The term Real Estate Investment Trust, or REIT, was coined in 1960 by the US Congress to describe a special tax-advantaged vehicle for collective real estate investments.
Today, real estate investment trusts are not limited to the US, as more than 30 countries from Germany to Australia have adopted similar regulation.
How does a REIT work?
A REIT is a company that owns, operates, or finances income-generating real estate.
These holdings can be apartments, shopping malls, hotels, self-storage facilities and many other types of real estate. Most REITs concentrate on one type of real estate, while some cover multiple property types.
Most REITs are publicly traded on stock exchanges. They present an easy way for investors to buy shares in real estate portfolios without actually having to go out and purchase, manage or finance properties themselves.
Investing in real estate through a REIT has the benefit of quick liquidity: if you own a rental property and need cash fast, you wouldn't be able to sell a part of the apartment in less than a minute, while with a REIT investment, you can sell part or all of your holding any day the stock market is open.
In the US, REITs are structured as corporations, but they are exempt from corporate income tax. A company must meet the following standards to qualify as a REIT:
- Invest at least 75% of total assets in real estate, cash or US Treasuries
- Derive at least 75% of gross income from real property rents, interest on mortgages that finance real property rents, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Have a board of directors or trustees
- Have a minimum of 100 shareholders after the first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
As you can see, some of these rules were created to protect retail investors.
How does a REIT work?
Types of REITs
Equity vs. Mortgage REITs
Most REITs are so-called equity REITs. They operate like a landlord, as they own, develop and operate income-producing real estate investments, like shopping malls or office buildings.
They lease space and collect rent on the real estate. The profits from this rental income are paid out to shareholders in the form of dividend. This is one of the reasons why income-oriented investors like people close to retirement often allocation some money to equity REITs in their investment portfolios.
Generally speaking, equity REITs often offer generous dividend yields in today's low-yield world and are believed to offer some level of protection against inflation, as they are backed by real assets.
On the other hand, mortgage REITs (mREITs) don't own property – instead, they provide financing for real estate by purchasing debt securities (mortgages and mortgage-backed securities) and earning income from the interest on these investments.
As you can see, the mREIT business model is close to what a bank does, as they earn profits on the spread between sourcing and lending money. As a result, their profitability is very sensitive to interest rate changes.
Historically, equity REITs have far outperformed mREITs.
Private vs. Public REITs
Publicly traded REITs are the most common. They work like any other stock traded on the stock exchange in that you can buy and sell shares through an online broker.
There are more than 200 publicly-traded REITs in the US alone. For example, if an investor residing in the UK would like to invest in a US REIT like Realty Income Corporation (NYSE: O) or National Retail Properties (NYSE: NNN), they'd need an online broker with access to the US market (the New York Stock Exchange in this example), which the majority of the brokers listed here at BrokerChooser do.
Shares of privately traded REITs on the other hand are not listed on public exchanges and in turn offer investors considerably less liquidity. As another drawback, their lack of access to public capital markets may hamper their growth prospects. Therefore, historically these REITs have underperformed publicly-traded ones.
How does a REIT work?
Want to learn more?
Hope you liked this quick rundown about real estate investment trusts. If you'd like to go deeper, continue by reading one of the articles below: