Over the past month or so we have been talking about the current real estate market being a great opportunity for investors. The low interest rate environment coupled with steadying prices in most markets make real estate attractive for investors looking for cash-flow and investment returns.
In the course of these discussions, real estate investment trusts (REITs) have been brought up. We have received a lot of questions about what they are and how they work. We also had a recent Facebook post about them that stirred up more interest. With this blog post we will answer some of these questions and talk about why REITs may be good option for some real estate investors. In later posts we will dive deeper into how to evaluate, value, and pick potential REIT investments.
What is a REIT?
REIT stands for Real Estate Investment Trust. A REIT is a company that owns and operates income producing real estate. A simple example would be a company that owns many apartment buildings in a region of the country that they rent out for a profit after expenses.
To further explain this example, Say you were able to buy a four unit building for $400,000. You put $100,000 down and take out a 300,000 mortgage. You can rent out each unit for $1,000/month for a total of $4,000 each month. Each month you have to pay expenses like mortgage, taxes, insurance, maintenance, property management, etc. If these expenses total to $3,000, you make $1,000 in profit each month.
A REIT does this same process but on a much larger scale. In order to finance the purchase of all this real estate, the REIT issues shares to shareholders. Many REITs are publicly traded and their shares can be bought on stock exchanges like any other stock. Other REITs are not publicly traded, but they are still registered securities. These shares must be bought from the company directly or from a representative.
As a shareholder in a REIT, you are buying into a percentage of the pool of real estate that the company owns and operates. To qualify as a REIT the company must distribute at least 90% of its taxable income to its shareholders annually in the form of a dividend. This way the company is not taxed on the corporate level. That means that the shareholders get to benefit directly from the income and the capital gains of the underlying properties.
Investing in a REIT allows you to take a stake in property ownership without the large capital and labor requirement. The investor owns the percentage of the physical asset as well as the income generated from that asset. With a REIT your capital investment is limited to the amount of the stock price which can be low a $10/share.
REITs provide a certain amount of diversification and leverage. A REIT company is able to buy numerous properties and that reduces the risk associated with owning a single property. A REIT also has loans and financing available to it that a individual may not have available.
Publicly traded REITs are highly liquid, meaning you can buy and sell them fairly easily through a broker. Contrast this with owning real estate outright, where it may take a very long time to sell your property and it could be very costly.
With REITs, a shareholder can benefit from the annual dividend as well as any increase in the stock price over time. Also, because of the tax advantages of distributing 90% of taxable income, REITs are not subject to the “double taxation” problem of other dividend stocks.
REITs allow you to build a portfolio over time. You can buy shares over time and most REITs have a dividend reinvestment plan that will automatically reinvest your dividends into more shares at no transaction cost if you choose to sign up for it.
As a REIT investor, you are still subject to the market conditions of real estate. In a bad market, real estate prices can decrease and that will affect your share price and your dividend.
REITs are also subject to other market forces such as interest rates and tight lending. Changes in these areas could affect a REIT’s profitability.
A REIT investor is also putting his/her confidence in the management team of the REIT. The real estate assets are managed by a professions team. The appreciation and income of these assets are related to the team’s ability to pick the right investments and make the right decisions. When choosing a REIT investment you must make sure to look into the management team’s experience and track record.
Types of REITs
As you know, there are many different types of real estate. REITs are no different. They are usually specialized to one area of the market. This makes sense because the management team may be experienced and have expertise in one area. Below are different types of REITs:
These REITs own and operate multi-family rental apartment buildings. These REITs will follow the market trends of rental housing.
These REITs own and operate shopping malls and retail real estate. Most shopping malls you frequent are owned by REITs. These companies will follow the retail industry itself. The REITs make money from rents from the retailers and if the retail industry is experiencing hard times it could affect the REIT.
These REITs invest in the real estate of hospitals, nursing facilities, medical centers, and retirement homes. These REITs are tied to the healthcare system and the health trends of the population.
These REITs invest in office buildings, industrial facilities, and other commercial real estate. These will be tied to the state of the economy and the business sector. If companies are doing well and expanding, they will require more space and rents will increase.
Some REITs invest in mortgages instead of the real estate itself. Some of these REITs originate the mortgages themselves while other buy mortgage on the secondary market. These REITs come with their own risks. There is the threat of default on mortgages and debt. There is also the risk of changes interest rates that can make mortgages less valuable. For example if a mortgage is issued for 4% and interest rates move up to 5% the next month, the 4% mortgage is worth less to potential buyers of the debt.
We hope this post sheds some light on what a REIT is. We think that they can be a productive part of an investment portfolio. They can also get an investor started in real estate for a lower startup investment than purchasing real estate outright. They are a good vehicle to know about and to consider, but diligence must be put into researching the industry, the market, the company, and the management team before investing. We will have more articles later about how to conduct this research and what to look for when evaluating a REIT.