Real Estate Investment Trusts (REITs) are used by investors to invest in real estate without the worry of vetting and purchasing individual properties. REITs provide investors with access to a professionally managed portfolio that consists of real-estate assets. They were created more than 50 years ago and are defined specifically in subchapter M, Chapter 1, of the Internal Revenue Code of 1986. An infographic provided by the National Association of Real Estate Investment Trusts (NAREIT), a Washington, D.C.-based trade group makes the following points:
- REITs own real-estate holdings valued at $1 trillion
- 50 million American investors invest in REITs (primarily through their 401(k)s)
- Nearly 300 REITs are registered with the U.S. Securities and Exchange Commission
- The 160 REITs listed on the New York Stock Exchange have a combined market capitalization of $650 million
- REITs own $88.7 billion of commercial property in California, while the most commercial property owned by REITs is in Texas (3,784).
Companies such as Apartment Investment and Management Co. (NYSE:AIV), Realty Income Corp. (NYSE:O) and Annaly Capital Management Inc. (NYSE:NLY) are examples of publicly traded REITs to whom investors can look for information on how REITs work and the types of investments they make, as well as how they benefit and profit investors.
What Are Real Estate Investment Trusts?
REITs are a type of investment trust similar to those known as "closed-end investment companies," familiarly known as exchange-traded funds (ETFs) and unit investment trusts (UITs). A REIT invests funds it acquires from investors in property (real estate), mortgages and mortgage interest on property, and may also invest in other REITs.
There are generally three types of REITs in which investors can choose to invest: equity REITs, mortgage REITs and hybrid REITs. Equity REITs invest in properties, deriving their income through rents; mortgage REITs make available mortgage loans (and may invest in mortgage-backed securities like those issued by Fannie Mae or Freddie Mac) and earn income through interest. A hybrid REIT, as its name implies, invests in properties for rental income and makes mortgage loans available.
How Do REITs Operate?
REITs are organized as investment companies subject to registration rules of the Investment Company Act of 1940, although mortgage REITs are not subject to the ICA registration requirement since they engage in mortgage banking. All REITs, however, operate in a similar manner pursuant to prevailing federal securities laws as well as the laws of the state in which the REIT is domiciled.
A REIT begins life by creating a portfolio (based on the type of REIT) and selling shares of beneficial interest to investors through an offering. This occurs, of course, after the trust has been incorporated for federal tax purposes. REITs are formed when they meet two ownership rules by their second operating year: (1) at least 100 unique shareholders; and, (2) no more than five (or fewer individuals) can own more than 50% of the value of the REIT's shares (known as the "5/50" rule). REITs must also invest 75% or more of assets in real estate and cash. Shares of REITs must be transferrable, which is why they trade on a public exchange, and derive at least 75% of gross income from real-estate-related sources (i.e. rents and mortgage interests).
How Do Investors Profit From REITs?
Investors who purchase REIT shares must receive at least 90% of the REIT's taxable income, distributed on an annual basis. This income is derived by the investment activities of the REIT, depending on the type of investment trust that has been created (i.e. equity, mortgage or hybrid).
What Are the Advantages of Investing in REITs?
One of the biggest advantages to investing in REITs is the passive nature of the investment. The investments that make up the trust are selected by professional managers who understand the market and have experience selecting the best investments for the portfolio. This removes the worry and fear that an investor might have over evaluating the quality of an investment and choosing which one to include in a portfolio of real-estate holdings. Another advantage is that of tax reporting. As an investor, gains and losses reported in any given tax year are provided with a 1099-DIV, which provides information on dividends distributed by the REIT as capital gains, return of principal and ordinary income. The 1099-DIV is attached to Form 1120-REIT, which is attached to the taxpayer's 1040 long form.
Investors looking for a simple and hassle-free way to invest in real estate should consider the benefits REITs can provide. Referencing again the infographic produced by NAREIT, $29 billion in dividends were paid by REITs in 2012. This should give you pause to look at REITs as your next investment opportunity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.