Why invest in REITs?
Real Estate Investment Trust (REIT)
Established by the Congress in 1960, a Real Estate Investment Trust (REIT) is a legal entity that allows investors to buy shares in real estate portfolios that generate revenue through a variety of properties. A REIT portfolio mainly includes properties such as apartments, health care facilities, hotels, data centers, office buildings, retail centers, etc. A REIT generally leases space to businesses and then receive rents on the properties, which is then distributed among its shareholders as dividends. REITs work as ‘mutual funds’ of real estate and are subject to market fluctuations.
Types of REITs
Generally, investors come across two types of REITs:
- Equity REITs – An Equity REIT owns and invests in real estate properties. The majority of REITs are Equity REITs. Equity REITs generate revenue through rents. Equity REITs are responsible for purchasing, managing, renovating, and selling real estate properties.
- Mortgage REITs – Mortgage REITs are entirely different from Equity REITs. Unlike Equity REITs, Mortgage REITs lend money to real estate developers or investors. Instead of investing in real estate properties, Mortgage REITs lend money on mortgages. The primary source of income of Mortgage REITs is the interests they earn on mortgage loans.
The difference between Equity and Mortgage REITs can be more clearly understood from the following example. Suppose, a company named ‘Xylus’ has qualified as a REIT. Now, it purchases an office building with the funds generated from its investors and then rents it out. Since the company owns and manages this real estate property, it is an Equity REIT. On the other hand, suppose a company named ‘Pentagon’ qualifies as a REIT. Instead of investing in real estate properties, it decides to lend money to real estate investors. In this case, the company Gamma will make money in the form of interests it would earn on the loan. So, it’s a Mortgage REIT.
Requirements for forming a REIT:
- In order to qualify as a REIT, a company must be taxable as a corporation.
- A company must invest 75% of its assets in real estate, cash, or treasuries.
- 75% of a company’s net income must come from rents or through selling real estate properties.
- A company must distribute 90% of its income as dividends among its shareholders.
- A company must be regulated by the Board of Directors or Trustees.
- Not more than 50% of a company’s shares should be held by its five or fewer shareholders.
Drawbacks of REITs:
- Since a REIT distributes 90% if its income among its shareholders, only 10% of its income can be reinvested. So, the growth of a REIT can be a concern for its investors.
- The dividends that investors get within a REIT are taxed as normal income.
- As investors within a REIT own interests in the trust and not in the real estate properties, it doesn’t qualify for a 1031 exchange.
- REITs often have high management and transaction fees that could worry some investors.
As you can see, like any other investment, a REIT also has its advantages and disadvantages. Therefore, it’s important that you consult an experienced advisor or expert before investing in REITs. The assistance of an advisor can help you in resolving the challenges that investors face within a REIT. Moreover, they can help you in planning your investment in advance.