What Is a Real Estate Investment Trust (REIT) and Why Would I Want to Own One?
Real estate has historically delivered attractive investment returns through a combination of current income and price appreciation. Many investors want to include real estate as a piece of a well-diversified portfolio. However, adding real estate to a traditional investment portfolio consisting of stocks, bonds and cash was a challenge. The Real Estate Investment Trust (REIT) structure was created to mitigate many of the challenges individual investors can have when attempting to invest in institutional-grade commercial real estate.
The Basics
A REIT is formally known as a Real Estate Investment Trust. REITs are pooled investment vehicles similar to a mutual fund that allow retail investors to access the benefits of large commercial real estate investments. REITs own, operate, or finance income-producing real estate. Congress originally passed legislation in 1960 allowing the creation of REITs. This law was refined with the passage of the 1986 Tax Reform Act. This allowed REITs to manage and operate real estate, while the prior legislation had limited REITs to simply owning and financing real estate. The enhanced ability to own and manage real estate created the foundation for the existing REIT investment landscape.
The Modern REIT era began in 1986 and accelerated during the 1990s as real estate companies transformed their businesses into qualified REITs. The major driver of this transformation was the attractive tax benefits offered. Investors in corporations are effectively taxed twice. The company pays the corporate income tax, then when dividends are paid to shareholders, these dividends are taxed again. REITs offer a solution to help manage this double taxation. REITs are able to avoid paying corporate income tax by meeting specific criteria.
How to Qualify as a REIT1
A company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. A company that qualifies as a REIT is allowed to deduct all of the dividends that it pays out to its shareholders from its corporate taxable income. Because of this special tax treatment, most REITs pay out at least 100 percent of their taxable income to their shareholders and, therefore, owe no corporate tax.
There are a number of other qualifications required that generally fall under the category that the corporation is substantially involved (75% or more) in real estate assets and that the gross income is derived from real estate sources including rents and interested paid on mortgages. This framework has allowed the creation of three major types of REITs: Equity, Mortgage, and Hybrid.
- Equity REITs
The majority of REITs are equity REITs. These are vehicles that own and manage income-producing real estate. - Mortgage REITs (mREIT)
Mortgage REITs utilize the income earned on debt to produce dividends. Mortgage REITs may invest in mortgage back securities (MBS), purchase existing mortgages, or lend directly to borrowers. - Hybrid
Hybrid REITs utilize investments in both Equity and Mortgage areas.
Public vs. Private
There are both publicly traded REITs and private REITs. Public REITs can take two forms: Publicly traded REITs and public non-traded REITs.
Comparison of Publicly Traded REITs vs. Non-Traded REITs
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Publicly Traded REITs |
Non-Traded REITs |
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Overview |
REITs that file reports with the SEC and whose shares trade on national stock exchanges. |
REITs that file reports with the SEC but whose shares do not trade on national stock exchanges. |
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Liquidity |
Shares are listed and traded on major stock exchanges, like any publicly traded stock. Most are NYSE-listed. |
Shares are not traded on public stock exchanges. Redemption programs for shares vary by company and are typically very limited. Investors may have to wait to receive a return of their capital until the company decides to engage in a transaction such as listing the share on an exchange or liquidating the company’s assets. |
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Transaction Costs |
Brokerage costs are the same as for buying or selling any other publicly traded stock. |
Typically, broker-dealer commissions and other upfront offering costs are charged at 9-10 percent of the investment. Ongoing acquisition and management fees and other expenses are also typical. Backend fees may also be charged. |
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Management |
Typically, the managers are employees of the company. |
Typically, the company has no employees and is managed by a third party pursuant to a management contract. |
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Minimum Investment Amount |
One share. |
Typically, $1,000 - $2,500. |
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Independent Directors |
Stock exchange rules require a majority of directors to be independent of management. NYSE and NASDAQ rules call for fully independent audit, nominating, and compensation committees. |
Many states have adopted the North American Securities Administrators Association (“NASAA”) guidelines, which require a majority of directors to be independent of management and that a majority of each board committee consists of independent directors. |
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Investor Control |
Investors elect directors. |
Investors elect directors. |
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Corporate Governance |
Specific stock exchange rules on corporate governance. |
Subject to state and NASAA guidelines. |
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Disclosure Obligation |
Required to make regular SEC disclosures, including quarterly financial reports and yearly audited financial reports. |
Required to make regular SEC disclosures, including quarterly financial reports and yearly audited financial reports. |
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Share Value Transparency |
Real-time market prices are publicly available. A wide range of analyst reports is available to the public. |
No independent information about share value available. The company may provide an estimated share value 18 months after the offering has closed. |
Source: National Association of Real Estate Investment Trusts (NAREIT)
Key Benefits & Risks Associated with REITs
REITs offer a number of benefits and associated risks, which a potential investor must consider. Here are a few of the key benefits and risks of investing in REITs:- REITs offer exposure to real estate without the associated management cost and requirements
- REITs can be a reliable source of income
- REITs are subject to economic and market risks
- REIT investors are dependent on the skill of the management team to produce returns -- poor management can lead to poor returns
- REITs can add meaningful diversification to a portfolio
To learn more about the benefits, risks, and key differences between various types of REITs, download our full white paper, About REITs as an Investment Alternative.
Contact BakerAvenue to understand if REITs are a good investment alternative for you.
Sources
1SEC Investor Bulletin Real Estate Investment Trusts (REITs)
2Return Correlations between REITs and the Broad Stock Market by Property Type