The definitive guide to help you easily comprehend Real Estate Investment Trusts, their types, advantages & disadvantages, functioning, and more.
Did you know that 44% of American households own REIT stocks? What is it about Real Estate Investment Trusts (REITs) that make it widely trustworthy, liquid, and tempting to invest in? Well for starters- what are REITs?
In this blog, I will help you get a detailed understanding of REITs in the easiest way possible, by covering the following topics:
- What Are REITs?
- Types Of REITs
- Qualifications Of REITs
- 5 Most Common REITs
- How To Invest In REITs & Tips For Smart Investments
- Advantages & Disadvantages Of REITs
- Which Is the Better Option- Investing On Your Own Vs Investing In REITs
- Conclusion
- Resources For Further Information
So let’s dive in!
What are REITs?
Conceptually, REITs are known to be very similar to mutual funds. REITs or Real Estate Investment Trusts are companies that buy and manage large-income producing Commercial Real Estate (CRE) properties– such as office buildings, hospitals, shopping centers, etc. A REIT primarily allows the public to invest in these buildings, without having to actively own them. This simply means that you will be a shareholder and receive the dividend from the property you invest in, without having to buy, manage or operate- all of which will be taken care of by the REIT company. The public shareholders, or you, get the majority ownership in the stock, and the REIT company gets minority ownership. Simply put, upon investing, shareholders get 90% of the taxable income from the REIT as their dividend.
This idea of REITs was conceptualized by Congress in the United States, in the year 1960. Congress was looking to figure out a way that allows the public to invest in large income-producing commercial real estate, without actually buying it. SEBI introduced REITs in India in 2007, and is still the regulating authority for the same. India saw its first REIT- Embassy Office Parks REIT (a joint venture of US private equity firm Blackstone Group and Embassy Group), in March 2019.
Now that we have understood the basic concept of a REIT, let’s move on to knowing its different types:
Types of REITs
REITs are widely categorized into three types– Equity, Mortgage and Hybrid REITs
- Equity REIT
In an Equity REIT, Commercial Real Estate Properties are physically owned and operated. Owners of Real Estate Properties lease it to companies and individuals to make money. This income is then distributed among REIT investors (public shareholders) as dividends.
- Mortgage REIT
In a Mortgage REIT, investment is made on the loans, and money is made off of the loans.
Mortgage REITs lend money to real estate owners and operators either directly (through mortgages and loans), or indirectly (through the acquisition of mortgage-backed securities).
They earn via Net Interest Margin which, simply put, is nothing but the difference of interest earned on mortgage and cost of funding the loans. This income is then distributed to you, a public shareholder, as dividends. In other words, income is drawn from the interests earned on the investment in mortgages or mortgage-backed securities.
- Hybrid REIT
Hybrid REITs invest in both Equity and Mortgage REITs.
Qualifications of REITs
There are various eligibility criteria for a company to qualify as a REIT. Generally, these are as follows:
A qualified REIT
- Must have a long-term investment horizon with the property
- Must invest 75% of its assets in real estate.
- Must derive 75% of its gross income from real estate itself (could be rental income, mortgages, etc)
- Must ensure that 90% of the taxable income from the REIT is paid out to the shareholders to hold on its standing.
- Must be taxable as a corporation per the IRS which lays all the rules and oversees REIT qualification (for the USA). For India, the SEBI oversees REIT
- Must have a minimum of 100 shareholders.
- Must ensure that no more than 50% of the shares are held by 5 or fewer individuals
- Must ensure that only 10% of the total investment is in real-estate under construction.
Know more about SEBI’s regulations for REITs here:
https://www.sebi.gov.in/sebi_data/attachdocs/1411722678653.pdf
5 Most common REITs
- Retail REITs– Own and manage shopping malls.
These comprise 24% of overall investments in terms of REITs in the US. They focus on large regional
malls, outlet centers, grocery-anchored shopping centers and power centers that feature big-box retailers.
When considering opting for Retail REITs, keep in mind the future of shopping centers. Given the worldwide shift to online shopping, it is a safer bet to predict that shopping malls in the long term may not actively function like today.
- Residential REITs– Own and manage large apartments.
When planning on investing in residential REITs, consider the following two factors:
Population, movement of people and demographics
Jobs in the locality of the property you’re planning to invest in through residential REIT.
- Office REITs– Own and manage a variety of office buildings.
An important fact to note while looking into this is that the future of investments in office buildings, tend to go with the economy.
- Healthcare REITs– Investment in hospitals, nursing centers, medical office centers, retirement facilities, etc.
Health care REITs own and manage a variety of healthcare-related real estate and collect rent from tenants.
- Mortgage REITs (mREIT) – Invest in mortgages.
These comprise 10% of US’s REIT investments. An individual may buy shares in a REIT, which is listed on major stock exchanges, just like they do for any other public stock.
How to invest in REITs & Tips for smart investments
Most of the REITs, especially the ones mentioned above, are publically listed. They are listed in stock exchanges so that investors can buy units in the trust. When talking about enlistment, there are three types of REITs to consider:
This page has a list of Publicly Traded REITs- https://www.reitnotes.com/list-of-public-reits/
TIPS FOR SMART INVESTMENTS:
- While choosing which REIT option works best for you, keep in mind these 2 performance factors. A good REIT has a decent
- Dividend yield and
- Long- Term Capital Appreciation.
- Make sure the company has a strong management and loads of experience. Although the experience part can be overlooked when it comes to India since REITs in the country are relatively new.
- Only invest in REITs that promise quality– quality buildings, quality tenants. This usually includes keeping in mind how long in time the lease contract of the tenant stands, so as to ensure maximum stability in your dividend.
- A good economic stronghold is a very imperative part when considering investing in REITs. Would you rather invest in a REIT in Mumbai with holdings of average office buildings, or invest in a REIT in Chandigarh with first-class office buildings?
Your answer should be the holdings of average office buildings in Mumbai because Mumbai is a city with a bigger economic powerhouse, therefore, ensuring safety to your investment.
Advantages and disadvantages of REITs
Let’s elaborate on the above table of comparison between the advantages and disadvantages of investing in a REIT.
ADVANTAGES:
- Public gets a higher dividend:
Since REITs have to pay 90% of their income back to the shareholders/investors- as an investor, REIT benefits you by getting you a higher dividend compared to the rest of the stock market/ other investment options.
- Income can be secured with the help of long-term leases:
Say you invest in a REIT that in turn invests in an office building that has an anchor tenant. It is most likely that this tenant has a 15-20 years’ long term lease contract, from which you can benefit off of. In other words, it guarantees you a steady and secure income in the long run.
- Liquidity:
Compared to direct investments, REITs have lower liquidity risks. Since a considerable amount of the major REITs are publically listed, it allows you to buy and sell at will. This makes REIT a very liquid investment.
- Professional Management:
Imagine having to buy a Commercial Real Estate property, manage and operate it, do the accounting, and a hundred other things that come with holding a CRE property- all by yourself. Leaving it up to a REIT saves you all the trouble, without having to compromise on the benefits.
- Transparency:
The Securities and Exchange Board of India (SEBI) is the regulating body for all REIT activities in the country. Since it is overlooked by this well-renowned and trusted government agency, investing in a REIT promises transparency to the shareholder. This also means chances of occurrence of fraud are decreased to a large amount.
In the US, the Security Exchange Commission (SEC) is the regulatory body for REITs who have to turn in periodic disclosures of their performances.
- Not as capital intensive as direct investments in properties:
This is because REIT eliminates the need for the public to directly buy/own and manage the property. Besides, the dividends are often higher than you can achieve with other investments.
DISADVANTAGES
- Lack of Diversification:
Let’s say you invest in a Healthcare REIT, in a hospital- if the hospital sector doesn’t do well then neither does your stock. Healthcare REITs only deal with hospitals, nursing homes, etc; if you invest in a Retail REIT, they only manage shopping centers, regional malls, etc. If one of those two sectors don’t perform well, then your stock doesn’t either. This lack of diversification proves as a disadvantage while considering investing in a REIT.
- Slow Growth:
What we learned as an advantage previously can also pose as a limitation. Since REITs have to give out 90% of their income to the shareholders, they are left with a mere 10% to re-invest to buy new holdings/ for their core product line.
- Tax Treatment:
Another downside to investing in a REIT is that your dividend is taxed as your regular income. So if you are a high paying person investing in a REIT, you will be paying a lot of taxes.
- Losses don’t pass to investors:
One of the biggest reasons to invest in Commercial Estate is because of all the tax benefits, as an investor you get write-offs. Although in this case, those write-offs are trapped into a REIT, making it another disadvantage while investing.
These are the pros and cons to be considered while investing in a REIT.
We’ve so far covered what a REIT is/ what is its basic objective, its types, qualifications/ eligibility for it to be called a REIT, 5 most common REITs, tips on investing in a REIT as well as the pros and cons.
Now that you have studied and comprehended everything about Real Estate Investment Trusts, can you find yourself asking- Is it better to do my own investing rather than in a REIT?
Before concluding, I’m going to dive into this question and provide you with an analysis of investing in REITs as compared to investing yourself.
Investing in a REIT vs Investing yourself
Refer to the table below for a comparative analysis:
It is for you to decide now, what suits you the best!
Conclusion
Real Estate Investment Trust or REIT is a dividend-paying stock introduced by the Congress in 1960, in America. It allows the public to invest in a large income-producing commercial real estate properties without having to directly own or buy the properties.
REITs can be of three types. Equity REITs physically invest, own/operate commercial real estate properties. Owners of these properties lease it to companies/individuals and this income is distributed among shareholders as dividends.
Mortgage REITs make money off of mortgage loans and draw income via Net Interest Margin (difference of the interests earned on mortgage and the cost of funding the loan).
Hybrid REITs combine the functioning strategies of both equity and mortgage REITs.
There are various qualifications that make a REIT eligible to be called one. An important qualification is that a REIT should payout 90% of its income back to the shareholders. There are many other qualifications. In India, SEBI is the regulatory authority for REITs.
The five most common REITs would be Retail REITs (shopping centers, regional malls, etc); Healthcare REITs (hospitals, nursing centers, medical offices, etc.); Office REITs (office buildings); Residential REITs (large apartment buildings, etc.); and Mortgage REITs.
We studied the three types of REITs when it comes to the way they’re enlisted- Publicly listed, Public but not listed, and Private REITs. We also went through ways to make smart investments while opting for REITs.
We then studied the pros and cons of investing in REITs. Some pros include, larger dividends, liquidity, professional management, transparency, stable cash flow, etc. Some cons include slow growth, taxation of dividends as regular income, etc.
We then analyzed whether it would be better to invest in REITs or invest by ourselves.
I hope you are now thorough with everything concerning REITs and are ready to make informed decisions on whether or not to invest and how to invest in them. You now have a detailed comprehensive outlook on this topic and are fully educated about the same!
Let us know in the comment box, your favorite REIT type. Share more information if you have any.
Just in case you want more information, here are some resources you can further refer to in order to better your understanding:
FURTHER RESOURCES
https://www.investopedia.com/terms/r/reit.asp
https://cleartax.in/s/reit-funds#types
Here are some extremely helpful videos for further research:
I personally recommend the following video. It gives you a very detailed and comprehensive outlook towards the topic: