10 Things You Need to Know About REITs
By: Olivia Faucher,
Ten Things You Need to Know about REITs offer important tips for investors.
REITs (real estate investment trusts) are unique investments that provide a convenient way for investors to gain exposure to real estate markets, and reap the financial benefits that those markets have to offer. Keep reading to learn 10 things you need to know about REITs.
10 Things You Need to Know About REITs #1: There are Different Types
REITs can be classified into four categories: equity, mortgage, public non-traded and private.
- Equity REITs: Equity REITs own or operate income-producing real estate, and they are publicly traded on major stock exchanges. Equity REITs are often simply referred to as REITs.
- Mortgage REITs: Also known as mREITs, mortgage REITs provide financing for real estate by buying or originating mortgages and mortgage-backed securities. mREITs earn income from the interest on the investments.
- Public Non-Traded REITs: Public, non-traded REITs are registered with the SEC but do not trade on national stock exchanges.
- Private REITs: Private REITs are exempt from Securities and Exchange Commission (SEC) registration and the shares do not trade on public stock exchanges.
Furthermore, REITs can be classified by the type of properties in which they choose to invest. For example, REITs may be categorized as residential, office space, retail, health care, lodging, and more. REITs with different portfolios operate in different real estate markets, making it important for investors to research REITs before investing in any of them.
10 Things You Need to Know About REITs #2: How to Invest
If a REIT is listed on a major stock exchange, investors can easily buy shares the same way any other public stock is purchased. The majority of REITs are equity REITs, which are all listed on public stock exchanges.
Investors also can invest in a REIT mutual fund or a REIT ETF (exchange-traded fund), through which the investor would be buying a collection of shares in an entire index of REITs. Private REITs and Public non-traded REITs can also be purchased; however it is more complicated. Those investments are generally limited to individuals and institutions who meet certain financial criteria.
10 Things You Need to Know About REITs #3: How REITs Make Money
Generally, REITs follow a simple business model: the company buys or develops properties that it leases out and collects rent as its primary source of income. The income generated by the company is paid out to shareholders in the form of dividends. REITs may also make money through buying and selling properties.
However, some REITs do not own any property, choosing instead to work on financing real estate transactions. These REITs generate income from the interest on the financing. Mortgage REITs are one such REIT that does not own any property.
10 Things You Need to Know About REITs #4: Often Volatile, But Can Produce Strong Long-Term Returns
Given that REIT performance is subject to market risk, REITs can be a volatile investment. REIT performance fluctuates in conjunction with changes in the real estate market.
There are certainly periods when REITs underperform, but the long-term performance of REITs is impressive. The five-year return of U.S. REITs was 15.76% in June 2020, as measured by the MSCI U.S. REIT Index. Additionally, REITs have historically outperformed corporate bonds over extended periods of time.
10 Things You Need to Know About REITs #5: Great for Providing Diversification
Real estate is an important asset class that investors should consider buying as part of a well-rounded portfolio. Real estate provides great diversification because it is a distinct asset class which does not have a strong correlation with other industries within the stock market. Historically, REIT performance tends to go up when other assets go down and vice versa. Therefore, REITs are largely beneficial in leveling out the overall volatility of a well-diversified portfolio.
10 Things You Need to Know About REITs #6: Differ From Direct Real Estate Buys
When looking to gain exposure to real estate markets, there are two possible routes for investors to take. Investors can either invest in REITs, or make a direct investment into real estate. In the former choice, investors become shareholders in a company that controls real estate. In the latter, an investor buys tangible real estate and operates it for his or her own financial benefit.
Direct real estate investors make money through rental income and appreciation. REIT shareholders gain money as the value of the REIT goes up, and through dividend payouts. REITs are an easier way to gain exposure to real estate, as there is no personal responsibility to maintain and operate any properties.
10 Things You Need to Know About REITs #7: Their Investing Advantages
REIT investments bring multiple benefits to the investor. REITs offer the benefits of real estate investment, but with the convenience and simplicity of investing in publicly traded stock. As previously mentioned, REITs also provide diversification because they are not correlated with other stocks and bonds. REITs also provide higher risk-adjusted returns, and REITs effectively reduce overall portfolio volatility.
REITs also give investors the benefit of receiving consistent, reliable dividend payouts. Plus, the long-term performance of REITs has been strong, as the total returns from REITs have been above that of the S&P 500 over the last 25 years. Finally, REITs are highly liquid, which eliminates the illiquidity risks that are usually associated with real estate investments.
10 Things You Need to Know About REITs #8: Their Investing Risks
REITs are sensitive to changes in the market, specifically fluctuations in interest rate. Rising interest rates are bad for REIT stock prices. REITs are subject to market risk, and REITs may underperform if market conditions are not ideal.
There are also property-specific risks associated with REITs. While investing in REITs provides diversification for the investor’s portfolio, most REITs do not hold diversified property portfolios. In other words, REITs that only hold one type of property may face serious financial distress if an event occurs that decreases the demand for such a property. For example, hotel REITs have taken a considerable hit throughout the Covid-19 pandemic, as travel has decreased and the demand for hotels has diminished.
Another shortcoming of REITs is that most of them grow at a slower pace than some other publicly traded companies in different industries. REITs are required to pay out 90% of taxable income to shareholders. Therefore, the company is generally only left with 10% of its income to reinvest into the core business each year. This may cause REITs to grow at a slow pace. In the same vein, REITs may rely heavily on debt in order to have more money available to invest in new properties. Many REIT managers choose to add leverage (take on debt) in order to expand the properties owned by the REIT.
Finally, the tax treatment of REITs presents a potential drawback for investors. The REIT does not have to pay taxes on profit, however investors must pay income tax on the dividend payouts as if those payouts are personal income. Investors can be faced with high REIT taxes, especially those in higher tax brackets. Other companies that are not required by law to pay dividends may be a more tax efficient investment.
10 Things You Need to Know About REITs #9: How Their Dividends are Taxed
REIT shareholders face an income tax liability that can be complex and difficult to understand. Each dividend payout from the REIT to its shareholders is composed of a mix of funds that are acquired by the REIT from an array of sources. Profits earned by the REIT from different sources can be placed into different categories, and each category has its own specific tax rules. Therefore, investors do not always pay the same tax rate on the distributions received from the REIT. Rather, the payout must be dissected and categorized to determine the tax treatment.
Dividend distributions may be allocated to three categories: operating profit, capital gains and return of capital.
Oftentimes, the dividend payouts are only made up of operating profit. When the company passes along operating profit to investors, it is received as ordinary income, and therefore the investor must pay his or her ordinary income tax rate on the dividend.
When the distributions consist partially of capital gains or return of capital, the tax rate that the investor must pay is different. To read about the taxation rules in these scenarios, click here.
However, it is most common that the payout consists only of operating profit, in which case the investor must pay his or her ordinary income tax.
10 Things You Need to Know About REITs #10: Passive vs. Active Investing
When deciding to invest in REITs, there are two main approaches: passive and active investing.
The passive investing approach entails investing in a REIT mutual fund or REIT ETF. In these options, investors buy an entire portfolio of REITs. Buying a collection of REITs has its benefits, including wide REIT diversification and little requirement of time and knowledge. However, this approach means buying every REIT in the index, regardless of considerable factors such as price, performance and quality.
The active REIT investing approach involves doing research, picking specific REITs to invest in and building an individual portfolio of REITs. This would entail finding REITs that the investor believes to be undervalued, or REITs that are a smart investment for another reason. The active approach is certainly more time consuming, and can be risky, but it has the potential to provide far greater returns than the passive approach if it is well executed
Olivia Faucher is an editorial intern with Eagle Financial Publications.