REITs are Real Estate Investment Trusts. These are corporations or trusts that do not typically pay income tax. They are also often tax-exempt for state income taxes. REITS were developed in 1960 as a rider to a bill in Congress.
REITs are used to own, obtain, develop and manage profit-generating properties and can include shopping centers and malls, apartments, industrial parks, health care facilities, and hotels. REITs can be a great diversification tool for portfolios but investments in them may not be for everyone.
How They Work
Management of REITS are handled like a mutual fund. The management team will select a portfolio of investment properties that are typically diverse in their geographic location for the shareholders. They manage the portfolio to increase the value for the shareholders. REITs are required by law to invest 75% of their assets into real estate. 90% of all taxable income must be paid out to shareholders.
REITs are categorized into three types:
- Equity REIT – this type owns real estate and income is generated from rent income on the properties.
- Mortgage REIT – this type loans money to owners of real estate and income is generated from the interest earned on the mortgage loans.
- Hybrid REIT – this type combines equity and mortgage real estate functions.
REITs started in the 60’s but became more modernized in 1993 whe high quality real estate management companies began to trade on the major exchanges. The became an viable resource for big investors as well as smaller ones because they were capable of market capitalization and showed significant improvement in liquidity. More than 300 REITs are publicly traded today but not all are investable.
Are They Right For You?
REITs are good for diversifying your portfolio but it is wise to not place too much into them as an investment resource. Some advantages of REITs include
- High liquidity of owning professionally managed real estate
- The potential for appreciation of owned property
- Solid track record of profitability in different cycles of the market
- High dividend potential
- Availability of return of capital distributions which are occasional non-taxable distributions
Some risks of REITS include:
- Risks associated with real estate including property damage, security issues, liability issues, poor property management, and pricing concerns
- Some REITs are heavy in debt. Variable rate debt can bring serious financial problems when interest rates rise.
- Issues with Wall Street selling extra supplies or REITs through IPOs and secondary offerings
Since the early 90’s, REITs have outpaced the S & P 500 with less risk. When used in moderation, the high dividends received from a REIT and they offer better leverage than the majority of publicly-traded companies. Their yield can be attractive especially in retirement and non-taxable accounts. The majority of REITs’ debt is in the form of fixed-rate. Rising interest rates can help make existing properties by more valuable by slowing down construction on new real estate. Investors who do not understand REITs often believe the opposite – that rising rates mean falling prices. However, if rates rise too high properties can remain vacant and the return on REITs is lowered for investors.
If you are interested in investing in REITs, make sure you understand how to make the most of your investment and do not put all your nest eggs in one REIT basket. Use REITs to diversify your portfolio but continue using other investment vehicles as well.