Interested in Investing in Real Estate Investment Trusts? Here is What You Need to Know.

Monday, Aug 30, 2021

Approximately 145 million people in the US are invested in a Real Estate Investment Trust, or a REIT. REITs typically provide high dividend yields- which make them a fine choice for investors looking for some extra income or who reinvest their dividends. So, what are REITs and how can you get started? This article will cover what you need to know, from the how-tos, to the risks and tax implications of the most popular form of Real Estate Investment Trusts.

What Are REITs?

Real estate investments trusts are companies which own or finance, and sometimes manage and/or operate, real estate which produces income. Generally, REIT’s specialize in one or more categories of property. This can include office space, apartment buildings, warehouses, shopping centers, medical centers, cell towers, data centers, and other commercial properties. Most REITs trade within major stock exchanges and can offer certain benefits to investors. REIT’s somewhat model mutual funds in the sense that they pool capital together from various investors to purchase real estate (either for ongoing income or resale.)

REITs were created by congress in 1960 to make it possible for everyday people such as you or me to benefit from income-producing real estate. They also have opportunities for dividends and returns. Anyone can invest in an REIT the same way they would for other stocks. You can purchase shares individually, through a mutual fund, or through an exchange traded fund (ETF).

So… how do REITs make their income? By owning properties which can be leased out, the REITs collect rent as income which is then paid out to the REIT’s shareholders as dividends. As a rule, REITs must pay 90% of their taxable income to their shareholders. Many pay out 100%!

There are 4 major different types of REITs- Equity REITs, mortgage REITs, Public Non-Listed REITs, and Private REITs. Equity REITs represent the majority. These are the REITs that are publicly traded and what folks are typically referring to when they simply say “REIT”. Mortgage REITs, or mREITs, purchase mortgages and/or mortgage-backed securities. Their income comes from the interest on their investments. Public Non-Listed REITS, or PNLRs, are registered with the Securities and Exchange Commission, but are not traded on the national stock exchanges. Lastly, Private REITs are not registered with the SEC, and their shares are not traded publicly. For the sake of this article, I will focus on Equity REITs, and refer to them simply as REITs.

Historically, REITs have delivered competitive returns- which makes them a good diversifier to add to your portfolio! So, how do you do it?

How to Invest in REITs

You can invest in REITs as you would for any other public stock. REIT mutual funds and exchange-traded funds are also available as options. At 5280 Associates, your advisor can assist you in analyzing your options and choosing investments that are right for your portfolio. It is best to assess the risks and tax implications before diving in.

How Can a Company Qualify as a REIT?

There are a few rules that companies must follow in order to be considered a Real Estate Investment Trust. These rules include, but are not limited to:

Invest a minimum of 75% of their total assets into real estate.
Own real estate as a long term investment.
Gain a minimum of 75% of their gross income from rent, interest of mortgages (mREITs), or the sale of real estate.
Have at least 100 shareholders.
Not allow 50% or more of their shares to be held by 5 or fewer individual shareholders.
Pay out a minimum of 90% of taxable income to their shareholders every year in the form of dividends.
See that 95% of the REIT’s income is passive.
Be a taxable business entity.
Have a board of directors or trustees.

Pros and Cons of REITs

Pros

One of the pros of investing in Real Estate Investment Trusts is they can add diversity to your portfolio. The performance of REITs is not always correlated to the performance of the stock market, and therefore, they can be a good diversifier.

REITs also offer dividends, as they must pay out a minimum of 90% of their income in this fashion. They may pay out more than 90%, but may never opt for less. Investors looking for a consistent flow of dividends may find REITs attractive for this reason. Because REITs don’t have to pay corporate tax, their dividend payout is higher than other investment options.

Lastly, REITs are relatively liquid compared to other real estate investment options. Buying and selling REITs takes less time than buying and selling properties. You also don’t have to deal with the struggle of managing a rental property.

Cons

REITs face their fair share of negatives, as all investment options do. While REITs don’t owe corporate taxes, they do still require the investor to pay taxes on dividends- and these dividends are taxed at income rates instead of the more favorable capital gains rate.

REITs are hypersensitive to changes in interest rates. Rising interest rates can sometimes mean falling prices for REITs. The value of REITs is also heavily influenced by trends. For example, if a REIT is invested in smoothie shops at outdoor malls while smoothies fall out of trend, the value of the REIT will fall. It is safer to invest in REITs with a diverse portfolio of properties that do not fall victim to fads.

REIT’s are also subject to tenant risk. Meaning, any REIT’s cash flows are only as reliable as it’s tenants. This risk can be mitigated by doing due diligence ensuring that the tenants of the potential REIT are of high credit quality with a diverse tenant base.

REITs, similar to other equity type investments, are meant to be held long term- at least 5-7 years. If you are looking for a short-term investment, REITs probably are not for you.

Tax Implications

As mentioned above, dividends from REITs are typically taxed as income for the investor. This is because the REIT owes no corporate tax, and therefore the income is passed from the company to you, the investor. A portion of these dividends may qualify for 20% deduction under the Tax Cuts and Jobs Act, passed by President Trump in 2017 as an amendment to the Internal Revenue Code. However, these potential deductions are set to expire after 2025.

While ordinary income usually makes up the bulk of REIT distributions and taxation, REITS can also make capital gain/loss distributions. This occurs when the REIT sells a property they have held for over a year and in turn, this gain or loss is also passed from the company to you. The REIT will let you know when they sell a property whether they faced a gain or a loss.

In addition to both of the above scenarios, a portion of the dividends can also be classified as a nontaxable return of capital. This occurs when the distributions to the REIT’s investors exceeds the REIT’s earnings. This part of the dividend is not taxable the year it is paid out. It is instead taxed when you sell that share of the REIT. However, if the cost basis falls below zero, any further payouts from the REIT are taxed to you as capital gains.

Real Estate Investment Trusts can be a good option if you are looking to add some diversity to your portfolio. Talk to your advisor about whether REITs are a good fit for your situation and how you can get started.