What Is a REIT?
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REIT (Real Estate Investment Trust)
A Real Estate Investment Trust (REIT) is a company that owns and operates income properties, collecting rent from residential or commercial tenants. Taking a page from mutual funds, REITs have a pool of investors behind them who take a portion of the profits generated by these properties.
How do REITs work?
REITs invest in different kinds of real estate using funds from a pool of investors. They then distribute the earnings from these investments among the initial investors, retaining a small percentage for themselves.
They operate similarly to mutual funds in form and function. The main difference is that a mutual fund buys stock in many other companies with the money from its pool of shareholders. The fund then distributes the earnings from its investments among shareholders, keeping a portion of those earnings for itself.
How do REITs make money?
You might be thinking that a REIT is essentially a landlord that collects rent from residential tenants. While REITs do invest in apartment buildings, they also invest in offices, warehouses, malls, hospitals, hotels and many other types of properties. There are also mortgage REITs (mREITs), which do not generate income from rent but rather from financing properties for borrowers. Finally, there are hybrid REITs, which do both these things. By law, REITs must pay out 90% of their income to shareholders in the form of dividends.
What are the advantages and disadvantages of REITs?
Compared with traditional real estate investments, REITs offer several advantages.
- First and foremost, liquidity: With a REIT, you can essentially take your money and leave with relative ease. In contrast, if you are a property owner looking to sell, the process could take months or even years, depending on market conditions.
- Lower risk real-estate investing: Because REITs invest in several properties, the likelihood of not receiving a dividend payment is low. Compare this to being the sole landlord of a particular property — you must either collect rent or hire a property manager to do so on your behalf. Either way, your income is largely dependent on your tenant's ability to pay each month.
- Diversity in property investment: Most folks aren't in a position to own an office building, a hospital or a warehouse. With a REIT, you can reap the benefits of investing in commercial real estate.
- Good potential returns: Generally speaking, real estate values tend to go up, and REITs also tend to increase in value over time. This is in addition to any income generated from dividends.
On the other hand, there are several potential disadvantages to investing in a REIT.
- Taxes on Dividends: REITs are required to pay a minimum of 90% of their profits to investors. If they fail to do so, they must pay taxes on those dividends. However, because they pay such a large amount of the profits to investors, it is the investors who end up paying taxes on the earnings. In many cases, REITs pay out 100% of the profit generated from the properties in their management for this very reason. And, contrary to dividends paid from stocks, which enjoy the lower rate of a capital gains tax, dividends on REITs don’t qualify for a lower rate and are usually taxed as ordinary income.
- REITs are sensitive to interest rates: This is particularly relevant today, given the rate hikes we have seen as part of the fed's attempts to curb inflation. REIT prices increase as interest rates increase. If you have been investing in a REIT for some time already, the recent rate increases will likely have been beneficial for you. However, if you are new to REITS, the price of admission, so to speak, is higher now than it has been in recent years. The opposite is also true — if interest rates go down, so do the price of REITs, meaning that, if rates go down, and you were planning on cashing in, you may be looking at a loss.
- Fees: Because REITs distribute most of their profits among investors, they see little or no revenue from their investments. To be profitable, REITs charge sales commissions and upfront offering fees, which means you may end up making less money from them than you initially expected. You'll want to make sure to consider these additional expenses when estimating returns on a REIT.
- Don’t expect to get rich quickly: REITs are long-term investments. Because several factors can impact the value of REITs, they are generally only considered ideal for those investing on a long-term basis.
How do I invest in a REIT?
Investing in a REIT is comparable to investing in stocks or bonds. Although there are public, non-listed and private REITs, most REITs are publicly traded on major stock exchanges. In addition, just like with stocks, there are REIT mutual funds and Exchange Traded Funds (ETFs) in which investors can buy shares.
Should I invest in a REIT?
Does investing in a REIT make you a real estate mogul? Absolutely not. The owners of the real estate in question will always be the REIT, so any claim that REITs are somehow an easy way to get into real estate should be taken with a pinch of salt. However, in a well-managed portfolio, REITs can add an extra layer of diversification.
Not every asset is right for everyone, so make sure you study any potential investment meticulously and, if needed, consult with a professional advisor.
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