Real Estate Investment Trust (REIT) Investing Basics You Need to Know

It would be accurate to state that investing money is essential for a happy and comfortable future. Investments help in growing your wealth over time. Besides, investing can provide you with an additional source of income and a backup fund that can be used in case of a financial emergency. Investing in the right instruments can also help you build your retirement corpus.

Of the many investment products available in the market, one such option is to invest in real estate investment trusts (REITs).

What is a real estate investment trust (REIT)?

A real estate investment trust (REIT) is a company that makes investments in income-generating real estate areas. Typically, REITs own, operate and finance commercial real estate and related assets. These assets may include everything from offices and apartments to shopping malls and hotels.

You could think of REITs as mutual funds that buy and trade in real estate instead of stocks. Once a trust fund qualifies as a REIT, individuals who want to invest in real estate can buy its shares. The money collected by the sale of these shares is pooled together by a REIT and used as capital to make real estate investments.

REITs can often become reliable investment vehicles that generate a steady income for investors. REITs allow investors to earn dividends from real estate properties without having to directly buy, finance, or manage them individually. Instead, REITs are professionally managed by one or more fund managers who decide upon a solid investment strategy and are responsible for implementing it.

What are the different types of REITs?

There are many real estate investment trusts that specialize in different kinds of assets. All of them can be broadly classified into two types:

Equity REITs

The most common type of REITs, equity REITs are trusts that primarily own and manage properties. Usually, these REITs earn their revenue through rental payments from tenants and not by purchasing and reselling properties. Most equity REITs specialize in specific types of real estate such as office buildings, apartment complexes, shopping malls, hotels, warehouses and commercial retail spaces, etc.

There are many advantages of equity REITS including a strong potential for income generation and growth. Moreover, equity REITs provide investors with the ability to invest in specific sectors of real estate.

One of the biggest drawbacks of equity REITs is that appreciation timelines are less predictable as compared to other investment options.

Mortgage REITs

Mortgage REITs primarily invest in mortgages and related assets. These REITs generally operate by borrowing money at low, short-term interest rates and use it to buy mortgages that pay higher, long-term rates. In this way, mortgage REITs finance real estate mortgages and generate income from the interest earned on these investments.

Mortgage REITs generate high income and offer steady, periodic returns to investors. The risk involved is also minimal.

A major disadvantage of mortgage REITs is that they do not offer much potential for long-term investment growth.

Some REITs own both property and mortgage assets and are known as hybrid REITs. Hybrid REITs diversify across both types of investments and use various strategies for maximum benefit. Although they can own property as well as mortgage loans, most hybrid REITs generally rely more on one type of investment rather than the other.

How does a company qualify as a REIT?

Many companies seek to become REITs. The reason is simple. By qualifying as a RIET, a company is eligible for accompanying tax benefits. There are also other advantages that make it an even more enticing proposition. However, to qualify as a REIT, a company must meet some stringent requirements. These are:

It must be an entity that is taxable as a corporation.
It must have at least 100 shareholders with no more than 50% of the total shares being held by 5 or fewer shareholders.
At least three-fourths (75%) of its assets must be invested in real estate, cash or U.S. Treasuries.
At least three-fourths (75%) of its gross income should be generated by real estate and related assets like rental income, buying and selling of real estate, and mortgage payments, etc..
At least 90% of its taxable income must be paid as dividends to shareholders annually.

Why invest in a REIT?

There are some distinct advantages of investing in a REIT:

REITs are often considered to be a stable and reliable source of continued income. Historically, they have been known to deliver competitive returns based on long-term capital appreciation.
Another significant advantage of investing in REITs is expanding and diversifying your portfolio. REITs share a comparatively low correlation with other types of investment assets which helps increase returns and minimize portfolio risk.
REITs can be very helpful for those looking to primarily invest in real estate. To begin with, individuals can easily buy shares of a REIT and then earn dividends on their real estate assets without any hassles. Owning and maintaining real estate properties directly can be quite a headache for individuals otherwise.

What are the risks associated with REIT investments?

Although real estate investment trusts are generally considered to be low-volatility investments, there are some risks that investors should be aware of. Some of the most important ones are:

Rising interest rates: Historically, REITs do not perform too well when interest rates rise. In such a scenario, many investors opt for risk-free options such as government-guaranteed treasuries. So, a hike in interest rates translates into reduced demand for REITs.
Choosing the wrong REIT: It may sound simple but choosing the right type of REIT is a major step that involves a lot of risks. Investors need to be smart and research the various options before making a final decision. For instance, it does not make sense to invest in an apartment building that has a history of rogue or fraud tenants.
Tax implications: Another big risk associated with REITs is its tax implications. This is generally overlooked by many investors. All income distributions from current and accumulated earnings are taxed as ordinary income. These taxation rates can carry a tax rate of as much as 15-20% depending on the investor’s income bracket.

To sum it up

Real estate has always been acknowledged as a very important and relatively risk-free investment class. Ultimately, investing in a REIT is probably the easiest and most profitable route for individuals to become real estate investors.

It is a major opportunity for investors to add real estate to their investment portfolios. The beauty of it all is that these investors can earn returns on their investments without having to worry about the hassles and expenses of direct real estate ownership.

For more information on REITs, you can get in touch with Financial Advisors.