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What is a REIT (Real Estate Investment Trust)?

By Arvin Sahakian · Jul 15, 2015 · Real Estate

What is a REIT (Real Estate Investment Trust)?

Image courtesy of Flickr, Pictures of Money

REITs are high-performing investments that allow shareholders to benefit from real estate investments without having to buy individual properties.

If you're looking for an investment similar to mutual funds that allows you to invest in properties, then consider a REIT (Real Estate Investment Trust). A REIT owns or finances income-producing real estate, and there are three types available.

  • Equity REITs invest in and own properties with revenue coming mainly from property rent.
  • Mortgage REITs invest in and own property mortgages, loaning money for mortgages or purchasing existing mortgages or mortgage-backed securities. Revenue comes mainly from mortgage loan interest.
  • Hybrid REIT s invest in both properties and mortgages.

The majority of REITs available to invest in are Equity REITs. Fewer than 10% of REITs available are Mortgage REITs and there are only a small number of Hybrid REITs. All REITs are tied to aspects of the real estate market, such as apartments, hotels, nursing homes, offices, and shopping centers.

How Does a REIT Work?

A REIT's stockholders (shareholders) earn a share of the income produced by the real estate investment. Generally REITs pay out all of their taxable income in the form of dividends to their shareholders.

An investment company must do the following to qualify as a REIT:

  • Invest 75% or more of its total assets in real estate
  • Make at least 75% of its gross income from property rents, interest on mortgages that finance property, or from real estate sales
  • Pay out 90% or more of its income as shareholder dividends every year
  • Be taxable as a corporation
  • Have a board of directors or trustees
  • Have at least 100 shareholders (stockholders)
  • Have 50% or less of its shares held by five or fewer individuals

Investing in REITs

You have a few options for purchasing REITs. Most REITs are listed on the major stocks exchanges. Currently, 195 REITs are available on the NYSE (New York Stock Exchange).

As an investor, you should consult with an investment advisor or financial planner who can recommend the most appropriate REIT investments based on your objectives.

Look for the following characteristics when searching for which REITs to invest in:

  • Reliable and consistent earnings
  • Management that reinvests cash while creating new revenue opportunities
  • Strong operations, such as corporate governance, use of accounting practices, and strong tenant relationships

Tax Implications

REIT dividend distributions fall under ordinary income, capital gains and return of capital. Each of these may be taxed at a different rate.

At the beginning of the year, REITs are required to provide their shareholders with an IRS Form 1099-DIV explaining how they will disburse the previous year's dividends for tax purposes.

  • Majority of REIT dividends are taxed as ordinary income up to 39.6% (the maximum rate), plus a separate 3.8% surtax on investment income
  • On average, 68% of the yearly dividends paid by REITs to shareholders qualify as ordinary taxable income
  • 13% qualify as return of capital
  • 19% qualify as long-term capital gains

REIT dividends qualify for lower tax rates in the following situations:

  • The individual taxpayer is subject to a lower income tax rate.
  • A REIT makes a capital gains distribution (20% maximum tax rate, plus the 3.8% surtax) or a return of capital distribution
  • A REIT distributes dividends received from a REIT subsidiary or other corporation (20% maximum tax rate, plus 3.8% surtax)
  • A REIT pays corporate taxes and retains earning when permitted (20% maximum tax rate, plus 3.8% surtax)

BeSmartee TipTip: Considering the tax implications discussed here, you can see that it can become quite complicated. Once you have considered investing in a REIT and consulted with an investment advisor, it is equally important to choose a tax professional who is experienced in filing tax returns for people with diverse investments.

REIT Advantages

Equity REITs offer you diversification because their returns show little similarity to broader stock market returns over the long term.

Advantage Description
Dividends Stable income stream
Liquidity Easily bought and sold
Performance Stronger performance than the S&P 500, Dow Jones Industrials and NASDAQ over most long-term horizons.
Transparency Operate under the same rules as other publicly traded companies for securities regulatory and financial reporting purposes

Essentially, you can benefit from a real estate investment without having to go out and buy or finance properties yourself.

For Example

If you invested $10,000 in combinations of stocks, bonds, and REITs on December 31, 1984, here's an estimate of what the value of each investment group would look like 30 years later on December 31, 2014 based on the average returns from each investment type over that period of time.

  1. $6,000 in stocks and $4,000 in bonds = $182,000 Today
  2. $5,500 in stocks, $3,500 in bonds, and $1,000 in Equity REITs = $196,000 Today
  3. $5,000 in stocks, $3,000 in bonds, and $2,000 in Equity REITs = $209,000 Today

Considering this example, the third combination, with more exposure to REITs than the first two, had the best returns over the last 30 years.

REIT Disadvantages

While REITs have several advantages that make them attractive to investors, they also have a few disadvantages, including:

Advantage Description
Sensitive to Demand for Other Investments When overall interest rates rise making Treasury Bonds a more attractive investment, people will be drawn away from investing in REITs thereby lowering their share prices.
Property Taxes Property taxes that REITs must pay can represent up to 25% of their total operating expenses. The higher property taxes go, the higher this expense becomes.
Tax Rates Taxes are due on REIT dividends you receive. The tax rates are usually higher than the 15% most other investment dividends are taxed.

Something to Consider

If you are a growth investor, then you may want to seriously consider investing in REITs. The real estate markets have consistently outperformed the stock market's S&P 500 over time. The real estate market has already recovered to post five-year returns following the financial crisis of 2008. In this high performing sector, REITs have been among the best-performing investments over the past 20 years.

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