Over the past several years, REITs (Real Estate Investment Trust) have become more popular with retirement investors because they offer a total return on investment through potentially high dividends, with the added potential for longer-term capital appreciation. This makes REITs a valuable addition to retirement investment portfolios, where the income stream to meet retirement living expenses, becomes the motivating factor.
What Is a Real Estate Investment Trust?
In the United States, Congress established REITs (real estate investment trusts) in 1960, and this was an extension of the Cigar Excise Tax. The extension provides a way for individual investors to buy shares in commercial real estate with earnings coming from a variety of properties such as data centres, hotels, and health care facilities, apartment complexes and office space. The REITs could also be in the form of energy pipelines, mobile phone towers, fibre optic cables, warehouses, and self-storage. In fact, anything that has multiple occupants or users and where a rental income could be factored in to the earnings, which made the investment more lucrative – as opposed to a single brick and mortar property valuation.
How a REIT works
The traditional business model for REITS: own a large property, lease space, and collect rental income, which is distributed among shareholders in the form of dividends.
In the US, the Internal Revenue Code sets up how a REIT operates. To qualify the REIT must own income generating real estate and this money distributed to shareholders.
The legal requirements:
- Total assets minimum of 75% must be in real estate, US Treasury’s, cash
- Gross Income of at least 75% must originate from property rental, interest on mortgages for real estate properties, real estate sale
- REIT is required to show an annual 90% taxable income return in shareholder dividends
- Minimum of 100 individual shareholders within the first year of business registration
- The minimum shareholding for five or fewer shareholders cannot be more than 50% of the company during the final six months of each taxable year
- The IRS requires the REIT to be a fully taxable corporation, and a board of directors or trustees must operate the fund management
- A real estate investment trust (REIT) therefore, is an incorporated company, which finances, owns, or manages income generation through real estate properties.
- Equity REIT: own and manage property- buildings/real estate
- Mortgage REIT: trade or hold mortgage backed securities and property mortgages
- Investors in REITs secure a steady stream of rental income, but there is less emphasis placed on capital appreciation from buildings
- REITs are publicly traded, making them more liquid than traditional real estate investment
Types of Real Estate Investment Trust Funds
There are three types of REITs. The classification relates to the business model and how the shares are bought and sold.
- Equity REIT derives revenue from rental and not resale. The business model: Buy, own and manage revenue generating real estate.
- Mortgage REIT (mREIT): real estate owners and operators borrow money through mortgages and loans or indirectly, through MBS (mortgage-backed securities) An MBS is a mortgage investment pool of funding issued by GSEs (government-sponsored enterprises). Their returns are derived from the net interest margin, which is the spread or difference between interest on mortgage loans and the cost of funding the loans. They are interest rate sensitive due to their mortgage-centric core.
- Hybrid REIT: An enterprise holds both mortgage loans and brick and mortar rental properties. They have a different business model developed in line with their core business function or either property or mortgage assets.
What are Public and Privately Traded REITs
In the United States, publicly traded REITs fall under SEC regulations and offer shares in a publicly listed property that is traded on the national securities exchanges (Stock Exchange). They are subject to market fluctuation, which makes them extremely liquid investment assets.
Public non-traded REITs also fall under SEC jurisdiction; they are not traded on public exchanges. The result is they are less liquid than the public traded REITs and therefore, more stable as an asset investment.
Private REITs are not listed or registered with the SEC, and therefore, they are not traded in any form of public exchange. The investors buy and sell in a private platform, and sales are, therefore, only to a select investor group.
Pros and Cons of REIT Investment
As part of a financial portfolio, REITs have exceptional investment potential for long-term earnings. However, as with all investments, there are pros and cons.
The Pros of REITs for Beginners
REITs are traded on public exchanges and therefore offer simplicity in their buy/sell options. Traditionally, real estate poses many downsides, as they are notoriously illiquid. This means that it often takes months to negotiate and close a deal, whether buying or selling in the traditional real estate market. Also, there are estate agent fees, legal fees and government taxes to calculate into the final figure which often come as a surprise and detrimental to the final value of the property, especially for the average person or real estate novice.
On a public domain such as a real estate REIT exchange, this illiquidity is somewhat mitigated, and that is why REITs are more attractive, especially when starting out with an investment portfolio.
In addition, REITs offer a better ROI (return on investment) as they have a more stable cashflow and attractive risk adjusted profitable returns making them a more accessible option asset class to offset bonds and equities in a financial portfolio.
The Cons of REITs for Beginners
The legal structure of a REIT Enterprise means that 90% of income must be paid to investors, leaving 10% taxable income for re-investment into the purchase of new physical assets. Dividends are taxed as “regular income,” and some REIT enterprises charge high transaction and management fees.
REIT asset base is linked to the economy via the real-estate market. This means that they are subject to market fluctuations, which is one of the risks involved. Also, capital appreciation is less, and there is no guarantee for profit or losses caused by market volatility.
Financial diversity offers a useful counterweight to asset portfolio
Transparency through Government Regulation
Risk adjustment offers better returns
Steady income through regular dividend payments
Real Estate Market association offers low capital appreciation and little room for capital growth
No tax incentives
High Fees – transaction and management
Susceptible to market volatility, which adds risk
How to Invest in REIT
There are several ways to invest. Publicly traded REITs require you to go through a broker to purchases shares, also invest in REIT exchange-traded funds or ETFs, also REIT mutual funds.
For non-traded REIT shares, there are now several platforms or broker financial advisors participating due to the popularity of this form of defined benefit and defined contribution retirement and investment plans for companies in the United States, among others. In the US alone, a survey by Nareit (National Association of Real Estate Investment Trusts) in Washington DC estimated that there are now over 80 million Americans with REITs as part of their retirement and savings portfolio. Nareit approximates that the US has over 225 publicly traded REITs, which means that there is much scope, but also much due diligence to undertake to find the right platform for your investment.
How to find the best REIT for beginners
Check up on the enterprise’s management team and their track –record. If they have a performance based compensation package for investors, the options are better for you because they will be working hard to secure the most lucrative properties and therefore, they will have advanced strategies in place.
When you calculate what your earnings will be, it is essential to look at how the anticipated growth per share is reflected against current dividends. Measure the generated cash flow achieved from the FFO (funds from operations), which calculates the revenue generated by the REITs assets.
Evaluate the areas in the real estate market where there is current growth, such as health care in the United States, which is one of the fastest growing industries incorporating physical buildings like retirement and frail care communities, medical centres and patient day care facilities.
Top REIT Companies
There are several places to find out which are the top REIT companies, and Nareit offers a broad spectrum from around the globe.
For example, HCP Inc. has a market cap of $15 billion, making it an extremely large company, and it is an S&P 500 listed company, which makes it extremely liquid. In April 2019, HCP recorded $31.25 per share, and with around 2.56 million daily traded shares, which at the end of their 52-week high, were offering a dividend yield of 4.32%. HCP recently restructured its property portfolio to focus on medical centres (office buildings), housing for seniors as well as life sciences such as laboratories, diagnostic centres, genomics, and others.
(Please Note: We do not offer HCP as an investment option- it is included only as an example of REIT enterprise with good earnings for investors.)
As a beginner in real estate investment, it makes perfect sense to put money into REITs. There are pros and cons for REITs, but the advantages far outweigh the disadvantages, and the government regulations are an advantage. Besides, having a regular dividend income, especially for retirement, without having to be concerned with the operational side of owning rental properties in the traditional sense, makes REITs a secure and trusted investment.
The tax implications can be viewed as a disadvantage, but when looked at realistically, the income adjustments also mean that the IRS is taken care of legally without fear of breaking the law.
The biggest hurdle for financial investors is always doing the homework. However, REITs are regulated meaning that there is information about them that is readily available, and it is up to each individual to ensure that they choose according to their needs and circumstances.