What is a REIT
A real estate investment trust, or “REIT” is a corporation focused on acquiring or financing income-producing real estate with numerous advantages over direct real estate investing. Originally modeled after mutual funds, REITs offer investors the benefits of both current income and long-term capital appreciation, while providing diversification and options for liquidity.
Unlike most corporations, a REIT is required to distribute at least 90% of its taxable income to investors, meaning REITs generally offer attractive dividend yields compared to other stocks. Additionally, because REITs are allowed to deduct dividends paid to investors from their taxable income, REITs can avoid the “double taxation” to which other corporations are subjected.
Types of REITs:
Generally, REITs are classified as either equity or mortgage REITs. Equity REITs own real estate and generate income primarily through the collection of rents. Mortgage REITs invest in loans secured by real estate and generate income through interest payments. Publicly-listed REITs are registered with the SEC and have shares that trade on national stock exchanges. Non-listed REITs may, or may not, be registered with the SEC and typically sell shares through private placement to both individual and institutional investors. Because most non-listed REIT shares do not trade on a daily basis, their share price is generally more insulated from shocks to the stock market.
Benefits of investing in a REIT, include:
|Dividends||Commercial real estate can provide a consistent stream of income through rents collected from tenants. Combined with the requirement to distribute at least 90% of taxable income, REITs typically provide stable dividend payments to shareholders.|
|Capital Appreciation||Commercial real estate has historically provided an opportunity for capital appreciation over the long-term.|
|Diversification||Commercial real estate historically exhibits a low correlation with traditional asset classes. Private REITs, in particular, offer portfolio diversification and may reduce volatility because they are not directly tied to fluctuations in the stock market.|
|Inflation Protection||Commercial real estate has historically provided investors with a hedge against inflation. Leases often feature annual rent increases and most operating expenses are paid by the buildings’ tenants, insulating investors from rising costs. As the cost of materials and labor increases, the cost to add new supply increases which brings with it a corresponding increase in rental rates.|
|Liquidity||Direct real estate investments are relatively illiquid due to the unique nature of each property and time and cost associated with selling an asset. Listed-REITs shares can be traded in seconds and non-listed REITs often offer redemption, or stock buy-back programs, allowing investors to cash out.|
Real Estate Investment Trusts are often structured as Umbrella Partnership REITs, or “UPREITs”. A REIT organized as an UPREIT will hold most, or all, of its assets in a holding company, typically a limited partnership, commonly referred to as the REIT’s “operating partnership”. This structure allows other property owners to contribute real estate to the REIT’s holding company without paying capital gains or recapture tax in exchange for ownership in the REIT’s large real estate portfolio. This is known as an UPREIT Contribution, or 721 Exchange.
The contributing property owner will receive Operating Partnership Units which typically carry the same value as the REIT’s common stock and pay an identical dividend.
UPREITs vs. Direct Real Estate Ownership
UPREIT transactions are completed on a tax-deferred basis. This allows property owners to turn unrealized gains into earnings, while avoiding the steep tax consequences often associated with real estate dispositions. In addition to tax advantages, REITs offer numerous advantages over direct real estate ownership, including:
|Diversification of Real Estate Holdings||Due to the unique nature of every property, real estate features a high level of idiosyncratic risk often resulting in erratic cash flows and property values. REITs mitigate this risk by owning a portfolio of properties often diversified by geography and/or property type. Consequently, REITs often provide a consistent stream of income and capital appreciation.|
|Economies of Scale||REITs leverage economies of scale into cheaper financing, favorable leases and larger acquisitions. Larger acquisitions are more cost efficient than smaller transactions because fixed costs are distributed over a larger basis.|
|Professional Management||REITs are managed by experienced real estate professionals overseen by a Board of Directors. The Board of Directors are elected by and accountable to the shareholders of the REIT.|
|Passive Investment||REITs are a passive investment requiring minimal time commitment from an investor; whereas direct property ownership requires a substantial amount of work as a property owner is responsible for managing, leasing and maintaining the building. REITs are responsible for all of the work associated with being a landlord as well as providing investors with the requisite tax forms.|