Real Estate Investment Trusts (REITs)
What is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is a company that has ownership in income-producing real estate. REITs offer investment opportunity through their real estate stock portfolio. A REIT typically combines the money of multiple investors to acquire a collection of real estate. The goal of a REIT is to eventually sell the collection for a profit. A collection of real estate is usually sold after cash flow is established via dividend pay-outs and after the property has had ample time to appreciate with some value-add projects. A REIT is usually composed of a team of experienced real estate and finance professionals who oversee the entire investment process. To be considered a REIT the following requirements must be met:
- A REIT must have at least 100 shareholders.
- No five shareholders in a REIT can make up more than 50% of the shares.
- At a minimum, 75% of the assets in a REIT must be invested in real estate, cash, or treasuries.
- 75% of the gross income in a REIT must come from real estate.
- REITs must pay out at least 90% of their taxable income to investors.
Real Estate Investment Trust (REIT) Example:
An ideal example of a REIT is a company that owns a new development of luxury apartments in a growing city. This company allows people to invest in a REIT to gather the necessary capital needed to operate the the properties. Over time, the city grows and young professionals move in and out of the apartments. Dividends can then be paid out to investors from consistent tenant rental payments. Over a ten-year period let’s say that the economy has boomed, and now the REIT is in a very good position to be sold for a profit. The two major types of REITs people tend to gravitate towards are equity and mortgage REITs.
The example above is an equity REIT. Equity REITs, for the most part, own and manage real estate. Typically, you will see equity REITs buy real estate and lease portions of it to tenants. By leasing or renting portions of the property to tenants, a stream of cash flow is created, which provides dividends to investors. In an environment where property values appreciate, the value of each investment included in the REIT grows. Between a steady cash flow, and increased property value, an equity REIT can produce a substantial return on investment for its investors.
Mortgage REITs are different. Mortgage REITs borrow money with low short-term interest rates and purchase mortgages to pay high long-term interest rates. So, the difference or spread between the two rates is the available profit for a mortgage REIT. Let’s say a mortgage REIT raises 5 million from investors and borrows an additional $30 million at 2% interest to buy up mortgages paying 4% interest. The difference between the interest income and the interest expense is the profit that could represent anywhere between a 12-16% annual return on investment.
Equity REITS are known for being stable long-term investments. Mortgage REITs tend to be volatile. By nature, mortgage REITS are much riskier and unpredictable compared to equity REITs. In a mortgage REIT, the opportunity to create a return on investment is contingent upon the cost to borrow. So, if the cost to borrow increases after the venture has commenced, the profit margin can disappear.
There are other types of non-traditional REITs such as a Public Non-listed REITs and Private REITs. These other non-traditional REITs have specific conditions and methods by which they operate.
REITs are unique. Given the tax structure of a REIT, smaller investors are encouraged to invest in large real estate projects. These smaller investors, without REITs, would not have access to large real estate deals because they simply would not be able to afford it. For instance, some of these large real estate properties include large apartment complexes, shopping malls, or hotels. Most REITs have a straightforward process and offer the investor a less hands approach to investing in real estate.