At the most basic level, a real estate investment trust is a company that owns, operates, or finances income-generating real estate.[1] They allow people to invest in a trust that then purchases a direct ownership stake in real estate properties. When you buy a REIT, you gain a slice of the profits and income generated from the real estate investment activity of the trust without having to buy, manage, or finance any of the properties yourself.[2] In layman’s terms, it’s a hands-off way to access professionally managed real estate by pooling your funds with other investors looking for the same thing.
REITs became available as an investment option to the public in 1960.[3] They started solely in commercial real estate, which up until then had been an asset class only available to the wealthy. They’ve broadened out since then and may seem similar to a mutual fund or exchange traded fund (ETF). But there are some key differences:
REITs are required to stay in the real estate space and must invest at least 75% of their holdings in real estate, cash, or treasuries. They must also distribute at least 90% of their taxable income every year in the form of a dividend. Mutual funds must distribute 100% of all capital gains, though ETFs have no annual distribution requirement.
The kinds of properties in a REIT can include:
- data centers
- apartment complexes
- hotels
- infrastructure
- healthcare facilities
- office buildings
- and many other income-generating properties[4]
Most REITs focus on a specific sector or kind of property similar to how other funds focus on specific strategies or areas of the market.[5] It’s a business decision as opposed to a regulatory mandate – REITs can be broad but tend to attract more dollars by offering expertise and strategies in a specific area.
Beyond the property types inside the REIT are the actual underlying activities that REITs take on. Most are equity REITs. This means that they generate money primarily through rent (not by buying and selling properties).[6] There are other forms of REITs, called mortgage REITs, that make their money either by offering loans and mortgages directly or by acquiring mortgage-backed securities.[7] These REITs are a little more complicated in terms of how they work.
Most of the profit from a mortgage REIT is generated through a spread on the interest they make from loaning money out and the cost of funding those loans. This spread is called ‘net interest margin’ and it’s very similar to how banks make profits.[8] There are also “hybrid REITs” which use both equity and mortgage strategies to generate dividends for their stockholders.[9]
A word of caution – many REITs are advertised as investments with lower volatility than the stock market. This can be true in some cases, but that doesn’t mean that the asset isn’t volatile. REITs can be publicly traded on an exchange, publicly traded but not on an exchange, or privately traded. The last in that list is typically reserved for institutional investors only. REITs that aren’t exchange traded are typically valued 1-2 times per year (no active daily market for shares). The infrequent valuations may make it seem less volatile, but the underlying assets inside that REIT must respond to the same pressures and forces that stocks and their exchange traded peers do. They aren’t insulated from losses. Pepper in the fact that non-exchange traded REITS often have restrictions on withdrawals, and you have a potential recipe for heartache when the economy sours. Proceed carefully.
REITs are like anything else; they’re great when understood and used correctly and bad when used improperly. If you’re debating REITs in your portfolio, or just generally trying to figure out how best to structure your assets to meet your retirement goals, then give us a call. We’ve helped hundreds of people think through their options and we can help you do so, too. Reach out to us today for a complimentary review and second opinion on your finances.
[1-12] https://www.investopedia.com/terms/r/reit.asp
