Real Estate Investment Trusts (REITs) have become increasingly popular among investors looking to diversify their portfolios and gain exposure to the real estate market. In this article, we will explore the fundamentals of REITs, their different types, and how investors can participate in this asset class. By understanding how REITs work and their unique features, investors can make informed decisions about incorporating them into their investment strategies.
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-generating real estate. Similar to mutual funds, REITs pool the capital of numerous investors, allowing individual investors to earn dividends from real estate investments without the need to directly purchase, manage, or finance properties themselves.
REITs offer investors a unique opportunity to participate in the real estate market while enjoying the benefits of liquidity, diversification, and potential dividend income. By law, REITs must distribute at least 90% of their taxable income to shareholders, making them an attractive investment for income-seeking investors.
Types of REITs
There are three main types of REITs: equity REITs, mortgage REITs, and hybrid REITs.
-
Equity REITs: The majority of REITs fall into this category. Equity REITs own and manage income-producing properties, such as apartment complexes, office buildings, retail centers, and industrial facilities. Their revenues primarily come from rental income generated by these properties.
-
Mortgage REITs: Unlike equity REITs, mortgage REITs do not own physical properties. Instead, they lend money to real estate owners and operators by directly providing mortgages and loans or acquiring mortgage-backed securities. Their earnings are primarily derived from the interest spread between the mortgage loans and the cost of funding.
-
Hybrid REITs: Hybrid REITs combine the strategies of both equity and mortgage REITs. They invest in both physical properties and real estate financing.
Investing in REITs
Investors can gain exposure to REITs through various means:
-
Publicly Traded REITs: These REITs are listed on national securities exchanges, making their shares easily accessible to individual investors. They can be bought and sold like stocks throughout the trading session.
-
Public Non-Traded REITs: While these REITs are also registered with the Securities and Exchange Commission (SEC), their shares do not trade on national securities exchanges. As a result, they are less liquid compared to publicly traded REITs but may offer more stability.
-
Private REITs: Private REITs are not registered with the SEC and are typically limited to institutional investors. They offer less liquidity but may provide opportunities for accredited investors seeking specialized real estate exposure.
Investors can invest in REITs through brokers or financial advisors, who can facilitate the purchase of publicly traded or non-traded REIT shares. Additionally, REITs can be included in certain retirement and investment plans, providing another avenue for investors to participate in this asset class.
Benefits of REITs
REITs offer several advantages for investors:
-
Diversification: REITs allow investors to diversify their portfolios by gaining exposure to different types of real estate assets, sectors, and geographical locations.
-
Liquidity: Unlike direct real estate investments, REITs are highly liquid, as their shares can be bought and sold on public exchanges. This liquidity provides investors with the flexibility to adjust their positions as market conditions change.
-
Dividend Income: REITs are required to distribute a significant portion of their earnings as dividends, providing investors with a steady income stream. This income can be especially appealing in low-interest-rate environments.
Summary
A Real Estate Investment Trust (REIT) is a pooled investment with a high dividend yield that invests in real estate.
REITs give investors an opportunity for participation and diversification in real estate investments, while also offering much higher degrees of liquidity and lower buy-in amounts than can be found in other real estate investments. A REIT operates much like a mutual fund, and would technically be taxable as a corporation if it weren't for its REIT status.
REITs must distribute 90% of earnings each year to the shareholders (in the form of dividends), and the tax burden falls on the investors. A DRIP is a Dividend Reinvestment Plan, which allows shareholders to reinvest the distributed dividends efficiently to capture the potential of compounding interest.
There are Equity REITs, in which investors hold shares of income-producing real estate, and Mortgage REITs, which either finance mortgage loans or acquire mortgage-backed securities, and there are REITs which are a hybrid of the two strategies.
Investors can also buy shares of REIT mutual funds or ETFs, which may be indexed or actively managed. REITs are often referred to as Alternative Investments, which offer diversification in assets low in correlation to other major asset types.
In recent years, however, many advisors consider REITs to be a core holding, due in part to their ubiquity and in part to the emergence of other liquid assets which offer even lower correlation to traditional investments.