What is a REIT and why you should know about it?
Real estate investing minus the hassles
If you have ever bought or sold a house or invested in commercial real estate, you are very well aware of the fact that investing directly in real estate is characterized by difficulties like high initial investment, requiring the use of excessive leverage, need for real estate expertise, if you are investing in commercial real estate, and most importantly, the lack of liquidity, especially when you need it the most.
That being said, investing in real estate has been known to offer important diversification benefits to a portfolio. But the problem is that the high price of the real estate investment means that this investment ends up being the bulk (if not all and then some) of your investment portfolio, throwing diversification out of the window.
What if you could invest in real estate (a) at a low price of your own choosing (b) with no leverage (c) in a liquid market (d) with a professional management? Sounds too good to be true? Not all all.
What is a REIT?
Let’s start from the beginning. Always a good place to start!
REIT stands for Real Estate Investment Trust.
This is how Investopedia defines REIT: “A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock. REITs provide investors with an extremely liquid stake in real estate. They receive special tax considerations and typically offer high dividend yields.”
So far, so good. The definition compares REIT to a stock in some sense, but it is better to think of it as a mutual fund rather. REIT can be listed and traded on exchanges, hence liquidity is not an issue, unlike direct investment in real estate.
REIT can be thought of as a mutual fund that invests in real estate through (a) property or (b) mortgages.
If the REIT invests through (a) property, it is called an Equity REIT. Most of the REITs belong to this class. Their focus is on income-generating properties as we will see later.
If the REIT invests through (b) mortgage, it is called a Mortgage REIT.
Hybrid REITs invest in both property as well as mortgages.
Any other requirements to qualify as a REIT?
In US, at least 75% of a REIT’s assets must be invested in real estate, cash or US Treasuries. And at least 75% of the gross income should come from real estate. All REITs must have at least 100 shareholders.
What makes REITs an attractive investment?
Following two points are critical to understanding REITs.
(1) REITs are generally exempt from federal income taxes at corporate level, provided they distribute most of their taxable income to the investors/shareholders. However, they do generally face taxation on any retained income.
(2) By law, REITs need to have a dividend payout ratio of at least 90%. That is, at least 90% of the income earned by REITs has to be distributed as dividend to the shareholders. This dividend payment is generally taxed at the shareholder level as ordinary income, unless the dividends are taken to be “qualified dividends”, in which case capital gain taxes are applicable on them.
Bottomline — Since REITs do not have to pay taxes at corporate level, they pass on the resulting benefit to the shareholders in the form of higher dividends.
What returns can I expect?
In US, equity REITs have generally yielded more than the 10-year Treasury bonds, as can be seen in the chart below.
Are there different types of REITs?
We have already seen one kind of classification of REITs, based on whether they hold property or mortgages.
REITs are also classified on the basis of the kind of property they own, as can be seen in the pie chart below.
Shopping centers/Regional malls dominate the chart. Residential and Office REITs are also very common.
This kind of classification can tell you a lot about what to expect out of the REIT. Apartment REITs are influenced a lot by the demographics in the area. Same is the case with health care REITs. Whereas, Office REITs would be influenced more by where the economy currently stands with respect to the business cycle. The income from Hotel REITs will be more cyclical compared to other REITs. Diversified REITs hold more than one kind of property.
REITs can also earn from developing and selling properties, but most of them are income focussed rather than development focussed.
So basically, a REIT owns all these properties, which are managed by professional managements, and the income from these properties, mostly in the form of rent, is distributed to the shareholders in the form of dividend income. These REITs can be easily traded on the exchange.
Sounds simple, should I start investing now?
As always, some points of caution. Since REITs mostly earn from rental income, the financial health of the tenants has a huge effect on the financial health of the REIT. For example, during the period of the Great Recession, many REITs were trading at a discount to their Net Asset Value.
While evaluating a REIT, you might want to pay attention to the lease terms, outlook for the real estate sector, tenant concentration, management, competition etc.
Also, most of the property purchases are heavily financed by debt. So one can’t say that REITs will be uninfluenced by the vagaries of the market as long as the rent checks keep coming in. This exposure to the debt market is a risk that definitely must be considered before investing in a REIT.
Here’s another interesting point. It’s great that REITs give great dividend yields and that is exactly the reason why we are investing in them, but this also implies that REITs hardly have any residual income with themselves for future investments. Hence, they have to go to the debt markets often to finance any new purchases.
And finally, since REITs are listed on exchanges, just like stocks are, they have ample liquidity. But this also means that their daily prices can be influenced by the mood swings of the markets, even though their inherent value might not change at all.
Why did we discuss only US REITs? What about my country?
REITs originated in the US in 1960. The rest of the world has taken its own sweet time to catch up.
Australia came on board in 1971, Canada 1993, Japan 2001, Germany and U.K. 2007.
Most of these countries have similar laws, especially when it comes to taxation of REITs and distribution of most of their income in the form of dividends.
India joined the club in 2014 and the emergence of REITs in India, was in fact, the motivation behind this article. In the next part of this series, we will have a look specifically at the Indian REITs.
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- Publicly Traded Real Estate Securities, Anthony Pa0lone, CFA, et al., CFA Level II curriculum