What Is a REIT and Why Should You Care?

REITs, or Real Estate Investment Trusts, let you invest in real estate the easy way.

It's a good tool for diversifying your portfolio. While not without risks, millions of Americans hold them through retirement funds and pension accounts. If you want to jump into the REIT market here's the breakdown of what you'll need to know.

What Is a REIT?

A REIT is a company that owns and (with some exceptions) operates income-generating real estate such as office buildings, shopping malls and parking lots. Each share of the firm distributes a certain percentage of the money those properties bring in. The REIT model is built along the lines of a mutual fund, with firms typically organized by category. For example one REIT might specialize in health care, while another focuses on retail and shopping.

Unlike a development company, a REIT makes its money from the proceeds of its assets. The company doesn't exist to sell the properties. Rather it operates them and collects profits from the rent, direct payments or other forms of income generated by the property.

This also distinguishes a REIT from shares of stock. With stocks and mutual funds, an investor typically makes their money off of capital gains (the sale price of the asset). Dividends, while real, are more rare.

Holders of REITs, on the other hand, make most of their money through operating profits. They return these profits to investors based on the trust's accounting, with many doing so monthly.

Example of a REIT in Action

Let's consider a hypothetical REIT called Shop Co. This firm focuses on retail properties, so it will avoid assets like office spaces, hospitals, storage units or the hospitality industry. The portfolio of Shop Co. instead holds three storefronts that it leases out to retail businesses. The company also owns 25% of a shopping mall and three gift shops in New York City.

Shop Co.'s business model is to operate these various businesses. While it might develop them it will do so in order to collect the future profits from increased business, not to drive the property value up prior to a sale.

As a result, Shop Co. calculates its profit using Generally Accepted Accounting Principles based on: the rent paid by its retail tenants; 25% of the operating profits from the shopping mall; and the revenue after expenses from its gift shops. Each investor in Shop Co. will receive a portion of that money, distributed on the 5th of each month.

REIT Categories

There are five significant classifications of REIT.

1. Public

A public REIT is traded on a stock exchange. They are available to anyone and subject to the same regulatory restrictions as any other publicly traded asset.

2. Private

Also known as non-traded REITs, these firms must be registered with the SEC (like a public fund) but are not available for public trading. While these shares can be higher value due to their more exclusive nature, they are also considerably harder to sell and can involve far less transparency than a public REIT.

The risks to a retail investor are significant enough that the SEC takes pains to spell them out.

3. Equity

A public equity firm is by far the most common type of REIT; so much so that when an investor refers to a "REIT" he is almost always referring to the public equity model.

An equity trust owns and operates its properties. It makes its money off of the income that these properties bring in, such as rent, profits or other proceeds.

4. Mortgage

A mortgage REIT owns property-backed debt such as mortgages and mortgage-backed securities. Some will purchase mortgages, while others will actively provide the financing for these loans themselves.

This trust makes its money off the debt payments that its properties bring in, with interest as the typical chief form of profit.

5. Hybrid

More rare, a hybrid REIT holds both direct-income generating properties and mortgages.

How Does a REIT Work?

A REIT operates according to a few simple rules.

• Investors purchase shares in the trust as they would a stock or mutual fund.

• A public trust must adhere to SEC guidelines for disclosures and oversight of publicly traded funds.

• The REIT must return at least 90% of its taxable income to shareholders.

• The trust must have at least 75% of its assets in real estate, cash or cash equivalents.

• The trust must make at least 75% of its income from real estate.

• And the REIT must have at least 100 shareholders, with no more than half of its shares held by five or fewer people.

These rules amount to one general principle: No cheating. A REIT can't just call itself a real estate investment. The SEC allows some diversification, but a REIT's main business must be real estate.

Example of a REIT Structure

Let's look at Shop Co. again.

This is an example of a public equity REIT in action. It trades on the New York Stock Exchange, with its share price typically based on how investors think the retail market will do in Manhattan (where Shop Co. owns the bulk of its properties).

It's an equity firm because its money comes from property incomes, not interest payments. It's a public firm because it's traded on an open exchange to any buyers, not just qualified investors.

In a normal year, all of Shop Co.'s profit comes from its property. Although it has taken some short positions on the cotton market to hedge its gift shops, the firm has taken a loss on that investment in most quarters. Otherwise, all of the firm's assets are in either cash or real estate holdings.

Except for 5% in overhead, the firm pays all of its revenues back to shareholders, who number 287. The firm's three founders hold 25% of the shares collectively. The rest are held by the shareholders at large.

Benefits of a REIT

There are three major reasons why people invest in REITs.

1. Investing Diversity

A REIT is completely unlike a stock in that its profit model comes from real estate, not corporate performance. This often makes REIT value countercyclical with the stock market at large, or at least only loosely related, and a very different kind of asset to invest in.

And it's not just that REITs add diversity to your portfolio, although they do. They are also typically diverse themselves. Built on the concept of a mutual fund, a REIT represents a collection of real estate interests. This means that they are far more shock resistant since individual properties can fail without bringing down the firm.

2. High Rates of Return

REITs tend to have high rates of return compared to stocks, mutual funds or other investments. One article in Forbes found that over 30 years, REIT funds averaged a 12% annual rate of return compared to the S&P 500's 10%. Real estate continues to appear a sound investment based on the numbers these funds give back.

3. Regularity of Return

As noted above, this is not unique to this asset class. Stocks can and do produce dividends, but rarely on a reliable basis. The entire idea of a REIT, however, is to generate a steady stream of investment-based income. What's more, in a healthy fund, that income steadily increases year by year as the property grows in value.

Negatives of a REIT

So why wouldn't you invest in a REIT? Well, there are a few sound reasons for caution.

1. Private REITs and Mortgage REITs are Entirely Different Beasts from Public Equity REITs.

Mortgage REITs typically hold much higher levels of debt, with rates of return far more susceptible to market shocks and interest rate fluctuations. Similarly, private funds can often provide higher rates of return than public shares, but they also can have far less transparency and will often use debt or operating capital to pay distributions.

Both have considerably different risk profiles than a public equity firm.

2. REITs Depend on More Specialized Knowledge

Any trading should start with serious research on the investor's part. You should never go in blind.

In the case of a REIT, it can be harder to fully understand what you're buying. This asset class moves with the real estate market, along with the market that your particular REIT clusters around (retail, food services, etc.). As a result you need to understand commercial real estate to more fully understand the strengths and weaknesses of any given offering.

That can be tough. Real estate is a notoriously obscure market with many closed loops of information. Retail investors may struggle to fully understand what they're buying.

3. REITs Can Breed Overconfidence

An REIT can actually lose money. If the operating costs fall below profits, let's say a firm's storefronts all stay empty for too long, the trust won't just fail to hand out distributions, it might actually go bankrupt. (Take, for example, the extraordinary conditions of 2008, when the REITs traded on the New York Stock Exchange averaged a negative-40% return.)

They can also under perform the market. Although REITs have generally beaten the S&P 500 over the past several decades, it isn't always so. In the past 15 years these funds have often under performed, even discounting the Great Recession.

Not to mention, as one blogger points out, the major real estate market is getting smaller and smaller every year. With less competition among property owners, REITs that appear competitive may often actually have many of the same managers with all the conflicts of interest that breeds.

All of this isn't to say that REITs aren't a strong choice for your portfolio, but rather to say take care. A good investment isn't the same thing as a bulletproof one.

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