Investing in real estate can be a successful strategy for earning passive income and diversifying your investment portfolio. Investors interested in real estate investment might have heard of real estate investment trusts (REITs) as a potential option. REITs are one way investors can have the opportunity to make passive income through real estate investment. REITs enable investors to combine their funds and make consistent income from dividends without the responsibility of managing real estate properties themselves.
If you are interested in getting started in REIT investments, this guide will explain why investing in REITs might be a good option for your investment goals.
What Is a REIT?
A REIT is a company that finances, owns, or operates income-generating real estate. REIT investors pool their funds to invest in real estate assets without having to manage or finance the properties themselves. When the REIT properties earn income, the investors receive their share in dividend payouts. Investors can buy shares of publicly-traded REITs on major United States stock exchanges, including the New York Stock Exchange, and purchase shares of non-traded REITs through a broker.
REITs can invest in various real estate assets, including retail centers, apartment buildings, hotels, and other commercial properties. Most REITs are sector-specific and include only properties of the same type, such as self-storage or healthcare. Diversified REITs hold multiple property types.
How Do REITs Work?
Equity REITs earn income by buying real estate properties, leasing the space, and collecting rental income from tenants. The REIT then distributes the income to the investors as dividends. Mortgage REITs operate differently — these companies finance real estate properties rather than own them and make income from the interest their investments generate.
Specific IRS requirements define what companies are considered REITs. These requirements include:
- The company must be managed by a board of directors or trustees.
- It must have at least 100 shareholders after its first year of operation.
- It must be taxable as a corporation, trust, or association.
- It must pay at least 90% of its taxable income to shareholders each year.
- At least 75% of the company’s assets must be real estate properties.
What Are the Differences Between Publicly Traded REITs, Public Non-Listed REITs (PNLRs), and Private REITs?
There are three main classifications of REITs — publicly traded REITs, public non-listed REITs (PNLRs), and private REITs. They are different in their regulation, where investors can purchase shares, and what requirements exist for investors to invest in them:
Publicly Traded REITs
Publicly traded REITs are traded in a similar process to other public securities. Investors can invest in these REITs through national securities exchanges. The Securities and Exchange Commission (SEC) closely regulates these REITs and requires that they officially register and file reports with the SEC.
Anyone can invest in these REITs because they don’t require accreditation. Because publicly traded REITs are publicly listed and frequently traded, investors have a daily indication of the value of their share in the REIT. This characteristic may be positive or negative, depending on when the investor wants to access their investment.
The SEC regulates PNLRs, also called non-traded REITs, though these REITs are not traded on the national securities exchange. Instead, investors can buy shares of PNLRs through a broker who participates in the PNLR’s offering or a financial advisor. PNLRs must still register with and file reports to the SEC. PNLRs don’t require investors to be accredited. Equity REITs are often PNLRs.
Because PNLRs are not traded publicly, they are more illiquid than publicly traded REITs. One disadvantage of a PNLR is that they typically face redemption restrictions which limit their liquidity. The share value of PNLRs may also be difficult to assess since they aren’t traded publicly.
Shares in private REITs are primarily sold to accredited institutional investors. These REITs are not regulated by the SEC or traded on the national securities exchange.
Because of their income or net wealth requirements for investment, private REITs are not accessible to most investors. They also typically have stricter holding requirements, making their shares generally illiquid. Since private REITs are not required to report their financial information to the SEC, investors have an even greater responsibility to perform their due diligence in researching potential investments.
What Are the Benefits of Investing in REITs?
Investors considering alternative investments might find REITs appealing because of the real estate investment opportunities they offer without the responsibility of actually owning or managing properties. Other potential benefits of a REIT may include:
REITs may deliver high yields through dividend payouts. Rental income remains steady if there is a consistent stream of tenants. Investors also have the opportunity to achieve capital appreciation through a REIT, as commercial real estate prices tend to increase over time. Rental rates for residential apartments have increased historically, which may mean that dividends from REITs holding apartments and other residential properties can also increase.
It’s essential to remember that yield from REITs depends on many factors, including management fees, upfront investment fees, and the occupancy and locations of the properties held in the REIT.
Simple Tax Treatment
Investors also benefit from REIT tax advantages. IRS regulations for paying taxes on REIT dividends are relatively simple compared to requirements for other corporations. Shareholders must fill out IRS Form 1099-DIV for the dividends they receive from their REIT investments. Corporations must report the dividends it distributes as ordinary dividends, which the IRS taxes as ordinary income, or qualified dividends, which the IRS taxes at capital gain rates. Most dividends that investors receive from a REIT are taxed at the investor’s individual tax rate as ordinary income.
Transparency and Flexibility
Buying shares in a REIT is relatively straightforward, making this passive investment accessible and flexible enough for many investors. Investors can choose from the three main REIT types to select the kind of trust that best suits their investment goals.
Publicly traded REITs also offer investors a level of protection through their transparency. Since these REITs are traded on the public stock exchange, information about share prices and trends is widely available. PNLRs are also fairly transparent, and managers are qualified to make financial decisions regarding the properties in the trust.
Liquidity of REIT Shares
Real estate investment is considered illiquid because it often takes weeks or months to sell a real estate property. Investors who want the benefits of real estate investment without the wait to cash out might consider REITs the solution.
Shares of publicly traded REITs are considered highly liquid since they are readily traded on the public securities exchange. This kind of real estate investment might be more attractive to real estate investors because it often takes less time and can be completed faster than investing directly in real estate properties. However, not all REITs are considered liquid. Since private REITs are not sold on the public securities exchange, these REITs are not highly liquid investments.
REITs can be a useful tool for portfolio diversification because these companies offer potentially easier entry into the real estate market than real estate investments. A REIT allows investors to invest in a wider variety of real estate assets than if they were to buy properties themselves. The ability to pool funds with other investors enables a more diverse portfolio.
Investors may also select a mix of equity and mortgage REITs to diversify their real estate income earnings further. Diversifying REIT investments can potentially provide greater protection from fluctuations in the market.
What Are the Risks of Investing in REITs?
Despite their benefits, REITs can also expose investors to a few unique risks:
While investors have daily visibility into the share value of publicly traded REITs, the share value of PNLRs is more challenging to gauge. The lack of transparency of a PNLR’s share value is because these REITs are not traded publicly. Although some PNLRs provide investors with regular estimates of their holdings’ value, others don’t disclose their share value until 18 months after the offering closes.
These factors could make it difficult for an investor to assess the value and volatility of their investment. Choosing a REIT with properties declining in value could make for a poor investment.
Although investors may take advantage of the tax benefits of REITs, there is one REIT tax advantage they won’t realize — the IRS does not tax any gains from the sale of properties in a REIT as passive income. These dividends are considered qualified dividends, so investors must pay taxes on their REIT dividends at the capital gains tax rate of 0%, 15%, or 20%, depending on the investor’s tax bracket. Ultimately, the REIT tax benefits an investor realizes depend on the type of dividends and the investor’s income.
Since publicly traded REITs are sold on public securities exchanges, their shares are more easily sold than those of a PNLR or private REIT. Investors who buy shares of a PNLR may be required to hold their shares for several years or pay a fine for retrieving their investment early.
PNLRs may sometimes pay investors distributions in excess of their income from operations, which could consist of borrowings from other investors’ money. This practice could reduce share value and diminish the funds PNLRs have to invest in additional properties.
REITs often charge upfront investment fees and management fees, which can diminish an investor’s returns from their shares. Investors may also be required to pay broker fees.
REITs are also subject to interest rate changes, which can cause share value to change. This susceptibility to interest rate fluctuations may or may not be a risk, depending on when the investor wants to sell their shares.
As with all investing, it’s important to read and understand the accompanying offering documents and literature so you know the costs and risks and their impact.
Learn More With 1031 Crowdfunding
The benefits of a REIT could make this type of investment appealing to some investors. Depending on the type of REIT, investors can gain several benefits, including portfolio diversification and the potential for high yields. At 1031 Crowdfunding, our experienced team of real estate professionals provides a large selection of vetted real estate offerings on our online marketplace, including alternative investments.
Our management team has a combined industry experience of over 78 years, giving investors confidence when investing in alternatives. If you’re interested in our public non-traded REITs or other alternative investments, register for an investor account to start the process, or visit our blog to learn more about our offerings.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.