Real Estate Investment Trusts or REITs have emerged as a popular choice for individuals who want to invest in real estate without shelling out a hefty amount of capital or taking on the pains of property management. In essence, they operate similar to mutual funds by pooling investments from many investors to purchase, operate, or finance income-producing real estate. In this article, we'll answer the question "What is a Real Estate Investment Trust (REIT)?" as well as explain why they're among the primary types of passive real estate investing and how to invest in them.

What is a REIT?

A Real Estate Investment Trust (REIT) is a company that makes investments in income-generating real estate, either through purchasing, operating, or financing. Pickett Sprouse Commercial Real Estate broker Brad Gregory explains, "You give the money that you want to invest to the REIT, and it is pooled with other people who want to do the same thing. It may be to buy higher-priced or A-type properties or to get higher returns." These usually include malls, apartments, office buildings, warehouses, and similar types of properties where you would have tenants. REITs can also invest in mortgages and loans. These REITs generate income from the interest on their investments.

Investor.gov, which is operated by the U.S. Securities and Exchange Commission (SEC), points out that unlike many other types of real estate companies, "a REIT does not develop real estate properties to resell them. Instead, a REIT buys and develops properties primarily to operate them as part of its own investment portfolio¹." Brad says the part that makes them one of the purest forms of passive real estate investing is that "you, as the investor, have little or no control over what the REIT buys. You're trusting the person that is controlling the REIT or controlling the fund to make good decisions."

Qualifications for a REIT

To meet the definition of a REIT under the Internal Revenue Code (IRC), a company must meet certain conditions². These requirements primarily involve owning long-term income-generating real estate and distributing income to shareholders. Specific requirements to qualify as a REIT include:

It must invest at least 75% of total assets in real estate assets, cash, or U.S. Treasuries.

At least 75% of gross income must be derived from rents, interest on mortgages that finance real property, or real estate sales.

A minimum of 90% of taxable income for REITs must be paid in the form of shareholder dividends each year.

The company must be taxable as a corporation.

Management must be done by a board of directors or trustees.

After its first year of existence, the company must have at least 100 shareholders.

No more than 50% of its shares can be held by five or fewer individuals.

Different Types of REITs

According to the National Association of Real Estate Investment Trusts (NAREIT), there are four different types of REITs³.

Equity REITs

An equity REIT is registered with the SEC, is publicly traded, and owns and operates income-producing real estate. This is the most common type of REIT. Because equity REITs trade on the major stock markets, they are usually referred to simply as REITs by the market and Nareit.

mREITs

mREITs, also known as mortgage REITs, offer funding for properties that yield income. They do this by either buying or originating mortgages and mortgage-backed securities. mREITs then generate earnings from the interest that accrues on these investments.

Public non-traded REITs

These are REITs that, while registered with the SEC, do not have their shares traded on national stock exchanges.

Private REITs

Private REITs are exempt from SEC registration. Their shares do not trade on any national stock exchange.

Both Public non-traded REITs and private REITs are also referred to as non-listed REITs.

How Does a REIT Work?

Fundamentally, REITs have a simple business model: they lease space, collect rents on the properties, and then distribute that income as dividends to shareholders. Brad sums it up in this way, "They raise the money, and then they go find properties to buy. There usually isn't a specific property in mind when the money is raised."

A REIT generates income primarily through the rental income from the properties it owns and manages. This rental income is then distributed to shareholders in the form of dividends. Brad says that REITs pay regular dividends to shareholders, usually on a quarterly basis, which are based on the income they generate. The dividends distributed to shareholders are determined by the REIT's board of directors and can fluctuate based on the performance of the properties and the overall market conditions.

In addition to regular dividends, REITs tend to benefit shareholders from the potential appreciation in the value of their shares, which can result in capital gains upon sale.

Overall, the income generation and distribution process with a REIT is designed to provide shareholders with a steady stream of income and the potential for long-term growth through property appreciation.

Advantages of Investing in REITs

REITs offer several advantages to investors. Brad explains what some of these are.

Steady source of income through REIT dividends. "REITs are a solid source of passive income. Once you've made the initial investment, all you have to do is sit back and wait for the checks to come in the mail every quarter."
REITs typically pay cash for properties. "Whoever's controlling the fund is going out and purchasing properties with cash. So, you may be able to get a better price and better terms, because it's all cash. There is no loan associated usually with equity REITs. There could be, but usually not."
Investments can be made in potentially higher-income-producing properties. "You don't have to rely only on the money that you have personally to finance real estate. By pooling funds with other investors, you can have a stake in a property that might be at a completely different level than what you could do by yourself."
REITs may be a safer option for new real estate investors. "For those who are just starting out in real estate investing, a REIT investment can be a good way to stick their toe in the water without having to take on all of the risks of owning a property themselves."

Risks of Investing in REITs

Despite the advantages, investing in REITs also comes with risks. Brad says that the main concern with all REITs is that the property that is invested in doesn’t do well or the market changes and the value of the property goes down.

When it comes to non-traded REITs, the SEC says there are additional risks to think about when buying shares in a REIT¹.

Share value transparency

The market price of a publicly traded REIT is easily obtainable, but gauging the value of a non-traded REIT share can be challenging. Non-traded REITs generally don't give an estimate of their per-share value until 18 months post the closure of their offering. This could be years after you made your investment. Consequently, it may be quite a while before you can assess the value of your non-traded REIT investment and know its volatility.

Distributions May Be Paid from Offering Proceeds and Borrowings

"Investors may be attracted to non-traded REITs by their relatively high dividend yields compared to those of publicly traded REITs. Unlike publicly traded REITs, however, non-traded REITs frequently pay distributions in excess of their funds from operations. To do so, they may use offering proceeds and borrowings. This practice, which is typically not used by publicly traded REITs, reduces the value of the shares and the cash available to the company to purchase additional assets."

Conflicts of interest

Because non-traded REITs usually have an external manager instead of their own employees, potential conflicts of interests can come up with shareholders. "For example, the REIT may pay the external manager significant fees based on the amount of property acquisitions and assets under management. These fee incentives may not necessarily align with the interests of shareholders."

May have high up-front fees

"Sales commissions and upfront offering fees usually total approximately 9 to 10 percent of the investment" for public non-listed REITs and private REITs. "These costs lower the value of the investment by a significant amount."

How to Invest in REITs

Investing in publicly traded equity REITs can be done by purchasing shares through a broker. Shares in non-traded REITs and private REITs can be bought through a broker or financial advisor participating in the non-traded REIT’s offering. Brad recommends going to whoever your financial advisor is, your accountant, and/or an investment person to get advice and recommendations for how to start the process. That's because "purchasing shares in a REIT is more of an investment rather than being simply a real estate purchase."

He also adds that if you are considering investing in a REIT, you should look at the past performance of whoever is controlling it or controlling the fund. “Take the time to examine what they have done in the past and to find out how they have performed."

It's important to note that REITs are also increasingly included in numerous defined-benefit and defined-contribution investment plans. According to Nareit, "Approximately 170 million Americans live in households that are invested in REITs directly or access them through REIT mutual funds or exchange-traded funds (ETFs)³." This can be done through a 401(k), IRAs, pension plans, and other investment funds.

Real-world Example of a REIT

When choosing REITs, it's beneficial to consider sectors of the real estate market that are thriving. One example is the healthcare industry, which is one of the fastest-growing industries in the U.S. Several REITs focus on this sector.

Another example is the apartment sector. While it is slowing, Brad points out that Greensboro-based Bell Partners is thriving as one of the largest apartment investment and management firms in the country. Nickolay Bochilo, EVP of Investments at Bell Partners said this about the company's December 2023 purchase of a 439-unit apartment community located in Alexandria, Virginia: “Bell Old Town is our second acquisition for Value-Add Fund VIII and is another example of our ability to leverage a broad presence in our target markets to acquire a well-located, quality asset with careful underwriting and a disciplined approach to risk management. The property provides a unique opportunity to create value and generate attractive returns to our investors by offering modern apartment floorplans with state-of-art amenities in a location within walking distance of the attractions of Old Town Alexandria⁴.”

Weighing the Benefits and Risks of REITs

Real Estate Investment Trusts offer an accessible and diversified way to invest in the real estate market. They offer a stable income stream and the potential for long-term capital appreciation. However, like any investment, it's crucial to conduct thorough research and consider both the benefits and risks before investing. Consulting with a financial advisor or investment professional can provide additional insights to make informed decisions.

How to ask us a question

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Sources

U.S. Securities and Exchange Commission. Investor.gov. Real Estate Investment Trusts (REITs)
Internal Revenue Service. Instructions for Form 1120-REIT (2023).
National Association of Real Estate Investment Trusts. What's a REIT (Real Estate Investment Trust)?
Bell Partners. Bell Partners Acquires Metro D.C. Apartment Community.