There’s little doubt that investing in real estate can be incredibly profitable. But for rare, economy- shattering events, real estate tends to increase over time — unlike other property — and it can generate ongoing income, such as monthly rent. However, there is one downside to investing in real estate: Illiquidity. The real estate market moves relatively slowly, so if an investor ever need to access their invested funds fast, they should seek some other, more liquid financial tool — like a REIT.
What Is a REIT?
REIT is an acronym that stands for “Real Estate Investment Trust.” In the simplest terms, a REIT is a company that owns real estate. Investors can purchase stock in the company, thereby obtaining an investment in large-scale properties or mortgages. REITs, like other securities and stocks, are typically traded, but they can be listed on major stock exchanges as well as be public non-listed and private. Stockholders benefit by earning a share of the income produced through real estate investment — without the hassle of buying or financing property themselves.
REITs pay most taxable income as dividends to shareholders, thereby avoiding typical business taxes; instead, shareholders pay income taxes to the government. Avoiding taxes is exceedingly advantageous — but not every company that owns real estate can become a REIT. Different countries boast different rules about how a REIT can form and function. In the U.S., REITs must:
- Pay out at least 90 percent of their income as dividends.
- Boast at least 100 shareholders.
- Prevent five or fewer shareholders from owning more than 50 percent of the shares.
- Invest at least 75 percent of assets in cash, Treasuries, or real estate.
- Derive at least 75 percent of income from real estate.
Conversely, in the U.K., REITs must meet most of the above conditions as well as be publicly listed on a stock exchange. In fact, the U.K. as well as a handful of other countries have altered their REIT regime rules in recent years thanks to the burst real estate bubble that ravaged the world after 2008. It’s likely that REIT rules will continue to shift as the economy fully recovers from the recession.
How Do REITs Make Money?
There are two discrete types of REITs: equity and mortgage, though some REITs function as hybrids. The qualities that define them are largely how they generate income.
Equity REITs purchase and own property in long-term increments, so their income is principally based on receiving rents. When REITs sell property, any capital appreciation is translated to stockholders through dividends, just like rents. Most equity REITs specialize in a type of property, such as:
- Shopping malls
- Health care facilities
- Single-family homes
- Apartment buildings
- Self-storage facilities
- Data centers
- Office buildings
- Industrial structures
The majority of REITs are equity REITs, so investors are most likely to interact with a REIT with an equity portfolio.
Meanwhile, some REITs choose to invest in mortgages. The manner in which a mortgage REIT does this typically differs from company to company. For example, some REITs may act as lenders, originating mortgage loans, while others may purchase mortgage-backed securities from agencies like Fannie Mae and Freddie Mac in the U.S. Often, mortgage REITs take out loans to pay for the mortgages they create. Then, the REITs generate income by collecting interest on home loans, which must outweigh the interest they must pay on their own loans. It is a delicate balancing act, which explains how the economy toppled about a decade ago.
Some REITs boast both equity and mortgage divisions, making them hybrids. Because managing property and managing mortgages require vastly different skills and tools, hybrid REITs aren’t particularly common.
What Are the Benefits of Investing in REITs?
There are several advantages to investing in REITs. For one, investing in individual properties is expensive and incredibly risky, and few investors are willing to put forward the time and energy to make property investment successful. Therefore, REITs allow savvy investors to diversify their investments and retain relatively liquid investments. Returns on REITs are relatively reliable, and many REITs outperform stocks, ensuring investors’ money works harder than it would with other stocks or funds. Finally, because of the recent trouble in real estate, REITs are more strongly governed than before, giving the market more transparency and stability. There are almost no reasons to refuse investing in REITs — in fact, to do so might be considered wrong.