A Real Estate Investment Trust (REIT—pronounced like Reet, rhymes with Street) is a real estate corporation that pools investment capital from a large number of investors in a way that avoids corporate tax. You buy and sell shares in REITs as you would common stock. REITs can be attractive investments depending on your financial situation and investment preferences and priorities, but they have their drawbacks as well.
REITs can be good for investors who seek better than usual dividend income. For those more focused on growth in the underlying investment, REITs are a mixed bag, ranging from very good to well below most other investments. Indeed their very volatility is another factor that needs to be taken into account when deciding whether they are worth one’s investment dollars. They also hold some appeal for investors looking to diversify their investments, and hedge their other investments. Another advantage is that REITs are more liquid than many investments.
In order to understand why REITs tend to have these characteristics, it is necessary to go into a little more detail about just what REITs are.
Equity REITs are those that invest in real property, generally property that receives rental income. Mortgage REITs invest in the secondary mortgage market, using borrowed money that has lower interest rates to buy mortgages that pay higher interest rates. Most REITs are equity REITs, with about 10% being mortgage REITs, and even fewer being hybrids of the two types.
For a corporation to be a REIT and avoid corporate income tax, all of the following conditions must be met:
* At least 100 shareholders.
* No more than 50% of shares held by five or fewer of those shareholders.
* Not a financial institution or insurance company.
* At least 75% of total assets in real estate.
* At least 75% of gross income derived from property income (rent, mortgages, foreclosures, etc.)
* At least 95% of gross income derived from property income, dividends, and interest.
* At least 90% of income distributed each year as dividends to shareholders.
As can be inferred from the above, REITs pay high dividends because such a high percentage of their income must be distributed as dividends each year.
REITs are volatile because they are dependent on real estate values, interest rates, and how many borrowers happen to default on their mortgages, none of which is a particularly stable or predictable factor. For long periods they tend to outperform most other investments, but then when there is the kind of crisis that hit the real estate and secondary mortgage markets recently they can have very bad years.
REITs are valued by some investors seeking diversity, because they’ve tended historically—certainly not always—to do best when the stock market was struggling and to do worst when the stock market was booming.
Because you buy and sell REITs like any other stock, they have a liquidity that most other real estate investments do not. When you buy and sell real property directly, it is a much lengthier and more laborious process than buying and selling stock.
To summarize, REITs are best for investors looking for good dividends, liquidity, diversity beyond the stock market, and possible excellent growth in value, but they carry with them the risk and volatility of possible loss of value when real estate values plummet and mortgage default rates skyrocket. For these reasons, REITs are a good choice for some investors but should be approached cautiously.
Sources:
David Harper, “What are REITs?” Investopedia.
Lee Ann Obringer, “How REITs Work.” How Stuff Works.
Henry W. Schacht, “Why Investors Should be Fearful of REITs, Despite Their Relatively High Dividend Yields.” Seeking Alpha.