Although investment vehicles such as stocks, exchange-traded funds and mutual funds are relatively well known to the public, many personal investors are not as familiar with real estate investment trusts. The history of real estate investment trusts in the U.S. dates back to the 19th century. However, the beginnings of its modern history can be traced to the Real Estate Investment Trust Act of 1960. Real estate investment trusts are intriguing to many personal investors because they offer comparatively “high” dividend income (when compared to other equity investments). However, real estate investment trusts are certainly not without risk as they are subject to both interest rate risk and cyclical fluctuations in the real estate industry.
What is a real estate investment trust? A real estate investment trust commonly referred to as a REIT is a company which purchases and manages a portfolio of real estate investments for a fee for its shareholders. The shareholders receive investment income in the form of dividends and/or capital gains distributions.
There are three types of REITS: equity, mortgage, and hybrid. Equity REITs invest in actual commercial real estate and they may also develop real estate such as resorts. Equity REITs include residential real estate such as apartment buildings, healthcare facilities, hotels, restaurants, self-storage property, vacation resorts, warehouses as well as retail, office and industrial space. Income is generated by the equity REIT through rents and capital gains when the real estate property is sold. Mortgage REITs specialize in mortgage-backed securities and real estate construction loans. The mortgage REIT generates revenue through the interest that is earned on real estate loans. A hybrid REIT can hold a combination of equity, and mortgage investments.
Important features of real estate investment trusts:
1. REITs are highly liquid investments. REITs are publicly traded on all major exchanges as well as over-the-counter. Therefore, REITs can be bought through a broker, just like a stock. Individual investors also have the option of participating in a REIT investment through a mutual fund. Many mutual fund companies have specialized REIT funds. REIT dividend reinvestment plans (DRIPs) and REIT exchange-traded funds are also available.
2. In order for a REIT to bypass taxation as a corporate entity, it must derive 75% of its gross income from real estate investments and distribute at least 90% of its taxable income to shareholders annually (generally in the form of dividends). Furthermore, in order for a corporation or a trust to qualify as a REIT, it must have a minimum of 100 shareholders. Another key stipulation is that no more than 50% of the company’s shares can be held by five or fewer persons during the last half of each taxable year. Special note: for shareholders, REIT dividend income is taxed as ordinary income.
3. REITs are managed by a board of directors or trustees.
4. A REIT is not an open-end investment company such as a mutual fund.
Investing in REITs requires specialized knowledge. Although the dividend yields of REITs are alluring, an investment should not be selected on the basis of the dividend payout. An inordinately high dividend can be indicative of inherent problems within the company such as an excessively heavy debt burden or other financial difficulties and/or mismanagement.
Information for educational purposes and not intended as investment recommendation or advice. Every attempt is made towards accuracy, however, no guarantee is made that the content is free of errors and/or omissions.