A Real Estate Investment Trust (REIT) is a public or private corporation that provides a way for investors to pool their funds to invest in real estate. The two main types of REITs (in addition to hybrids of the two) are Equity REITs and Mortgage REITs.
Equity REITs invest in real property. They are corporations that purchase, hold, and manage rental and commercial property.
Mortgage REITs invest in mortgages on real property, not the property itself. The corporation can originate or underwrite the mortgages, or purchase them in the secondary market, often heavily leveraged. They seek to make money on the difference between the short term interest rate at which they borrow the money to buy these mortgages, and the long term interest rates that the property owners are paying on the mortgages themselves.
So what are some of the pros and cons of this form of investing? First the pros:
Because REITs pool the funds of many investors, it’s possible to invest in real estate without putting up a great deal of money. For example if you are trying to diversify your investment portfolio by adding some real estate, but you only have $3,000 or $5,000 or $10,000 that you want to slide over into this new area, normally there aren’t a heck of a lot of properties you can purchase for those amounts. But with an REIT, because you are merely one of many in the corporation, you don’t have to do it on your own. You can own 1% of a skyscraper, or 3% of a bunch of mortgages on various properties, because there are other folks putting up the other 99% or 97%.
With REITs you can invest in real estate without a lot of the hassle that can otherwise sometimes be involved. If you buy a rental property, for instance, you have to interview prospective tenants, pick one, collect rent each month, etc. But with an REIT, you’re purely a hands off investor. The REIT as a corporation hires others to take care of these property management functions.
REITs are appealing for their tax advantages. If it is structured properly, an REIT is not subject to corporate federal income tax. Structured properly meaning it fulfills the following conditions: It is not a financial institution or insurance company; it is jointly owned by at least one hundred people; no more than 50% of its shares are held by five or fewer people during the last half of the taxable year; at least 75% of its total investment assets are in real estate; at least 95% of its income is derived from dividends, interest, and property income; and at least 90% of its income is distributed as dividends to shareholders each year.
Many investors have found REITs to be an especially good investment for tax deferred plans such as IRAs and 401Ks, because the income is not taxable until it is withdrawn. So corporate income tax is avoided entirely, and personal income tax is advantageously put off.
As mentioned, REITs must pay out 90% of their income as dividends each year in order to reap their tax benefits, which means investors can generally count on substantial dividend income compared to many alternative investments.
REITs avoid one of the frustrating things about other forms of real estate investing, which is the difficulty of liquidizing. If you own a piece of real property, there’s no guarantee you’ll be able to sell it that day or that week or that month if you want to get your money out. But if you own shares in an REIT, you can buy and sell those shares comparable to how you would buy and sell stock. You don’t have to worry about selling the underlying properties.
OK, what about the downside? Here are some cons of REITs:
Because you and your fellow members are not yourselves managing any properties your REIT holds, you must pay someone to do so, which eats up some of the potential profit.
Because you’re not owning and managing the property individually yourself, you’re giving up the decision making of what to buy, what to sell, what to fix up, etc. (much like by investing in a mutual fund you’re giving up control of what specific securities to trade).
Because it’s so easy to get in and out of REITs compared to conventional ownership of real property, prices can fluctuate more. If many members of the corporation jump ship, very quickly the remaining members can see the value of their shares take a big hit.
Because the REITs pay out so much in dividends, they don’t have as much flexibility to use that money so as to foster the long term value of the underlying real estate.
Maybe the biggest con of REITs is the one we’ve seen played out in recent history. Buying and selling bundled mortgages of dubious value is one of the factors people point to as a cause of the present economic troubles. When the real estate market tumbled, that ruined many mortgage holders and led to them defaulting on their mortgages. Suddenly these REITs of mortgages that had long had a default rate low enough for them to return a tidy profit had massively larger default rates. Since the REITs had borrowed much of the money to purchase these now troubled bundles of mortgages, they sometimes in turn defaulted on their loans, as the chain reaction worked its way through the system.
So an REIT that looks like a great deal can still be vulnerable to the vagaries of interest rates and property owners defaulting on their mortgages.
There are many advantages and many disadvantages to investing in REITs. But certainly given their history, they should be approached with caution.
Sources:
“All About REITs”
“Pros and Cons of Real-Estate Investing”
“REIT Mutual Funds Are Popular For A Reason”
“What is a Real Estate Investment Trust?” Mortgage News Daily