A real estate investment trust (REIT) is a company that finances, owns or operates income-generating real estate. These companies may require property care responsibilities from tenants while collecting rent, or they may operate, manage and maintain real estate directly. REITs operate similarly to mutual funds, allowing individuals to invest in various property types and collect dividends that REITs must pay to shareholders.
Like all investment opportunities, REITs come with risks. However, REITs also present opportunities to generate income and grow wealth over time. Since REITs are required to distribute a set percentage of their taxable income to their investors, shareholders can collect returns on their investments. Individuals interested in investing in REITs can choose several different property types from a wide variety of industries. This helps diversify portfolios and can decrease risk.
What Are REITs?
REITs are companies that own and sometimes manage commercial and residential real estate that produces income. Some REITs make or invest in obligations such as loans that are secured by collateral from real estate. Some REITs are publicly traded and regulated by the U.S. Securities and Exchange Commission (SEC). In 1960, the United States Congress developed the legislative framework for REITs to allow public investors to benefit from large-scale commercial real estate investments.
REITs can have the following benefits:
- They have the potential to produce significant dividend income.
- REITs have long-term capital gains potential.
- They can serve as a useful tool for diversifying portfolios.
- Over time, REITs’ dividend growth rates have performed well despite periods of inflation.
- Investors can decrease overall risk through diversification with REITs.
- Real estate can include rent which may be useful for predicting income.
Types of REITs
A REIT can include apartment complexes, office buildings, malls, hotels, warehouses, data centers, self-storage facilities and healthcare facilities. The four types of REITs include the following:
Mortgage REITs (mREITs)
Rather than investing in real estate that produces income, mortgage REITs invest in mortgages and mortgage-backed securities. Mortgage REITs purchase or originate these securities, provide financing for income-producing real estate and then collect interest on the financing. They provide the capital other REITs need to invest in real estate and then collect interest on the funds they lend to other REITs.
The majority of publicly traded REITs are equity REITs. When you invest in an equity REIT, you are actually putting money toward companies that invest in income-producing real estate portfolios. The law requires equity REITs to distribute dividends of at least 90% of their income to shareholders.
Public Non-Listed REITs (PNLRs)
Public non-listed REITs own portfolios in income-producing real estate, and they operate or finance the real estate portfolios. They are not traded on major exchanges, and the SEC places strict redemption restrictions on PNLRs. Public non-listed REITs must make regular SEC disclosures, so they do not always remain liquid.
Private REITs are not traded on national stock exchanges, but they are exempt from SEC registration, unlike public non-listed REITs. This means that private REITs are not required to publicly disclose financial reports.
REITs can own a wide variety of real estate, from hospitals to storage units and many diverse properties in between. Investing in REITs means you can choose to invest in different industries and diversify your portfolio. Before investing in REITs, consider the following REIT specializations:
- Healthcare REITs: Healthcare REITs own healthcare-related real estate such as hospitals, doctors’ offices, life science operations, senior housing and wellness centers.
- Office REITs: Office REITs can invest in various assets within the office industry, but commercial office space is the primary focus. Office REITs can also invest in single-story offices, high-rise buildings and other office-related properties.
- Hospitality REITs: Hospitality REITs typically invest in restaurants, hotels and sometimes retail outlets.
- Data-center REITs: Data-center REITs own properties equipped to hold data centers. These properties usually have sizable land plots, temperature regulation specifications and increased security measures. Data-center REITs are becoming more popular as cloud technology advances.
- Self-storage REITs: Self-storage REITs own self-storage facilities and rent storage units to earn monthly income.
- Industrial REITs: Industrial REITs own large industrial properties such as distribution centers, warehouses and factories.
- Retail REITs: Retail REITs own properties such as shopping centers, malls and net-lease properties.
- Residential REITs: Residential REITs own various housing assets such as apartment complexes, single-family homes and student housing.
- Timberland REITs: Timberland REITs own large land plots and use them to grow various trees used for harvesting and producing products that the companies sell for profit.
- Infrastructure REITs: Infrastructure REITs own various land plots and properties such as cell towers, fiber optic networks and infrastructure assets that need physical properties or land to operate.
- Specialty REITs: Specialty REITs include any real estate properties or land plots that aren’t included in the types listed above. They can include farmland, educational facilities, prisons and other unique properties.
- Diversified REITs: Diversified REITs own a combination of different properties.
REITs as Long-Term Investments
A REIT is a long-term asset class investors can use to generate income and build wealth over time, often allowing them to build a passive income for retirement. The law requires REITs to pay a minimum of 90% of their taxable income to shareholders. They pay this percentage of their income to investors in the form of dividends, which means investors receive dividend payments monthly, quarterly or annually, depending on the company.
To optimize long-term returns on their investments, REIT investors could focus on REITs invested in growing markets such as warehouses, healthcare facilities and data centers. While past performance is not a guarantee of future returns, they may also consider a REIT’s growth and dividend payment track record. When investing in REITs as long-term investments, consider both sustainability and quality.
How to Assess a REIT
It’s important to consider the dividend profile when evaluating REITs. The dividend profile consists of dividend safety, potential long-term growth prospects and yield. Dividend safety is the most important factor to consider because potential dividend cuts can cause investors to permanently lose capital. However, due to the tax structure of REITs, the traditional methods of measuring dividend safety are not reliable in determining if a REIT is a wise investment.
Metrics such as price-to-earnings (P/E) and earnings-per-share (EPS) are not reliable methods to evaluate REITs. One way to judge a REIT’s value is the funds from operations (FFO) method. This method makes adjustments for distributions, depreciation and preferred dividends.
The FFO method adds non-cash expenses such as amortization and depreciation to the net income. It also subtracts losses or gains on asset sales. Use the FFO method in combination with other metrics such as debt ratios, dividend history and growth rates to estimate the value of a REIT.
Another helpful method is adjusted funds from operations (AFFO). The AFFO method deducts the predicted expenditures necessary to manage the REIT portfolio, and it’s the method that professional analysts use to estimate a REIT’s value.
Professional analysts prefer the AFFO method because it more precisely measures the available residual cash flow to shareholders, and it reflects true residual cash flow. These factors make the AFFO method useful for determining a REIT’s capacity for future dividend payments.
The AFFO method reflects how much cash a company generates after operating its properties and investing capital to preserve its owned properties. It reflects a REIT’s funds that are available for distribution. The AFFO method accomplishes this by subtracting maintenance capital expenditures from FFO.
When evaluating the value of a REIT, it’s also important to consider the following factors:
- External growth prospects
- The possibility of rent increases
- The prospect of maintaining or improving occupancy rates
- Plans to upgrade facilities
Conservative dividend investors often focus on REITs that have grown their dividends reliably over time because they create generally stable income that grows. It’s important to look at which businesses perform well during recessions when evaluating REITs. Some industries, such as healthcare, can be more stable than others during recessions.
What to Know About Investing in REITs
When individuals invest in REITs, they are not directly investing in real estate properties but instead gaining access to the companies that invest in real estate. This allows people to invest in real estate without purchasing physical assets.
Investors can invest in REIT mutual funds or exchange-traded fund (ETFs), or they can purchase individual REITs.
Publicly traded REITs allow investors to invest in commercial real estate and invest in a publicly traded security, which presents the following benefits:
- Shareholder value: REIT shareholders can receive dividend income and share value appreciation.
- Liquidity: Investing in REITs is like investing in any publicly traded company. Investors can trade publicly traded REITs on major United States stock exchanges, including Nasdaq, the American Stock Exchange (AMEX), the New York Stock Exchange (NYSE) and various after-hours markets.
- Disclosure obligation: Publicly traded REITs are required to regularly disclose financial details to investors. Required disclosures include yearly and quarterly audited financial results.
- Corporate governance/active management: Typically, publicly traded REITs are corporations actively managed by professionals. Publicly traded REITs follow the same corporate governance principles as other public companies.
- Low leverage: REITs typically have capital structures with moderate debt levels.
- No shareholder liability: When investors invest in publicly traded REITs, they are not personally liable for the debts of the REITs they invest in.
There can be many benefits to investing in REITs. However, even though REIT investing helps investors gain income, it comes with potential risks, including:
- Interest rates: Publicly traded REITs can potentially lose value when interest rates rise, which reduces demand.
- Investing in the wrong REIT: Changing trends can cause certain types of real estate, such as suburban malls, to decline in popularity, so there is a risk of choosing the wrong REIT to invest in.
- Tax rates: REIT dividends can be allocated and taxed as income, return of capital or capital gains rather than as passive income.
- Lack of share value transparency: It can be challenging for investors to determine the exact value of their shares in a private REIT since this type of REIT isn’t publicly traded. Many REITs publish regular reports of their share value, but some don’t.
- Potential illiquidity: Some REIT shares are also illiquid compared to publicly traded REITs because investors can’t sell their shares. PNLRs also often have limited liquidity due to redemption restrictions.
Paying Taxes on REITs
You can build wealth investing in REITs by collecting annual dividend payments, which also means you will most likely need to pay taxes on your dividends to the Internal Revenue Service (IRS) since dividends are considered a form of income. Earned dividends are subject to income tax unless your investments are within a tax-advantaged retirement account such as an individual retirement account (IRA).
With a tax-advantaged retirement account, you can avoid paying dividend taxes and grow your investments more as time passes. REIT dividends in a standard, taxable brokerage account can complicate your tax situation because they have a complex tax structure.
You will also need to report your capital gains earned any time you sell your REITs. If you hold your REITs for less than a year, you will need to pay on short-term capital gains. If you hold your REITs for more than a year and then sell them, you will need to pay on long-term capital gains, which are less than short-term capital gains.
You might hold REITs for longer than a year because you will pay lower taxes on any capital gains earned than you would if you sell them within a year.
How to Get Started in REITs
REITs provide opportunities for individuals to invest in real estate properties they wouldn’t normally be able to directly invest in. REIT investing for beginners involves knowing how to invest in REITs to explore this earning potential option down the road.
The first step is to open a brokerage account and start researching REITs. Once a potential investor determines what property types to invest in, they can become a shareholder and start investing. When you make an investor account at 1031 Crowdfunding, you gain access to a collection of investment properties, ranging from industrial to multifamily types.
Determining how much to invest in REITs depends on how much you can afford and how much you are willing to risk. REITs have growth potential and are typically lower-risk investments than individual properties because of their diversification and professional management, but they do still come with some risks to keep in mind.
Invest With Confidence at 1031 Crowdfunding
Invest in REITs as an option to earn a passive income and build wealth over time. While REITs present risks just like all investment opportunities do, they can present growth possibilities as well.
At 1031 Crowdfunding, we have a wide variety of REITs for investors to choose from. We provide data to help you make an informed decision for your investment needs, and our team of experienced real estate professionals will support you along the way. Register with 1031 Crowdfunding to start adding real estate to your investment portfolio.
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.