by Jesse Jurgenson
Choosing between various investment options can be overwhelming. This task is only complicated further when you start looking at your available options outside of the traditional stocks and bonds. However, spending the time and energy to look at opportunities and products that may fit better with your risk tolerance and investment objectives may be highly rewarding. One such option are Real Estate Investment Trusts, or REITs. REITs offer investors a unique set of potential benefits along with their own share of potential disadvantages. This short posting is not meant to sway you either for or against the purchase of REITS, but only to expose you to another investment option you may or may not have been aware of and potentially entice you to learn more from your own trusted investment professional on how they may fit with your own personal investment goals.
A REIT is a publically-traded closed-end investment company that invests in a managed, diversified portfolio of real estate or real estate mortgages and construction loans rather than in financial securities such as stocks and bonds. A unique characteristic of a REIT is that they are not subject to tax at the corporate level if they distribute at least 90 percent of their net annual earnings to shareholders and meet a few other certain requirements1. The investor must pay the tax on the REIT’s earnings as they are disbursed. Therefore, REITs allow investors to share, with limited liability, the financial and tax benefits of real estate while avoiding the double taxation (both the corporation and the individual shareholder paying taxes) that is present with corporate ownership (stocks).
There are three types of REITs in which an investor may choose from each with their own characteristics and benefits.
(1) Equity REITs look to gain an ownership share in commercial, industrial, or residential properties (shopping malls, apartment buildings, warehouses, etc.). Most of their income is likely received from renting out these properties to tenants but they may also realize capital gains from the sale of properties that have increased in value.
(2) Mortgage REITs invest in real estate indirectly by lending money to those who construct properties or permanent mortgages. In a limited amount of cases, they may also invest in mortgage-backed securities. Income is received from the interest paid by those whom funds were loaned to.
(3) Hybrid REITs combine the features of both equity and mortgage REITs by investing in both properties and mortgages.
First, let us discuss a few of the advantages of investing in REITs:
(a) Limited Liability – much like purchasing common shares of a corporation, the liability of REIT shareholders is limited to the amount of their investment.
(b) No Corporate-Level Tax – as discussed above, as long as the REIT distributes at least 90 percent of its income to shareholders and meet a few other provisions, investors are able to avoid the normal double-taxation of earnings we experience in corporate ownership.
(c) Liquidity – generally speaking, investments in real estate are highly illiquid whereas shares in a REIT are comparatively marketable and are widely traded on the various exchanges. Also unlike purchasing real estate directly, you do not have to sell the entire asset (like a house) if you only need a little money because you are able to sell only the number of shares of the REIT you would like to.
(d) High Dividend Payout – this is because of the requirement that REITs distribute at least 90 percent of their income.
(e) Diversification Beyond Stocks and Bonds – by adding real estate to an investment portfolio, the potential for higher returns and limitation of risks is increased compared to a portfolio with only stocks and bonds or only real estate.
(f) Hedge Against Inflation – real estate has shown to be a reasonable hedge against the potential of rising inflation. As equity REITs are direct ownership in real estate, they should also provide the same hedging advantages.
As with any potential investment decision, there are drawbacks of purchasing shares in a REIT that should be carefully explored and discussed with your investment professional. They include:
(a) Loss of Control – much like investing in mutual funds, the investor does not enjoy the ability to choose specifically what assets are bought and sold within the REIT as that task is up to the REIT management. Because a REIT must distribute at least 90 percent of the income from both rents and interest and gains on sales of assets, the timing of some of the transactions management undertakes may not be advantageous to an individual investor.
(b) Management Fees and Administrative Charges – management fees for a REIT may range anywhere from 0.5 percent to 1.50 percent and, however small it may be, should be viewed as an additional expense that would not be incurred if an individual investor managed their own investment. Although transactions costs are lower through a REIT than with an individual investor, fees and charges need to be critically examined as to ensure they do not negate the potential returns.
(c) No Flow-Through of Tax Benefits – the REIT may pass only tax-sheltered income through to investors and not losses. In contrast, investors who have direct ownership in real estate or with interests in limited partnerships enjoy the ability to have losses flow-through to them.
(d) Considerable Risk – REITs price per share can be just as volatile as stock prices. The volatility can vary greatly based on the type of REIT, management philosophy, or other factors such as the REITS specific list of assets and liabilities.
(e) Poor Inflation Hedge – mortgage REITs that invest in fixed rate mortgages, having characteristics very similar to that of investing in bonds, are not likely to be good inflation hedges. What this means is that if inflation rises and causes interest rates to rise, the value of the underlying mortgages and loans will typically fall. The result will also be that the per share price of mortgage REITs may also fall.
There are over 150 publically traded REITs available to investors in U.S. markets. These REITs have a wide variety of investment objectives and vary considerably in their size, fees, management performance, investment philosophy, capital structure, and asset characteristics. The selection process for REITs is at least as involved as that for stocks or mutual funds because REITs share any of the characteristics of each. Investors should consider many factors, and consult a trusted investment and/or tax professional, before making their selections.
It may be advisable to consider buying shares in several different REITs that have the basic investment characteristics and investment philosophy that you are looking for. By diversifying among several different REITs, an investor may only receive average performance, but they will also minimize the potential of losses.
- National Association of Real Estate Investment Trusts (NAREIT) (http://www.reit.com)
- U.S. Securities and Exchange Commission (SEC) “Real Estate Investment Trusts (REITs)” (http://www.sec.gov/answers/reits.htm)
- Financial Industry Regulatory Authority (FINRA) “Public Non-Traded REITs—Perform a Careful Review Before Investing” (http://www.finra.org/investors/protectyourself/investoralerts/reits/p124232)
- Block, R. L., (2011). Investing in REITs: Real Estate Investment Trusts. Hoboken, NJ: Bloomberg/Wiley.
Leimberg, S. R., Doyle, R. J., Robinson, T. R., & Johnson, R. R. (2013). The tools and techniques of investment planning. REITs Real Estate Investment Trusts (pp. 209-221). Erlanger, KY: The National Underwriter Company.
126 U.S. Internal Revenue Code § 856 and § 857
Guest contributor Jesse Jurgenson is an AFCPE Accredited Financial Counselor and past Financial Counseling Supervisor with an NFCC certified non-profit family service organization. He is also a current Ph.D. student and Graduate Instructor in the Personal Financial Planning Department.