Investing In Real Estate Investment Trusts (REITs)
A REIT, or real estate investment trust, is an income-generating investment that is required to pay out 90% of its taxable income as dividends to shareholders. Find out how REITs work, the types of REITs, and the pros and cons of investing.
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What Is a REIT?
REIT stands for real estate investment trust, which can be defined as a company that owns or operates real estate property to generate income for the owners, partners, or shareholders. Properties that REITs may own or operate include office buildings, apartments, hotels, hospitals, shopping centers, and storage buildings.
Some investors choose REITs as income investments because they tend to pay high dividends compared to conventional dividend stocks, while other investors may choose REITs to diversify a portfolio. The reason why REITs are generally considered income investments is because they are required to pay out 90% of the trust's taxable income as dividends to shareholders. Put simply, REITs enable investors to participate in passive real estate income without directly holding real estate property.
How REITs Work
REITs are designed for passive real estate income. The Internal Revenue Code establishes the rules for the formation and taxation of REITs. For example, the Code says that REITs must hold 75% of assets in real estate, Treasury bonds, or real estate, and distribute 90% of taxable income as dividends to shareholders each year.
The rules and requirements for REITs are:
- Invest a minimum of 75% of assets in real estate.
- Pay at least 90% of taxable income per year as dividends to shareholders.
- 75% of gross income must come from rents, real estate sales, or interest on mortgages financing real property.
- Must be an entity that is taxable as a corporation.
- Must be managed by trustees or a board of directors.
- Minimum requirement of 100 shareholders.
- No more than 50% of the REIT's shares can be held by five or less individuals.
Types of REITs
There are multiple types of REITs, but they can be broken into two main types, which are equity REITs and mortgage REITs.
- Equity REITs: office REITs, residential REITs, and retail REITs
- Mortgage REITs: own interest-producing assets or debt obligations
- Hybrid REITs: combine equity and mortgage REITs
Each type has unique qualities that investors need to know before considering an investment.
1. Office REITs
Office REITs own and operate office real estate and earn income by renting or leasing space to tenants in those properties. Office REITs may vary by market, such as inner-city high rise office buildings or suburban office parks, or they may focus on types of tenants, such as tech firms or government entities.
Before investing, REIT investors may consider factors that may impact office REITs, such as economic conditions and location. For example, a strong economy with low unemployment and a growing metropolitan area can support higher rents for office REITs compared to a weaker economy in a city with dying industries.
2. Residential REITs
Residential REITs are real estate investment trusts that own or operate residential buildings, such as apartments, manufactured housing, student housing, single-family housing, and condos. Residential REITs tend to have defensive qualities in that housing is a necessity and can maintain some stability of demand, even in recession.
Some of the factors to consider when thinking about residential REITs may include population, job growth and vacancy rate, which is the percentage of available units in a rental property. For example, a trend in higher job growth and falling vacancy rates can be a positive environment for some residential REITs.
3. Retail REITs
Retail REITs are real estate investment trusts that own retail properties, such as shopping malls, outlet centers, and big box retailers. The primary income source for retail REITs comes from rents and lease income from tenants, which are often large retail companies.
Some considerations about retail REITs for investors to keep in mind may include consumer trends and anchor tenants. For example, many shopping malls are losing market share to online retailers, such as Amazon (AMZN). But a shopping center anchored by a big box retailer like Kroger (KR) may provide greater cash flow stability.
4. Mortgage REITs
Mortgage REITs are real estate investment trusts that own assets, such as mortgages or mortgage-backed securities, that generate revenue from interest. This differs from REITs that primarily hold a physical asset, such as a building or land.
An important aspect of mortgage REITs to keep in mind is that they are sensitive to interest rates. For example, rising interest rates tends to place downward pressure on mortgage REIT book values.
5. Hybrid REITs
Hybrid REITs hold a combination of equity and mortgage assets. Offering a mix of the two main types of REIT holdings may offer investors more diversity compared to REITs focusing on niche real estate areas, such as office REITs or retail REITs.
Pros and Cons of Investing in REIT Stocks
As with any other investment type, REITs have unique benefits and risks. Therefore, investors are wise to consider their advantages and disadvantages of before buying shares.
Advantages
- Diversification: Real estate is an asset class that does not highly correlate with other investment assets, such as stocks and bonds, which can offer diversification to an investment portfolio.
- Access to passive income: Investors can gain access to passive real estate income without directly holding physical real estate assets.
- High yields: Because of their requirement to share 90% of taxable income as dividends to shareholders, REITs often have higher yields compared to traditional dividend stocks.
Disadvantages
- Taxation: Since dividends from most REITs don't meet the IRS definition of qualified dividends, they are taxed at higher rates than ordinary dividends.
- Interest rate sensitivity: their stock prices generally move in the opposite direction as rising interest rates, which makes REITs riskier investments in rising interest rate environments.
- Lower relative growth: they generally don't provide significant capital growth because 90% of income is paid out as dividends, rather than reinvested back into the capital structure.
REIT Funds and ETFs
Investors wanting diversified exposure to REITs, as well as benefits like dividend income, may consider investing in REIT mutual funds or REIT ETFs. REIT funds and ETFs may hold a wide range of real estate investment trusts or they may specialize in certain types, such as equity REITs or mortgage REITs.
How to Invest in REITs
Investors considering an investment in REITs have a number of ways to gain exposure, including the purchase of shares of publicly traded REIT stocks or buying shares of a REIT mutual fund or REIT ETF. Many index funds, such an S&P 500 fund, include some exposure to the real estate sector or to REIT stocks.
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