A real estate investment trust (REIT) owns and finances income-generating real estate for investors who own shares in the company. REITs pool funds from multiple investors to purchase their properties, enabling investors to receive dividends from the REIT’s rental income without having to buy or manage the properties themselves. A REIT often focuses on properties in a specific sector, such as healthcare, self-storage, or multifamily housing communities.
While all investments carry the risk of loss, REITs can allow investors to benefit from a steady stream of passive income. Understanding the various types of REIT offerings and how to invest can help you determine whether investing in this type of opportunity aligns with your financial goals.
What is a REIT?
A REIT is a company that buys and manages real estate and holds them for the long term. REITs receive funding from investors and use the capital to purchase and operate properties. Most REITs rent out the properties to tenants and generate rental income, which it distributes to investors in the form of dividends.
REITs are either equity or mortgage REITs, and the two types of REITs operate differently. Equity REITs buy real estate properties like industrial buildings, apartment complexes, medical facilities, and hotels and collect rental income from the tenants. Mortgage REITs provide real estate owners and operators with funding through mortgages or loans and make money from interest on their investments.
Whether they own properties or finance them, most REIT companies focus on one property type, although hybrid REITs invest in multiple asset classes. Additionally, investors can choose from three REIT classifications — publicly traded REITs, public non-listed REITs, and private REITs.
To qualify as a REIT, companies must follow specific regulations outlined in the Internal Revenue Code (IRC) that primarily deal with how REIT companies distribute dividends and REIT ownership. The Internal Revenue Service (IRS) lists several requirements for qualification as a REIT, including the following:
- The company must be a corporation, trust, or association.
- A board of trustees or directors must oversee the company.
- The company must have beneficial ownership held by at least 100 people and evidenced by transferable shares.
- The company would otherwise be taxed as a domestic corporation.
- Dividends paid — excluding capital gain dividends — must equal or exceed 90% of the REIT’s taxable income.
- The company must derive at least 75% of its gross income from rents from real property, interest from mortgages financing real property, or the sale of real estate.
The Differences Between Publicly Traded REITs, Public Non-Listed REITs (PNLRs), and Private REITs
The three REIT types have varying regulations for investment and differ in how they are bought and held. Knowing the differences between each REIT classification is critical for understanding each type’s specific benefits and risks.
Publicly Traded REITs
Publicly traded REITs are traded on major United States stock exchanges, such as the NASDAQ and NYSE. The investment process for these REITs is similar to investing in other exchange-traded public securities. Because these REITs are sold on public stock exchanges, they tend to be more liquid and volatile than other REIT types.
Publicly traded REITs also have no accreditation requirement, so generally anyone can invest in them. These REITs must register with the Securities and Exchange Commission (SEC) and comply with its reporting requirements.
Private Non-Listed REITs (PNLRs)
Also referred to as public non-traded REITs, PNLRs are sold through broker-dealers rather than on a public stock exchange. This difference leads to some significant distinctions from publicly traded REITs. For example, PNLRs tend to be less liquid because they aren’t sold on a public exchange, unlike publicly traded REITs. PNLRs may also have a minimum holding period requirement for
Another difference between PNLRs and publicly traded REITs is their share value transparency. PNLRs don’t appraise their assets every day since they aren’t traded publicly. However, net asset value (NAV) REITs calculate their holdings’ value regularly and may provide investors with a better understanding of their share value. The lack of correlation between PNLRs and the public stock exchange could help reduce volatility and diversify investors’ portfolios.
Many PNLRs are open to all kinds of investors, whether accredited or not, while others have some suitability requirements regarding net worth and annual income. These REIT companies must also register with the SEC and file regular reports.
Unlike the other two REIT types, these REITs are not regulated by the SEC and are not required to file regular compliance reports. Because of this lack of regulation, private REITs are only available to accredited investors.
Since private REITs are not bought or sold on a public exchange, their prices may be less subject to market volatility. Private REITs calculate their share prices less frequently than public REITs, perhaps every quarter, so investors don’t have to worry about daily fluctuations. These REITs are primarily sold by broker-dealers and may be challenging to value and trade because of their lack of publicly available information.
Why Were REITs Created?
Congress created REITs in 1960 to enable investors to buy shares in large-scale commercial real estate portfolios. REITs allow individual investors to benefit from commercial real estate ownership without having to purchase and manage properties themselves. REITs reduce the barrier to entry into real estate investment by allowing investors to pool their funds to access and gain exposure to real estate in their portfolios. This makes REITs a more affordable method of real estate investment than purchasing a property outright.
REITs can provide investors with regular dividend yields, although they also carry certain risks. Because of these risks, REITs may not be suitable for all investors. Investors should consider their personal financial situation and consult with a financial professional before investing in a REIT.
REIT Pros and Cons
The construction of REIT companies gives them a unique set of pros and cons. Consider some of the benefits of REIT investment:
- More affordable real estate investment: A REIT’s structure makes real estate investment a more affordable alternative than buying commercial real estate properties. Investors may be able to invest any amount they want, although some REITs have varying investment minimums. Investors then receive dividend distributions proportional to their share of ownership in the REIT’s underlying holdings.
- Substantial dividend yields: Some REITs may offer higher dividend yields than other investment types.
- Diversification: REITs may invest in hundreds of properties across several geographic locations, meaning investors can have more portfolio diversification than if they had to purchase individual properties.
REITs may also bring a few cons, including:
- Lack of liquidity: REITs have varying degrees of liquidity that may make it harder for investors to sell their shares to other buyers. Since they aren’t bought or sold on public exchanges, PNLRs are illiquid investments. This characteristic makes it difficult for investors to liquidate their assets quickly.
- Taxes: In most cases, REIT dividends from all REIT classifications are taxed as regular income. Investors should consider the overall tax implications by working directly with a tax advisor.
- Limited share value transparency: The transparency of REIT asset value varies depending on the REIT classification. Publicly traded REITs tend to be the most transparent, while private REITs are the least transparent because they aren’t required to file regular reports.
- Dividend and redemption suspension: If the REIT’s underlying assets are not performing, the REIT may suspend dividends and redemptions.
- Lack of control: A potential drawback of investing in REITs is the lack of control investors have over their funds. A REIT manager oversees the trust’s assets, meaning investors have limited control over the trust’s management. Investors also don’t directly own a REIT’s underlying assets because they are investing in the real estate company. Investors who prefer more control over their investments might choose a different route.
- Suitability requirements: Some REITs require investors to meet certain suitability requirements, such as having a net worth or an annual income above a specific threshold.
Stakeholders Involved in a REIT
Several stakeholders are involved in the operation of REITs, including the following:
- Sponsor: A REIT sponsor is the originator of the real estate investment trust who transfers their properties to the trust. The sponsor also appoints the REIT’s trustee.
- Trustee: A REIT trustee sits on the board and holds the assets on behalf of the unitholders.
- Manager: The REIT manager is a professional who oversees the trust’s assets by determining and implementing an investment strategy to maximize shareholder value. Investors must perform due diligence in reviewing the available information about the REIT’s investment strategy to decide whether it aligns with their financial goals.
- Unitholders: REIT unitholders are the trust’s beneficiaries. These investors pay taxes on their interest, dividends, and capital gains from the REIT, which are subject to various taxation requirements.
- Independent valuer: REITs also appoint independent third-party valuation experts who periodically value the REIT’s assets.
- Auditors: Auditors investigate a REIT’s investment and financial statements to ensure it follows the relevant laws regarding dividend distributions and asset management.
- Registrar and transfer agents: REITs also need third-party entities to oversee the transfer of shares. Registrar and transfer agents handle these responsibilities, maintaining records and managing the changes in ownership of REITs.
- Merchant bankers and custodians: A merchant bank provides banking services for REITs, while custodians safeguard the trust’s assets to minimize the threat of loss.
- Broker: Since shares in PNLRs and private REITs are securities, investors must purchase them through a broker who participates in the REIT’s offering.
The Structure of a REIT
Different REIT classifications have similar structures. All REITs must have a board of directors or trustees who oversee the assets. REITs must also have at least 100 shareholders after their first tax year. The REIT manager implements the REIT’s investment strategy to maximize value.
If a REIT doesn’t directly own its assets, it may own a special purpose vehicle (SPV) or a holding company. An SPV is an entity created by a parent company to acquire and finance certain business ventures while protecting the parent company from specific risks associated with those ventures. A holding company owns the assets of other companies and may oversee some management decisions.
Understanding a REIT’s structure is essential for investors, as these details influence how the unitholders receive distributions and who manages the assets. Investors can find information about a publicly traded REIT’s or PNLR’s structure in the prospectus, a document containing details about the REIT’s offerings. A prospectus might describe the REIT’s investment strategy, specific risks, offering terms, and other information relevant to potential investors. Supplements to the prospectus are amendments to the original document with updated information. For private REITs, the private placement memorandum (PPM) contains this information.
How Does a REIT Work?
REITs work on a fairly straightforward business model. For publicly traded REITs, the sponsor raises funds for purchasing assets through an initial public offering (IPO). The REIT’s offerings are then listed on a public stock exchange where any investor can access them. PNLRs and private REITs are only available through brokers, so people interested in investing must go through a broker who participates in the REIT’s offering.
The REIT then uses funds from investors to acquire a pool of real estate properties, which it leases to tenants. Tenants could be individuals renting units in an apartment complex or companies leasing industrial or commercial space for their business operations. REITs also use investors’ funds to pay for renovations, repairs, and property manager, manager, and trustees’ fees. Investors then receive dividend distributions from the REIT’s rental income.
REITs regularly pay distributions to investors. Some REIT companies pay dividends annually, while others pay quarterly or monthly. Because REITs must pay at least 90% of their taxable income in the form of dividends and net capital gain, REITs can only use up to 10% of their income to reinvest in properties.
How to Invest in a REIT
Those who want to invest in a REIT have several options depending on the type of REIT they wish to buy.
Publicly Traded REIT
Since shares of publicly traded REITs are listed on major stock exchanges, investors can take the same steps to invest in them that they would for other stocks. Investors may go through a broker service to purchase publicly traded REITs. An investor in a publicly traded REIT can be accredited or unaccredited.
To invest in a PNLR, investors must go through a broker who participates in the REIT’s offerings. Although these REIT companies aren’t publicly listed on any stock exchanges, investors may access information about the REIT’s offering through the broker. Accredited and unaccredited investors can invest in PNLRs, although they may have to meet suitability requirements.
Only accredited investors can buy shares in a private REIT, meaning that investors must meet the SEC’s accreditation requirements to invest in these REIT companies. Accredited investors must meet wealth thresholds and have specific professional or investment criteria. Private REITs may have higher investment minimums than other REIT types.
Returns Investors Seek From a REIT
REIT investors seek two types of returns from their investment in a REIT:
- Income: Equity REITs can earn regular rental income from tenants, whether they are organizations renting office space, companies renting retail space, or individuals renting living space. Mortgage REITs earn income from loan payments and interest.
- Asset appreciation: Property values fluctuate over time, and any appreciation in a PNLR or private REIT’s underlying holdings will affect the REIT’s overall value. As the properties a REIT owns appreciate, the individual shares that investors hold will also appreciate, leading to higher dividends for investors. Of course, dividends and share prices will also decrease if property values decrease. Publicly traded REITs have other market factors influencing the share price.
Investors realize their returns from income-generating real estate in the form of dividend distributions, which are paid in proportion to their share of ownership in the entire trust. However, investors typically can only realize returns from capital appreciation when they sell their shares in the REIT. Whereas income is distributed regularly, appreciation is realized in a lump sum that investors can only receive upon selling their shares.
However, REITs may also realize returns from asset appreciation in the form of capital gain distributions when they sell their underlying holdings without investors having to sell their shares. Investors typically do not have any say in when a REIT sells its assets.
Learn More With 1031 Crowdfunding
REITs allow investors to generate passive rental income without the same responsibilities as property owners or managers. Understanding your financial goals and the types of REIT investments available can help you select a REIT that enables you to achieve your goals.
At 1031 Crowdfunding, we are a real estate investment platform offering REIT investment options. The management team at 1031 Crowdfunding has over $2.2 billion in combined real estate transactions and the experience to help investors navigate the scenarios they might encounter with this type of investment.
Learn more about REITs and alternative investments on the 1031 Crowdfunding blog, or register for an investor account to unlock and view our full 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.