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What are REITs? Complete Guide to Real Estate Investment Trusts

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Do you want to make money by investing in REITs?

REIT stands for Real Estate Investment Trust. It is a special kind of financial vehicle that has been a good place to be over the last 20 years. One of the biggest reasons why investors like REITs is the fact that they pay cash, sort of like a dividend.

The structure of a REIT helps it to deliver great returns to investors, and minimize the taxes it pays.

There are a few different kinds of REITs out there. All of them invest in some sort of cash-bearing asset, like commercial real estate. There are also REITs that invest in mortgages, which come with both advantages and disadvantages.

If you are looking for an asset that will pay you to hold it, and could also rise in value, it is worth learning more about REITs. Many REITs can be bought with a simple stock trading account as well, which makes them a great way to get a foothold in the real estate sector as a small investor.

REITs Have to Pay Investors!

The assets that compose a REITs holdings can vary, but no matter what, they have to pay their unitholders (the investors who own the REIT) 90% of their income in order to qualify as a REIT in the USA.

What is so special about being a REIT?

It is all about taxes.

A REIT is a form of unit investment trust, and instead of treating its income as profit, it flows through directly to the unitholders.

In essence, rental income is the business of a REIT. As a unitholder, you would receive the income from the REIT’s holdings straightaway, which is why REITs seem to pay such high returns.

According to the IRS, a REIT must use these rules:

  • Any rental income has to be treated as business income. Any and all expenses related to rental activities can be deducted from a REIT’s taxes, in exactly the same way that a company could deduct business expenses.
  • Additionally, current income that is paid to the REIT’s unitholders isn’t taxed (YAY!), but if that income is paid to a non-resident beneficiary, that income will be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains (unless otherwise noted).

The net result of this is a financial structure that is highly advantageous for investors. The trust structure that ‘owns’ the REIT’s assets is basically tax-exempt, unless it fails to pay 90% of its income to the unitholders, or retains cash for some other reason.

Real Estate vs Stocks

Read: Investing in Real Estate vs Stock Market: Pros & Cons of Each

REIT Unitholders Can Win On Taxes as Well

The money that REITs pay to their unitholders will generally fall into one of three categories. Return of capital, ordinary income or qualified dividends. This makes the income from a REIT a bit more complex than a regular dividend, but it can also be advantageous to unitholders.

Depending on a person’s financial position, money coming in as ordinary income or qualified dividends could be preferable to other forms of income.

The real winner for REIT holders is money that is paid as a return of capital, as this income will likely reduce the amount of taxable income for the unitholder in the year that money is received. It can also be deferred until the capital asset is sold, which could be years.

If you are planning to make a large investment in REITs, it is a good idea to talk to a qualified financial planner about which kind of income would be the best for you. Regardless, the tax advantages that REITs offer are worth knowing about and put them into another class of income-bearing asset.

The Kinds of REITs That You Can Buy

There are three basic kinds of REIT structures

  • Equity REITs
  • Mortgage REITs
  • Hybrid REITs

An equity REIT invests in some form of income bearing real estate. There are a few kinds of equity REITs, which will be described in greater detail below.

Mortgage REITs are very straightforward. They invest in mortgages and pass the income along to their unitholders.

A hybrid REIT is simply a REIT that holds both equity and mortgages.

Breaking Down Equity REITs

Equity REITs will represent some form of ownership in a real estate asset that creates a revenue stream. With the exception of mortgage REITs, most own commercial real estate.

It is important to consider the health of the sector that a REIT invests in, as those tenants will be responsible for creating the income that will flow through the REIT to you!

Mortgage REITs

Mortgage REITs create income by buying mortgages of all different types.

Unlike synthetic mortgage bonds, mortgage REITs tend to own the mortgages directly. As we learned in 2008, not every housing market is created equal. The mortgages that a mortgage REIT owns will determine how it performs, so knowing something about the areas where it invests is vital to your success.

Like any other form of lending, the higher the risk, the higher the return on the investment. Most mortgage REITs attempt to create a diversified portfolio by buying a range of mortgages, though some seek to create higher yields by focusing on higher risk loans.

Residential REITs

Residential REITs are a more direct way to gain access to the revenues that residential proprieties create. Many people think of single-family homes when residential real estate comes up, but residential REITs focus on larger buildings or apartment complexes.

There are many levels of residential proprieties, and each type will have benefits and drawbacks. Location is also a big deal, and you should look into the holdings of any REIT before you buy into it.

One of the biggest advantages that residential proprieties have over other kinds is that people absolutely need somewhere to live. Depending on what socioeconomic demographic a residential property caters to, it could be highly resistant to an economic downturn.

On the downside, lower-income housing tends to be in areas that aren’t worth as much, which could mean lagging performance when an economic boom hits.

Other residential REITs specialize in student housing, which tends to be a very consistent market. Schools have a new crop of students every year, which makes these REITs a good bet for consistent income.

Regardless of the type of property, rents tend to keep pace with inflation, which makes residential REITs worth learning more about.

Pros:

  • Residential REITs tend to produce stable income.
  • Residential real estate may be more resilient to a downturn in economic conditions.
  • There will always be a demand for some forms of residential real estate.

Cons

  • Residential real estate can be subject to higher damage rates than other forms of real estate (this means lower profits).
  • High-end residential real estate can be hit hard when economic conditions worsen.

Retail REITs

Retail REITs invest their capital in real estate that caters to the retail industry. They will generate income based on the rent that retail tenants pay, all of whom will be on long-term contracts.

Retail real estate was a solid investment for many years. As the US economy has shifted to the “Amazon” model, where consumers shop online in increasing numbers, retail real estate has become a mixed bag from an investment standpoint.

In the US, retail real estate like malls has been suffering over the last few years. Stores like Sears and Toys R Us have gone out of business, which makes it hard to be super bullish on the sector as a whole.

Potential for Bargains

Remember that REITs have to pay out the vast majority of their income to unitholders. That means that if a REIT picks up some retail proprieties on the cheap, and rents rebound, the value of the REIT’s income will rise.

In the real-world Amazon has been sniffing around nearly abandoned retail proprieties, and looking for places they could turn into distribution centers.

While it is more likely that a heavyweight like Amazon would just buy retail proprieties outright, that one-off profit would make a lovely payment for a REIT’s unitholders.

Regardless, retail REITs don’t currently offer the same level of security that residential REITs can, but there is room for them to deliver surprises given how depressed the market has become.

Pros

  • Retail property in the USA has been beaten down and may present value at this point.
  • Some areas seem to be more resilient to the retail real estate blues and may trade at a discount due to the overall direction of the market.
  • Retail rents do tend to keep up with inflation, though this may no longer be as true as it once was.

Cons:

  • Retail real estate has been getting smashed for years and isn’t the safest place to invest.
  • There is a substantial amount of empty retail real estate on the market currently.

Office REITs

If you think that the commercial world is doing well, buying into a REIT that owns offices could be a good idea. Like any REIT, office REITs rely on their tenants to create cash flow. Office REITs have companies that pay rent for office space as their clients.

Stop and think about all the office space there is in the USA. Every state has a few big cities, and there are numerous offices that serve businesses in those areas.

You might have heard that the most important thing in real estate is ‘location, location, location’, and this is very true for office buildings. Unlike residential property, companies will only rent office space if they absolutely need it, and its use can change rapidly based on the overall economy.

If you are interested in office REITs, it is important to know a lot about the kind of office space they own, and exactly where they are located. In many areas, the space of a few miles can separate prime real estate from skid row, which makes a huge difference when it comes to revenues.

Pros:

  • Office REITs tend to rent on a long term basis.
  • Most companies have ‘deeper pockets’ than individuals, and will be able to meet their obligations.
  • Offices are a necessary part of a larger business, and they are relatively difficult to shut them down once they are established.

Cons:

  • Investors need to do a lot of research when investing in office space, as every market will be nuanced.
  • Offices are often one of the first things to be cut from the budget when an economic downturn hits, and this impacts revenue for an office REIT.

Healthcare REITs

It’s no secret that healthcare is big business in the USA. Healthcare REITs own hospital buildings, as well as nursing homes and other care facilities.

There are a lot of people who are approaching old age in the USA, and this represents a potential opportunity for healthcare REITs. Older people consume healthcare services in much larger amounts than younger people.

The USA also has an ‘insurance culture’ when it comes to healthcare, which may or may not introduce risk to the healthcare REITs’ business model.

The revenue of hospitals that have a large number of patients who use Medicare or Medicaid will only be as strong as the insurance programs that support its patients. If you are interested in healthcare REITs, it will be important to dig into the specific type of healthcare facilities that support the REIT’s income streams.

Pros:

  • One of the few areas of the economy that is virtually guaranteed to see growth over the next decade.
  • Vital service to the economy (unlike retail).
  • Steady returns, especially for nursing homes and other managed care facilities.

Cons:

  • US healthcare is in flux, with “Obamacare” coming under increased scrutiny.
  • Healthcare is an umbrella term (see below).

The Healthcare Industry is a Diverse Market

Out of all the kinds of REITs, there are, healthcare REITs may be the most resistant to deteriorating economic conditions. The reason for this is simple, unlike other forms of economic activity healthcare spending is rarely voluntary.

People end up in hospitals and care facilities because they need help, not because they want to use their insurance. With an aging population that will need increasing levels of care, healthcare REITs are in a sweet spot (on a relative basis), no matter what happens in the broad economy.

That said, it is extremely important to understand how the health REIT you choose to invest in generates income. The healthcare situation in the USA is in flux, and disruption to state-sponsored medical benefits could take a toll on medical facilities that rely on de-facto government funding to stay profitable.

Hospitals

Owning the land that a hospital sits on, or the building it operates in is a pretty good business model. Unlike office or retail space, there aren’t a lot of options out there for hospitals. Building a hospital is a specialty project, which may offer healthcare REITs that own hospitals a unique advantage.

On the other hand, hospitals may decide to upgrade their facilities or seek a building they own. There is no guaranteed way to make money, and the risk that a hospital may more or go out of business always exists.

Nursing Homes

With the baby boomer generation on the cusp of old age, it would seem like nursing homes are the perfect place to invest. The sector as a whole may be one of the best places to be as an investor, no matter what happens in the wider economy. That said, it is important to look into exactly what kind of facilities a REIT that owns nursing home proprieties owns.

Private Insurance v. Public Assistance

One last thing to consider in the healthcare REIT space is where the REIT’s tenants get their money from.

This is a consideration no matter what kind of REIT you are evaluating. It is especially important in the healthcare sector, due to the fact that almost no one can pay for heal services without some form of insurance in the USA.

People rely on either public insurance programs, like Medicaid, or private insurance they receive from some other source. With all the changes in public programs over the last few years, it is especially important to consider any REIT that relies indirectly on public insurance to create a profit.

REITs Tend to Produce Solid Returns

It is difficult to find another asset class that has been as consistent an earner as REITs. While there are many REITs out there, the FTSE NAREIT Equity REIT Index is often used as a gauge for the REIT sector as a whole.

In the 20 years ending in 2010, the FTSE NAREIT Equity REIT Index returned almost 10% per year, every year. Aside from mid-cap US stocks, that is the best returning asset class in the US markets.

The returns since 2010 have been solid, and more or less in line with historical results. One of the reasons why REITs have been so steady is the fact that the USA has been in a long-term expansion since the early 1980s, and real estate was an obvious beneficiary of a good economic environment.

There are Emerging Risks in the Real Estate Sector

As most investment products are legally required to tell you—don’t assume that past performance is a guarantee of future returns.

The domestic economy in the USA has been changing, and the real estate sector is in flux. REITs were able to ride a wave of economic expansion and low-interest rates that allowed people to buy far more than their incomes would normally allow.

An easy-money fueled boom started in the mid-1990s, but really heated-up after the dot-com collapse in the early 2000s. We all know how the home loan crisis came to a head in late 2007, and that without new forms of central bank intervention, the financial landscape would look very different today.

Over the last two years, there has been a massive collapse in retail stores across the USA, but it could just be the first sign of another impending collapse. REITs won’t be able to average 10% returns in a period of long-term economic decline, especially in real (inflation-adjusted) terms.

There are undoubtedly areas of US real estate that will be able to create solid returns for REIT investors, but it isn’t going to be as easy as it was over the last quarter-century.

Not only will REIT investors need to get the direction of the overall real estate market correct, but they will also need to know a lot more about the areas where a REIT invests. This isn’t the same market that a REIT buyer would have encountered in 2003, so be aware of the risks that are out there.

Are REITs Right for You?

REITs fall into a unique investment niche. For investors that are able to do some research about what kind of proprieties a REIT invests in and the overall direction of the economy, REITs have the potential to create great returns.

Despite the recent hardship in the retail sector, there are probably some great REITs out there in many areas. Offices in major cities (like New York, Boston or Washington D.C.) will likely be good earners, even if there is continued softness in the broad economy.

REITs have many of the same benefits that commercial debt offers to investors. In addition to producing income that is higher than government bonds, REITs give investors direct ownership in income-producing real estate.

For investors that want to gain access to real estate, but don’t want to take on debt and buy rental proprieties directly, REITs are a great way to invest. They also allow investors to spread their money over a number of proprieties and sectors, which would be nearly impossible for smaller investors in any other way.

REITs aren’t going to be as easy to invest in as they were a decade ago. The real estate boom that helped REITs create steady returns for 20 years is probably over. With some research, investors can still find lots of opportunity in an asset class that provides income, and direct ownership in real assets!

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Nicholas Say grew up in Ann Arbor, Michigan with a father that would read him the Wall St. Journal along side of other bed-time fare. He has traveled extensively, and been lucky enough to study a changing global economy in person. Nicholas spent many years in the Southern Cone of South America, sometimes in the middle of the countryside where livestock starts its journey to all points of the globe. Today he is thoroughly bemused with the stance that Central Banks have taken in the wake of the 2008 meltdown. There is no telling what will come out of the global financial system next, but he is glad that he lives somewhere that gold can be bought and sold readily! nick@moneycheck.com


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3 Comments

  1. Avatar
    Jagriti Singh Reply

    Great read! From a top-down perspective, REITs can be affected by anything that impacts the supply of and demand for property. Population and job growth tend to be favorable for all REIT types.

  2. Avatar

    Thank you for the insight. Have been researching REITs and your article offers good foundational reading that was missing from my research.

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