REITs: The Basics Of Real Estate Investment Trusts
The real estate market can be a great investment opportunity for the average investor, if the timing is right. Real estate, like any asset class, is cyclical in its behavior. This can present short-term as well as long-term opportunities. Many investors have opted to buy individual properties as their primary residences as well as for vacation homes. These investors may purchase with the intent of renting one or both of these properties in order to generate cash flow.
Whether the discussion is regarding a residential or vacation property, becoming a landlord can be accompanied by a number of headaches. Not all property owners are interested in getting a call that there is a plumbing problem which will require the immediate presence of a professional. In regard to vacation homes, few investors will be able to fix it themselves, due to proximity as well as experience and ability. This type of overhead can create expenses both in terms of capital as well as time, and should be considered when looking at any investment. Additionally, due to the higher overall initial minimum investment and the difficulty in obtaining financing…many potential investors are priced out of the market.
REITs
There may be an easier way. Real Estate Investment Trusts (REITs) present the opportunity for individual investors to add real estate exposure to their investment portfolio. This is possible without the time and commitment required in making a direct purchase of an individual property. REITs are securities that typically trade like a stock on an exchange that individual investors can purchase into at any time. REITs are organized in the form of a Unit Investment Trust and can be broken down into two core categories:
Equity REITs
An equity REIT will purchase and own individual properties which will generate cash flow via rentals which eventually pass thru to the shareholders in the form of a dividend. Additionally, the ownership of an equity REIT provides the shareholder the opportunity for capital appreciation in the value of the underlying real estate which may eventually be sold for a profit. Some equity REITs may have a specific concentration in certain areas of the market such as hospitality properties or shopping malls, while others can be extremely diverse in their underlying property holdings.
Mortgage REITs
A mortgage REIT is an investment which owns the underlying mortgages of the real estate owners. Rather than owning equity in a property, the mortgage REIT shareholder is a creditor of the property owner. The REIT effectively holds the note on the property the same way a bank would hold the mortgage note on a home. Because the mortgage REIT market is more of a fixed income investment, it will typically be accompanied by higher dividend payments and less opportunity for capital appreciation.
Special Tax Treatment
The dividend income received by a REIT is typically taxed as ordinary income and will be taxed at the shareholders top marginal tax rate. The advantage is that unlike the stock of an individual company which must pay tax first at the corporate level and then again at the individual level, REIT investors will only pay the tax at the individual level. The reduced layer of taxation often means a higher return to the shareholder. Additionally, a portion of the dividend payment received by the shareholder can be deemed a Return of Capital to the shareholder. This means that this portion of the payment is treated as tax-free while deferring the capital gain on the underlying assets further into the future.
Diversity
While a REIT will typically hold multiple properties in the trust, some investors may seek greater diversity. As a result, a group of REITs may be purchased as mutual funds, or exchange traded funds (ETFs) for a lower cost passive approach to investing.
What’s most important to note, is that real estate is just one of many asset classes that make up a more complete portfolio for a longer term investment strategy. However, regardless of an individual’s personal views on short term investment opportunities currently available in the real estate market, the REIT marketplace can fill the void for the average investor as a simplified solution with added tax benefits that will allow for diversified participation.
Additionally, REITs have shown an overall lower correlation to traditional equity benchmarks like the S&P 500. Today, as opposed to past decades, REITs exist in these traditional benchmarks. However, they only comprise about 2% of the S&P 500, the risk of redundancy is minimal and they can offer greater portfolio diversification.
