Are you interested in owning hospitals, apartment complexes, hotels or shopping malls without having to fork over the necessary cash?
A real estate investment trust, commonly referred to as a REIT or REIT index, is a company that owns or finances income-producing real estate, and in most cases, manages those properties. To a lesser extent, REITs also invest in real estate-related securities.
Most REITs have publicly traded stocks listed on major exchanges. In the simplest terms, a REIT gives you the chance to invest in a diverse portfolio of large-scale properties such as hospitals, nursing homes, student housing and other types of real estate without the need to finance or manage them.
What Is a REIT? Real Estate Investment Trust Rules
To qualify as a REIT, a company must invest at least 75 percent of its assets in real estate, derive at least 75 percent of its gross income from real estate and pay at least 90 percent of its taxable income to shareholders as a dividend each year. REITs purchase and manage a portfolio of real estate properties for the benefit of shareholders. The rent from these properties, or income from their sale, is paid to investors in the form of a dividend.
“REIT investments are a great way for individual and institutional investors to get exposure to the real estate market without the burden of becoming a property manager,” said Dennis Leontyev, president of InterMarket Edge. “It also largely eliminates liquidity risk because you can simply sell the stock instead of waiting for a property to list and sell.”
Types of REITs
Equity REITs are the most common type of REIT and include companies that own malls, hospitals, office buildings and other retail, residential and commercial properties. Equity REITs typically own these properties, manage them and derive income from the rent they receive from tenants. Additional income might come from sales of these properties, but this is not the primary source.
The other main type of REIT is called a mortgage REIT. These make up roughly 10 percent of all REITs and generate income in a different way. Mortgage REITs invest in mortgages, rather than directly investing in real estate. Their returns are closely tied to the real estate market. A mortgage REIT may directly initiate mortgages or trade in mortgage-backed securities in the secondary market. Freddie Mac and Fannie Mae are the most well-known examples of this type of company.
There is a third type of REIT as well, known as a hybrid REIT. These REITs deploy capital both in equity purchases of property and in the mortgage market. By seeking multiple sources of return, these REITs hope to generate more stable income streams.
Pros and Cons of REIT Stocks
Like any investment, determining whether a REIT is appropriate for your portfolio is largely about understanding its benefits and drawbacks. On the positive side, because a REIT is required to pay the bulk of its earnings to shareholders, it tends to offer high dividend yields that are attractive to investors seeking to generate income. There are tax considerations to these high-income-producing securities, but generally, this is a good allocation.
On the negative side, major economic shifts tend to put downward pressure on the price of REIT stock. If the REIT depreciates significantly in value, the net asset value or trading price of the REIT is likely to fall as well. It’s important to balance the income element of a REIT investment against the potential depreciation in the stock price. Additionally, because REITs have very specific accounting requirements, assessing them can be more challenging. Finally, REITs can have unexpected reactions to shifting interest rates. Higher rates can mean higher costs.
Overall, REITs are a unique type of investment vehicle that offer some attractive qualities for your portfolio. Their income and liquidity features give you the ability to get real estate exposure at a much lower point of entry than directly owning real estate as an investment. Like other investments, however, they are not without risks.