Established by congress in 1960, Real Estate Investment Trusts (REITs) was created as a modification of the Cigar Excise Tax Extension of 1960. Pronounced “reets”, they are basically described as investment equities usually used by people who want to improve the returns on their portfolio.
REITs generally guarantee incredible returns in terms of dividends but similar to every investment with high returns, they come with an additional risk.
The question is, are the potentiality of high profits guaranteed by REITs worthy of the risk attached? We’ll soon find out.
Real Estate Investment Trusts (REITs) – the definition
REITs can simply be described as companies whose sole business focusses on the ownership and operation of real estate properties. Typically, a REIT may buy and manage apartments while the other may invest in some special types of commercial assets. Examples of these assets include office properties, public buildings, facilities and more.
Essentially, REITs are corporations whose activities revolves around acquiring and running real estate mortgages and properties.
The provision that established REITS allows anyone purchase shares in a REIT that has been publicly traded. This is because they provide the benefits of owning a real estate and it is even better due to being void of expenses or stress of being a landlord.
The properties captured in a typical REIT portfolio often include health care facilities, data centres, complexes, hotels, learning centres, and other infrastructure that may take the form of energy pipelines, fibre cables, masts, cell towers – self-storage, warehouses, tourist centres and more.
Generally, the common practice is for most REITs to specialize in specific sectors of the real estate – investing their resources and time in ensuring that their particular area of interest yields.
Based on what the law provides, 90% of profits in form of dividends generated by REITs must be distributed.
While some REITs distribute these profits to their investors on a quarterly basis, others have different durations attached to them. However, the quarterly distribution serves as a convenient source of interest for retirees who desire a source of income that is steady.
As opposed to what’s obtainable with public corporations, REITs are always excluded from corporate income tax. The profits realised after the management deductions are distribute accordingly – pretax, to REITs investors.
Based on what history tells us, between the period of 2010 – 2015, REITs have done better than corporate bonds overall.
How REITs work
When the congress decided in 1960 that smaller investors should also be able to invest in large scale income generating real estate, it discoverd that the best approach is to adopt the model of investing in several other industries by purchasing equity.
In the case of REITs, investment especially in income generating real estate often leads to an increase in the investor’s net worth. For a lot of people, investment in real estate especially commercial real estate is usually not an option due to the financial implication.
However, REITs are accessible enough for potential investors to pull their resources with other small investors and then invest in a large scale commercial real estate as one group.
Investing in some particular REITs provides the investor with the all-important liquidity and diversity needed. Unlike what you get from traditional real estate property, these shares can be sold off quickly and with much ease.
Also, because your investment cuts across different properties rather than a single asset, less financial risk is involved.
Essentially, most REITs have a business model that is straightforward. They lease space and collect money on rented properties then in turn, they distribute the money collected as dividends to all shareholders.
Regulatory requirements to qualify as a REIT
There are certain features that prequalifies a company as a REIT. The company must adhere to specific provisions of the internal Revenue Code.
These provisions are similar to organizational structure, distribution, operation and compliance.
The regulatory requirements to qualify as a REIT includes;
- A REIT must be created in any state as a corporation capable of being taxed for federal purposes, but for its REIT status.
- Managements of the REIT must include board of directors, trustees and its shares must be transferable
- From its second year of operations, a REIT must have a minimum of 100 shareholders
- During the last half of a taxable year, a REIT is expected to have no more than 50% of its overall shares held by five or fewer individuals.
- 75% of the total gross income of a REIT must be derived from sources that are real-estate related. Furthermore, an additional 20% must also be gotten from real estate sources or other income forms such as dividends and interests from sources that are non-real estate
- Service fees, non-real estate business or any other source that is non-qualifying should in no case constitute more than 5% of a REITs income
- At least, 75% of a REITs total assets must be invested in real estate
- A REIT cannot own beyond 10% of the total voting rights of any other corporation except it is another REIT, Taxable REIT Subsidiary (TRS) or a Qualified REIT Subsidiary (QRS)
- A REIT can also not own a stock rather than a REIT, QRS or TRS – in a case where the stock value makes up more than 5% of a REITs asset.
- The total stock value of a REIT’s TRS should not make up more than 25% of the REIT’s asset
Dividend Distribution Requirements
- On an annual basis, at least 90% of a REITs overall taxable income must be paid as dividends to shareholders. On the income that’s left, taxes must be paid just like any other corporation.
Types of REITs
There are majorly 2 types of REITs, they are either Equity or Mortgage REITs.
They are the most common type of enterprise. These entities specialise in the purchase, ownership and management of income producing real estate. The revenues come basically through rents and not from the resale of portfolio properties.
With most REITs taking the equity form, they usually invest in single family homes, healthcare properties, shopping malls, industrial buildings, data centres, freestanding retail, office buildings, apartment and residential buildings among others.
REITs like apartment buildings aswell as the single family homes are all classified as residential REITs
These are REITs that own and run a single and multi-family rental apartment buildings including manufactured housing. There are several factors to put into consideration when looking at this type of REIT.
For example, the best apartment market is usually where home affordability is relatively low compared to other areas of a country.
In cities like Los Angeles and New York, the expensive cost of single homes leave people with no choice other than to rent and this inflates the charges levied by landlords on a monthly basis. The result of this is that the biggest residential REITs usually focus on large urban centres.
Within the specific markets, investors are expected to look for the growth of the population and jobs aswell.
Usually, when there is a rapid immigration of people to a city, it’s because the economy is growing and there is an increase in the means of livelihood – jobs and opportunities. A reduction in the vacancy rate alongside rising rents is an indication that demand is improving.
As long as the supply of apartment in a market remains low and the demand is on the high side, residential REITs always thrive.
They are the other type of REITs and they invest in Mortgage-backed securities. These companies sometimes invest in agency mortgages (those guaranteed by Ginnie Mae, Fannie Mae and Freddie Mae), commercial mortgages, non-agency mortgages or government sponsored enterprises that purchase mortgages in the secondary market.
An estimate of 10% of the overall REIT investment are in mortgages as against real estate itself.
Simply because these type of REIT doesn’t involve buying doesn’t mean they are void of risks.
An increase in interest rates leads to a corresponding decrease in mortgage REIT book values, driving stocks lower.
These type of REIT holds a combination of physical rental properties aswell as mortgage loans in their portfolios.
Subject to the stated investment target of the entity, they may weigh the portfolio to comprise of more mortgage holdings or property.
Are investments in REITs worth it?
REITs offer a total value in terms of returns. Basically, they provide high dividends alongside the potential for moderate aswell as long term capital appreciation.
The long term total returns of REIT stocks can be likened to those of value stocks and also more than the returns provided by bonds of lower risks.
The strong dividend income of REITs provide a decent investment for retirees who require a source to meet their living expenses as well as retirement savers.
fundamentally, REITS offer a competitive long term performance, substantial and stable dividend yields, liquidity, transparency aswell as portfolio diversification.
REITs have been made accessible to investors by the federal governments, enabling them buy into large scale commercial real estate projects since 1960.
However REIT didn’t get popular until the last decade when lots of investors embraced it. The reasons include low rates of interest which drives investors to overlook bonds in the quest for income producing investments.
Today, REITs now represent an excellent source of income although just like any other investment, it has its own risks.