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In this article, we learn what is REIT and what different types of REITs are available across different industries.
What is REIT?
Real Estate Investment Trusts (REITs) are companies that allow investors to invest in commercial or residential real estate to generate income. Similar to mutual funds, when you invest in REITs, you can combine your capital with several investors so that all will be able to get the dividends. REITs are easy to buy and sell as they are traded publicly on the secondary market. They offer greater diversification for your portfolio and higher returns with lower risk.
Types of REITs
Usually, there are two major categories of REITs: Equity REITs and Mortgage REITs. Most equity and mortgage REITs are traded on national stock exchanges.
Equity REITs
Equity REITs generate profits through dividend income received by ownership of long-term properties. They own and operate income-generating real estate such as shopping centers, apartment complexes, office buildings, and more. Equity REITs cover a wide range of property types, making them a versatile investment option.
Mortgage REITs
Mortgage REITs (mREITs) earn their profits through interest income generated from investing in residential and commercial mortgages. They provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities.
Public Non-Listed REITs (PNLRs)
Public non-listed REITs are registered with the SEC but do not trade on national stock exchanges. They offer limited liquidity options, such as share repurchase programs or secondary market transactions, but generally provide steady income streams similar to publicly traded REITs.
Private REITs
Private REITs are exempt from SEC registration and do not trade on national stock exchanges. They are typically sold only to institutional investors or accredited individuals, offering potentially higher returns but with increased risk and less liquidity.
Types of Equity REITs by Sector
Commercial REITs
Retail REITs are companies that acquire retail locations like malls, shopping centers, and freestanding properties. About 24% of REIT investments belong to this category. When you start thinking about retail REIT investments, you need to check both REIT itself and its retail industries. Firstly, keep in mind that REITs generate your income from the rent which is charged from tenants.
If retailers are facing poor sales, there can be different problems that affect your portfolio income. Secondly, you need to check if REIT has good profits, little debt, and strong balance sheets. It is essential because REITs only with significant cash positions can buy good real estate at reasonable prices.
Residential REITs
These kinds of companies own multi-family homes, apartments, and manufactured housing. Residential REITs are attractive investments as you can benefit from economic growth and population growth. Thus, more people will be in search of rent.
High prices of owning houses make people rent and pay higher fees. Moreover, it would be best if you considered several important factors before investing in residential REITs. You must invest in REITs with houses where home affordability is low compared to the rest of the country. For instance: large urban areas can be good options to choose from.
Healthcare REITs
Healthcare REITs are another attractive investment option since healthcare costs are increasing. They invest in hospitals, nursing homes, and assisted living facilities. Are all examples of healthcare REITs. It is excellent and safe to have a diversified group of investments in different property types.
Office REITs
Office REITs invest in office locations. They receive rental income from office tenants and benefit from longer leases compared with tenants of industrial properties. However, since more and more people start to work from home during the pandemic, companies are rethinking how they manage their offices. So, it is always better to invest in economic strongholds.
Must Read: 4 Must-Know Types of REITs For Investors
How REITs Work
REITs pool capital from multiple investors to purchase and manage income-producing properties. They provide a way for smaller investors to own a share of large real estate portfolios, earning income through dividends and potential capital appreciation.
REITs must adhere to certain IRS requirements, such as distributing at least 90% of taxable income to shareholders.
Benefits of Investing in REITs
- Dividend Income: REITs are required to pay out 90% of their taxable income as dividends, making them attractive for income-seeking investors.
- Diversification: Investing in REITs provides exposure to real estate, which typically has a low correlation with stocks and bonds, reducing overall portfolio risk.
- Professional Management: REITs are managed by professionals who handle property selection, acquisition, leasing, and maintenance, offering the benefits of real estate investment without the hassle of direct property management.
- Liquidity: Publicly traded REITs offer liquidity similar to stocks, allowing investors to buy and sell shares easily on the stock market.
Learn More: 5 Benefits of Investing in REITs You Should Know
Considerations and Risks
- Interest Rate Sensitivity: REITs can be sensitive to interest rate changes, which affect borrowing costs and the attractiveness of their dividend yields compared to fixed-income securities.
- Market and Economic Conditions: REIT performance can be impacted by economic cycles, property market conditions, and tenant stability.
- Sector-Specific Risks: Different REIT sectors face unique risks, such as the impact of e-commerce on retail REITs or regulatory changes affecting healthcare REITs.
- Tax Considerations: REIT dividends are generally subject to ordinary income tax rates, which can be higher than the tax rates on qualified dividends.
Evaluating and Investing in REITs
When evaluating REITs, consider factors such as property type and quality, occupancy rates, lease terms, and financial metrics like funds from operations (FFO) and net operating income (NOI). Investment strategies include direct investment in individual REITs, REIT mutual funds, or REIT exchange-traded funds (ETFs) for broader diversification.
Understanding REIT Performance Metrics
When investing in REITs, it’s crucial to understand the key performance metrics that can help evaluate the financial health and potential of a REIT. These metrics provide insight into the REIT’s profitability, efficiency, and overall performance.
Funds from Operations (FFO)
Funds from Operations (FFO) is a key metric used to measure the cash generated by a REIT from its operational activities. It is calculated by adding depreciation and amortization to earnings, and subtracting any gains on sales of properties. FFO is a better indicator of a REIT’s performance compared to net income, as it excludes non-cash items that can distort profitability.
Net Operating Income (NOI)
Net Operating Income (NOI) is another essential metric, representing the total revenue from a property minus all reasonably necessary operating expenses. NOI provides a clear picture of a property’s profitability before factoring in financing costs, taxes, and capital expenditures.
Debt to Equity Ratio
The Debt to Equity Ratio indicates the relative proportion of shareholders’ equity and debt used to finance a company’s assets. A lower ratio generally indicates a more financially stable REIT, as it suggests the company is not overly reliant on borrowing to fund its operations.
Occupancy Rates
High occupancy rates are critical for the success of REITs, as they directly impact rental income. Investors should look for REITs with consistently high occupancy rates, as this indicates strong demand for the properties in the REIT’s portfolio.
Tax Implications of REIT Investments
Investing in REITs comes with specific tax considerations that investors need to understand to maximize their returns and comply with tax regulations.
Dividend Taxation
REIT dividends are generally taxed as ordinary income, which can be at a higher rate than qualified dividends from stocks. However, a portion of REIT dividends may qualify for a lower tax rate if they meet specific criteria. It’s essential to consult with a tax advisor to understand how REIT dividends will be taxed in your situation.
Capital Gains Tax
If you sell REIT shares at a profit, the gains are subject to capital gains tax. The rate depends on how long you held the shares. Long-term capital gains (on assets held for more than a year) are typically taxed at a lower rate compared to short-term capital gains (on assets held for less than a year).
Tax-Deferred Accounts
Investing in REITs through tax-deferred accounts like IRAs or 401(k)s can be beneficial, as it allows the dividends and capital gains to grow tax-free until withdrawal. This can be a strategic way to minimize the immediate tax impact of REIT investments.
Also Read: A Complete Guide on Islamic REIT: A Liquid Investments Accessible to Retail Investors
Financial Goals FAQs
What are REITs?
REITs (Real Estate Investment Trusts) are companies that own, operate, or finance income-producing real estate. They allow investors to earn income from real estate without directly owning properties.
What types of REITs are there?
The main types of REITs include equity REITs, mortgage REITs, public non-listed REITs, and private REITs. Equity REITs own properties, mortgage REITs invest in mortgages, public non-listed REITs are registered but not publicly traded, and private REITs are not registered and are sold to accredited investors.
What are the benefits of investing in REITs?
REITs provide dividend income, portfolio diversification, professional management, and liquidity. They can be an effective tool for income-seeking investors and those looking to diversify their portfolios with real estate exposure.
What are the risks of investing in REITs?
Risks include interest rate sensitivity, market and economic conditions, sector-specific challenges, and tax considerations. It’s important to evaluate these factors before investing in REITs.