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What Is a Real Estate Investment Trust (REIT)?

When it comes to real estate investing, not many people can follow in the footsteps of Sam Zell…

Be it simple genetics or a lack of business savvy, most investors just don’t have the time, money, or knowledge that it takes to be among the best in the real estate game. And make no mistake: Without any one of those three things, real estate investing can be feast or famine.

housing on the riseAs we have seen, the bursting of the housing bubble has bankrupted enough real estate geniuses to nearly topple the entire system.

The good news is that there is a type of investment that can put you into the real estate arena without buying a fixer-upper or searching for decent tenants…

And this investment protects you from many of the dangers that come with investing in real estate directly.

If you’re an investor who’s looking to hedge risk and still make a profit in real estate, a real estate investment trust (or REIT for short) may be an excellent choice for you.

What Is a REIT?

That’s a good question. A REIT is a company that owns and manages income-producing real estate. As I mentioned above, REIT stands for a real estate investment trust.

REITs were created by an act of Congress in 1960 that enabled large and small investors to enjoy the rental income from commercial properties.

REITs are governed by many regulations, the most important being that they must distribute at least 90% of their taxable income to shareholders as dividends each year. This is why they’re so popular with investors who are seeking steady income.

All REITs share the following requirements to qualify. By law they must:

  • Be structured as a corporation, business trust, or similar association.

  • Be managed by a board of directors or trustees.

  • Offer fully transferable shares.

  • Have at least 100 shareholders.

  • Pay dividends of at least 90% of the REIT’s taxable income (most REITs actually pay out nearly 100%).

  • Have no more than 50% of their shares held by five or fewer individuals during the last half of each taxable year.

  • Hold at least 75% of total investment assets in real estate.

  • Have no more than 20% of their assets consist of stocks in taxable REIT subsidiaries.

REITs specialize by property type. They invest in most major property types, with nearly two-thirds of investments being in offices, apartments, shopping centers, regional malls, industrial facilities, and even fast-food chains.

The rest is divided among hotels, self-storage facilities, health care properties like hospitals and nursing homes, and some specialty REITs that own anything from prisons and theaters to golf courses and timberlands.

Several popular REITs are Annaly Capital Management, American Capital Agency, and Two Harbors Investment.

How Does a REIT Help Minimize Risk?

One of my investing mentors told me about how real estate, though lucrative, was the one investing sector that he really regretted getting into.

Why? Mainly because he had to evict and handle unruly tenants… And for him, the profits simply didn’t justify the headaches.

That’s why REITs have managed to attract so many investors. They facilitate a stream of profits without the day to day of actual real estate ownership. They also minimize investors’ risk.

Investing in the private real estate market presents more legal risk and also higher costs and maintenance. Investors are often accountable for their whole investments, which is time-consuming.

For investors who want to capitalize on real estate but remain hands off, REITs offer profits in controlled environments. There are also numerous other benefits, which I break down below…

Benefits of REITs include:

High Yields. For many investors, the main attraction of REITs is their dividend yields. The average long-term (15-year) dividend yield for REITs is about 8% — well more than the yield of the S&P 500 Index. Also, REIT dividends are secured by stable rents from long-term leases, and many REIT managers employ conservative leverage on the balance sheet.

Simple Tax Treatment. Unlike most partnerships, tax issues for REIT investors are fairly straightforward. Each year, REITs send Form 1099-DIVs to their shareholders, containing breakdowns of the dividend distributions. For tax purposes, dividends are allocated to ordinary income, capital gains, and the return of capital. As REITs do not pay taxes at the corporate level, investors are taxed at their own individual tax rate for the ordinary income portion of the dividend.

The portion of the dividend taxed as capital gains arise if the REIT sells assets. Return of capital — or net distributions in excess of the REIT’s earnings and profits — are not taxed as ordinary income, but are instead applied to reduce the shareholder’s cost basis in the stock. When the shares are eventually sold, the difference between the share price and reduced tax basis is taxed as a capital gain.

Liquidity of REIT Shares. You can buy and sell REIT shares easily on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.

Diversification. Studies have shown that adding REITs to a diversified investment portfolio increases returns and reduces risk since REITs have little correlation with the S&P 500.

So, there you have it — a quick and dirty introduction to REITs.

All said, there are some clear benefits to investing in real estate through REITs. They limit investor responsibility and have the potential to make good gains.

But, like an investment venture, REITs come with some risk. Most of that risk occurs in the early stages, particularly when investors are selecting REITs to invest in.

This means that investors need to be aware of the kinds of REITs they are getting into. For instance, public non-traded REITs tend to knock investors down with hidden fees. They also tend to be illiquid and have fewer SEC protections for investors.

For beginners in the REIT market, it may be best to stick with publicly traded REITs. These offer investors more protection.

How Much to Invest

How_Much_to_invest_houseThis is a big question for investors. And unfortunately, it has a lot of answers.

Someone who has made a killing in real estate will suggest investing more. Someone who got burned will likely caution to invest less. That is just the way of peer investment feedback.

So, for most investors who are just venturing into the REIT market, the best path is to turn directly to analysts. Analysts often give more generalized asset-allocation ranges, which fits the needs of a wide net of investors.

Analysts from the Motley Fools suggest allocating 15–20% of a portfolio to a REIT. Other analysts are more conservative, suggesting an investment of just 5%.

At the end of the day, the amount of money to invest in a REIT is up to the individual investor. They will have to consider a variety of factors, including whether they want to invest actively or passively in REITs.

For investors who are seeking more information, we’ve included a list of articles that detail REIT investments. Good luck with your investment ventures!

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