What Is a Real Estate Investment Trust?
Congress established real estate investment trusts (REITs) in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. The provision allows individual investors to buy shares in commercial real estate portfolios that receive income from a variety of properties. Properties included in a REIT portfolio may include apartment complexes, data centers, health care facilities, hotels, infrastructure in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.
Most REITs specialize in a specific real estate sector, focusing their time, energy, and funding on that particular segment of the entire real estate horizon. However, diversified and specialty REITs often hold different types of properties in their portfolios.
How a REIT Works
Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders.
To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code. These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a company must meet specific requirements including:
- Invest at least 75% of its total assets in real estate, cash or U.S. Treasurys
- Receive at least 75% of its gross income from real property rents, interest on mortgages financing the real property, or from sales of real estate
- Return a minimum of 90% percent of its taxable income in the form of shareholder dividends each year
- Have a minimum of 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
Other requirements including the REIT be an entity that is taxable as a corporation in the eyes of the IRS. Further, the enterprise must have the management of a board of directors or trustees.
Types of REITs
There are several types of REITs. The funds have classifications that indicate the type of business they do and can be further classified depending on how their shares are bought and sold.
Equity REITs is the most common form of enterprise. These entities buy, own and manage income-producing real estate. Revenues come primarily through rents and not from the reselling of the portfolio properties.
Mortgage REITs, also known as MREITs, lend money to real estate owners and operators. The lending may be either directly through mortgages and loans or indirectly through the acquisition of mortgage-backed securities (MBS). MBS are investments holding pools of mortgages issued by government-sponsored enterprises (GSEs). Their earnings come primarily from the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. Due to the mortgage-centric focus of this REIT, they are potentially sensitive to interest rate increases.
Hybrid REITs enterprises hold both physical rental property and mortgage loans in their portfolios. Depending on the stated investing focus of the entity, they may weigh the portfolio to more property or more mortgage holdings.
| Type of REIT | Holdings |
|---|---|
| Equity | Own and operate income-producing real estate |
| Mortgage | Provide mortgages on real property |
| Hybrid | Own properties and make mortgages |
| Publically Traded | Listing on a national exchange |
| Public Non-traded | Registered with the SEC but not publically traded |
| Private | Work only as private placement investments |
Publicly Traded REITs offer shares of publicly traded REITs that list on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
Public Non-traded REITs also registered with the SEC, but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs but tend to be more stable because they’re not subject to market fluctuations.
Private REITs are not registered with the SEC and don’t trade on national securities exchanges. They work solely as private placements selling solely to a select list of investors.
Pros and Cons of Investing in REITs
REITs can play an important part in an investment portfolio. As with all investments, they have their advantages and disadvantages.
On the plus side, REITs are easy to buy and sell, as most trade on public exchanges. This marketable feature mitigates some of the traditional drawbacks of real estate. Traditionally, real estate is notoriously illiquidity—property can take a long time to sell or purchase—and its lack of transparency as not all markets offer reliable information on taxes, ownership, and zoning. REITs are regulated by the SEC and must file audited financial reports.
Performance-wise, REITs offer attractive risk-adjusted returns and stable cash flow. Also, a real estate presence can be good for a portfolio, diversifying it with a different asset class that can act as a counterweight to equities or bonds.On the plus side, REITs are easy to buy and sell, as most trade on public exchanges. This marketable feature mitigates some of the traditional drawbacks of real estate. Traditionally, real estate is notoriously illiquidity—property can take a long time to sell or purchase—and its lack of transparency as not all markets offer reliable information on taxes, ownership, and zoning. REITs are regulated by the SEC and must file audited financial reports.
On the downside, REITs don’t offer much in terms of capital appreciation. As part of their structure, they must pay 90% of income back to investors. So, only 10% of taxable income can be reinvested back into the enterprise to purchase new holdings.
Dividends received from REIT holdings are taxed as regular income. One primary risk for REITs is that they are subject to real-estate market fluctuations. Also, like most investments, don’t guarantee a profit or ensure against losses. Further, some REITs have high management and transaction fees.On the downside, REITs don’t offer much in terms of capital appreciation. As part of their structure, they must pay 90% of income back to investors. So, only 10% of taxable income can be reinvested back into the enterprise to purchase new holdings.
Pros
- Liquidity
- Diversification/Counterweight to other assets
- Transparency
- Steady dividends
- Risk-adjusted returns
Cons
- Low growth/Little capital appreciation
- Non-tax-advantaged
- Subject to market risk
- High management and transaction fees
Key Takeways
- A real estate investment trust (REIT) is a company that owns, operates or finances income-producing properties.
- Equity REITs own and manage real estate properties
- Mortgage REITs hold or trade mortgages and mortgage-backed securities.
- REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
- Most REITs are publicly traded like stocks, making them highly liquid—unlike most real estate investments.
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