watch

Rates hit REITs: Should you dump them?-from CNBC

Real Estate Investment Trusts (REITs)-On Investor.gov

Take When The Market Gives – Income Opportunities, Part 5: REITs-on Seeking Alpha

Use REITs to Invest Like a Property Mogul-from the Wall Street Journal

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