REITs: What It Is and How to Invest
Real Estate Investment Trust, also known as (REIT) is an entity that acquires, manages, or provides funding for properties that produce revenue. Similar to mutual funds, REITs gather investments from a variety of contributors, enabling them to receive income distributions from property investments without having to purchase, oversee, or directly fund the properties themselves.
John Paulson, a billionaire hedge fund manager, states, “I still think buying a home is the best investment any individual can make.”
Key Takeaways:
- Income Generation: REITs are companies that own, operate, or finance income-producing properties.
- Steady Income Stream: They provide steady dividend income but typically offer little capital appreciation.
- Liquidity: Most REITs are publicly traded like stocks, making them highly liquid compared to direct real estate investments.
- Diverse Investments: They invest in a variety of property types, such as apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.
How REITs Work
Established by Congress in 1960 through an amendment to the Cigar Excise Tax Extension, REITs democratize access to commercial real estate portfolios, which were previously available only to wealthy individuals and large financial intermediaries.
Types of Properties:
REITs might include various properties such as apartment complexes, data centers, healthcare facilities, hotels, and infrastructures like fiber cables, cell towers, and energy pipelines. Specific REITs may specialize in one type of real estate sector.
In contrast, diversified and specialty REITs may hold various property types within their portfolios.
The majority of REITs are listed on significant securities exchanges for public trading, providing investors the opportunity to purchase and offload shares in a manner akin to stock transactions.
Qualifications for a REIT
To qualify as a REIT, a company must adhere to specific guidelines under the Internal Revenue Code (IRC), which include owning income-generating real estate for the long term and distributing a substantial portion of income to shareholders. The requirements are as follows:
- Investment: At least 75% of total assets must be invested in real estate, cash, or U.S. Treasuries.
- Income Source: At least 75% of gross income must come from rents, interest on mortgages financing real property, or real estate sales.
- Dividends: At least 90% of taxable income must be paid as shareholder dividends annually.
- Corporate Structure: The entity must be taxable as a corporation, managed by a board of directors or trustees.
- Shareholder Base: After its first year, it must have at least 100 shareholders, and five or fewer individuals must hold no more than 50% of its shares.
Categories of REITs
Equity REITs:
This type of REIT is involved in owning and overseeing properties that generate earnings. They mainly profit from the rent collected from these real estate assets.
Mortgage REITs:
These entities provide financing to real estate owners and managers by offering mortgages and loans or purchasing securities backed by mortgages.
Their income largely stems from the difference in the interest earned on these mortgages and the cost associated with funding the loans. This structure renders them susceptible to changes in interest rates.
Hybrid REITs:
Hybrid REITs incorporate the investment strategies of both equity and mortgage REITs, holding both properties and mortgages in their portfolios.
| Type of REIT | Holdings |
|---|---|
| Equity | Owns and operates income-producing real estate |
| Mortgage | Holds mortgages on real property |
| Hybrid | Owns properties and holds mortgages |
Investing in REITs
Investors can choose from several types of REITs:
Publicly Traded REITs:
Shares of these REITs are listed on national securities exchanges and are regulated by the U.S. Securities and Exchange Commission (SEC). They are highly liquid and can be bought and sold like stocks.
Public Non-Traded REITs:
These REITs are registered with the SEC but do not trade on national securities exchanges. While they are less liquid than their publicly traded counterparts, they tend to be more stable due to reduced market fluctuations.
Private REITs:
Private REITs are entities that have not undergone registration with the Securities and Exchange Commission (SEC) and their shares are not available on public stock exchanges. Typically, they are accessible solely to institutional investors and individuals with substantial wealth.
Investment Options:
- Publicly Traded REITs: Easily accessible via stock exchanges.
- REIT Mutual Funds: Funds that invest in a diversified portfolio of REITs.
- REIT ETFs: Exchange-traded funds that focus on REIT investments.
- Non-traded REITs: Available through brokers or financial advisors.
Example of a REIT
An example of a prominent REIT is Healthpeak Properties (PEAK), an S&P 500 company that owns, operates and develops high-quality real estate for healthcare discovery and delivery.
How can a company qualify as a REIT?
In order to qualify for a Real Estate Investment Trust (REIT), a company must meet several specific criteria:
Asset Allocation: At least 75% of its assets must be invested in real estate.
Income Sources: It should derive at least 75% of its gross income from:
-
- Rents from real property
- Interest on mortgages financing real property
- Sales of real estate
Dividend Payout: The company must pay a minimum of 90% of its taxable income as shareholder dividends each year.
Taxable Entity: It must be a taxable entity as a corporation.
Management Structure: The company should be managed by a board of directors or trustees.
Shareholder Requirements:
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- It must have a minimum of 100 shareholders.
- Five or fewer individuals can hold no more than 50% of its shares. These conditions ensure that a company qualifies as a REIT and can enjoy certain tax benefits associated with this status.
