What is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is a company that owns, operates and finances income-generating real estate. A REIT is modelled after mutual funds and allows individual investors to earn dividends from real estate investments without having to finance or manage the property themself.
As a collection of shares that can be combined to make a portfolio, a REIT is very much an option for investors who are looking to start putting money down but don’t want to fully finance a new property.
This is typically a low-risk, low-return way of investing, as 90% of the rental profit will be shared with all of the stakeholders. REITs will typically deliver a steady income stream for investors but don’t offer as much in the way of capital appreciation.
However, because many REITs are publicly traded they’re highly liquid, unlike physical real estate investments. They’re also usually composed of multiple property types including residential, hospitality, commercial and service assets.
How Does a REIT Work?
Typically, a Real Estate Investment Trust is specialised, targeting a specific real estate sector. However, some are more diverse, holding different types of properties in their portfolios from a variety of sectors.
Many are publicly traded on major exchanges and investors can buy or sell, much like the stock market. Because of the way they’re traded, REITs are typically considered very liquid assets and traded under substantial volumes.
In general, REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties.
The majority of REITs work in the following way: The REIT leases space and collects rent on the property, which is distributed as a dividend to any shareholders. Mortgage REITs don’t own the real estate but finance it instead – these REITs earn income from the interest on the investment.
Investments are usually held in an ISA, SIPP or LISA, which makes them very tax efficient. With more than 50 REITs listed on the London Stock Exchange, they have a combined value of around £54 billion.
To be eligible as a REIT in the UK, the firm must hold at least 75% of its gross assets in rentals and generate at least 75% of its profits from these assets. The REIT must own at least three properties and no individual property can be more than 40% of the fund’s total asset value.
What are the Different Types of REITs?
There are three common types of REITs:
- Equity REITs – The majority of REITs run on an equity basis – where they own and manage income-producing real estate. Revenues are generated primarily through rents, not by reselling.
- Mortgage REITs – These types of funds lend money to real estate owners either through a mortgage or loan. Their earnings are generated typically by the net interest margin, which is the outcome of the interest they earn on mortgage loans and the cost of funding these loans. This means this type of REIT can be impacted by interest rate increases.
- Hybrid REITs – These REITs use the investment strategies of both equity and mortgage REITs.
REITs can also be categorised on how their shares are bought and held:
- Publicly Traded – Shares of these public REITs are listed on major exchanges, where they can be traded by individual investors. These are usually regulated by the appropriate government body.
- Public Non-Traded – These REITs are regulated but don’t appear on major exchanges, which makes them less liquid than publicly traded REITs. They tend to be more stable as they’re not impacted as much by the market.
- Private REITs – These REITs aren’t registered with government regulations and don’t trade on major exchanges. These REITs are generally only sold to institutional investors.
What are the Pros and Cons of Investing in REITs?
A Real Estate Investment Trust can play an important part in a portfolio because they can offer a strong, stable annual dividend. While the potential gains are typically less than that of a traditional investment, REIT total returns over the last 20 years has outperformed the S&P 500 Index as well as the rate of inflation.
REITs can offer further diversification and dividend-based income in a portfolio, which are generally higher than similar investments. However, REITs don’t offer much in terms of capital appreciation as the majority of any income is paid back, leaving little for reinvestment. Similarly, REITs can incur higher management fees than a traditional investment.
Typically, a REIT is ideal for those that don’t have the finance or time to manage a traditional single-let investment, providing a low-risk, low-return alternative to Buy-to-Let. That said, the potential ceiling for returns in a REIT is much lower than a single-let investment as it isn’t able to provide the same level of capital growth and rental returns.
As with any investment, REITs come with their own pros and cons, the decision you have to make is how they suit your personal circumstances. With the potential for long-term returns, despite the lack of capital appreciation, REITs can be an important part of a diverse property portfolio.