Finance
What Are Real Estate Investment Trusts – REIT?
REIT, or real estate investment trust is a company that owns, finances, or manages investment real estate. REITs also allow individuals to own shares and trade them on the major stock markets.
Opening the door for small investors to join in with billion-dollar hedge funds, real estate investment trusts (REITs) have provided a less complicated way to invest in property with added tax advantages for more than 60 years.
“Real estate has traditionally been very difficult to invest in for several reasons,” said Robert R. Johnson, PhD, CFA CAIA and professor of Finance at the Heider College of Business, Creighton University. “Chief among (the reasons are) illiquidity, large minimum investment, the unique nature of properties, and monitoring and upkeep required.”
“(REITs) allow smaller investors to participate in large real estate projects,” said Howard Krieger, managing director of Reitreal. “When you think of skyscrapers, they can cost hundreds of millions (of dollars). Some campuses can cost up to a billion. The REIT was conceived as a way to sort of fractionalize and break up (the cost) and democratize investment into it.”
Commercial real estate is becoming a popular investment, but getting into large, successful projects requires a capital entry that exceeds the resources of the small investor. Investing in a REIT buys into real estate projects and provides a tax planning opportunity.
What are REITs?
REITs own or finance income-producing real estate across a range of property sectors. These real estate companies must meet a number of requirements to qualify. Most REITs trade on major stock exchanges, offering investors several benefits.
The National Association of Real Estate Investment Trusts says, “In total, REITs of all types collectively own more than $4 trillion in gross assets across the U.S., with public REITs owning approximately $2.5 trillion in assets. U.S. public REITs own an estimated 575,000 properties and 15 million acres of timberland across the U.S.”
President Dwight D. Eisenhower signed the tax and investment vehicle into law in 1960 as part of the Cigar Excise Tax extension.
According to NAREIT, REITs invest in a wide range of real estate property types such as:
| offices | retail centers |
| apartment buildings | medical facilities |
| warehouses | data centers |
| cell towers | infrastructure |
| hotels |
Most focus on a particular property type, but some hold multiple property sectors.
“This is where the tax advantage comes in, and that’s what’s different about a REIT,” said Krieger. “When folks try to transfer real estate, especially large parcels, it triggers all kinds of tax issues. You’ll have this big, large, expensive building or campus. Then someone passes away unfortunately, and it gets transferred to their kids…that’s a taxable event.”
According to Krieger, a REIT doesn’t trigger immediate taxation or make the tax disappear. “The REIT just helps kick it down the road,” he said.
How Do REITs Work?
“REITs are publicly traded closed-end investment funds that invest in real estate directly or through mortgages on real estate,” explained Johnson. “REITs trade just like shares of stock on major stock exchanges.”
“The biggest advantages of REITs vis-a-vis direct real estate investing are liquidity and diversification, Johnson said. “Investors can buy and sell REIT shares the same way they buy and sell shares of Apple stock. In contrast, buying and selling direct real estate involves considerable time and expertise.”
The IRS sets REIT rules and expects companies to function similarly, including in terms of ownership structure. “A REIT has to have a minimum of 100 investors,” Krieger said. “No five investors can control more than half.”
These fundamental requirements keep the REIT “truly democratized.” The regulations prevent a concentration of investors from making decisions on behalf of everyone.
Krieger said that a REIT needs a board of directors to make fiduciary decisions. The board hires an administrator or manager for the REIT, typically an outside company that will choose or advise on the REIT’s investments.
“By their very nature, most REITs are diversified, representing ownership in many different real estate properties or mortgages, not one specific property or a mortgage on one specific property,” said Johnson. “So, returns to REITs tend to be more stable than returns to individual properties.”
Both Johnson and Krieger point out that REIT investment value is commensurate with stock market returns. The advantage comes from income.
“Those properties pay rent, and the rent is tallied at the end of the year,” Krieger said. “The board looks at how much they collected, how much it cost to run the REIT, and 90% of what’s left has to be distributed out as a dividend to the investors.”
Johnson says that’s how the investors get paid, both from rents and any profits from property dispositions during the year.
REITs may qualify for a 20 percent deduction on the qualified business income portion of the distribution, reducing overall taxes. Much of the payoff, net income, is taxed as ordinary income. When assets are sold, that can trigger tax at long-term capital gain rates. If part of the distribution is classified as a return of capital, no tax liability might come into play. The IRS has Tax Topic 414 detailing this information.
What are the Types of REITs?
In the market, there are three kinds of REITs, according to Johnson:
- Equity REITs purchase commercial, industrial, or residential real estate properties. Their income is derived primarily from rental income and from the sale of properties that have increased in value. These may be focused on a market segment or geographic region.
- Mortgage REITs invest in property mortgages. They may make original mortgage loans, purchase existing loans or buy mortgage-backed securities. The income is primarily from the interest they earn on the mortgage loans.
- Hybrid REITs invest both directly in property and in mortgages on properties.
What is the future of REITs?
The future looks to further the simplicity of small investors taking advantage of the program.
“A project we’re spearheading is the tokenization of REITs as well as other forms of property ownership,” said Krieger. “This is an even greater democratization of participation.”
He says that real estate is a complex asset to transfer because of the complexity of ownership. With tokenization, people can buy and sell in fractions on the market through a blockchain, just like cryptocurrency and other digital assets.
“The competitive advantage is that you don’t need a big kind of that capital,” Krieger said. “(Investors) can participate in these marketplaces more easily just by going online.”
Finding a REIT today involves a lot of research. “Start with Google,” he said. NAREIT has lists of REIT mutual funds and a REIT directory.
Investing in REITs is not a hold-and-grow proposition. Johnson cites NAREIT studies that show the mean return on a REIT is a little over 11 percent per year, less than the higher 12 percent per year from the S&P.
“REITs are appropriate for investors seeking income and are not appropriate holdings for investors seeking long-term growth,” he says.
