One of the most popular investments in the past few years have been REITs, or real estate investment trusts. If you’ve ever been to an outlet mall, it was probably owned by a real estate investment trust. It’s just one way for investors to get into real estate without buying property.
Back in 1960, Congress passed a law allowing real estate investment trusts. REITs, for the most part, are traded just like stocks. This allowed the average investor access to large, income generating real estate investments with only a small amount of capital. But there are some unique tax differences every investor should be aware of before buying.
What Is A REIT?
The SEC defines a REIT as a company that owns and/or operates income-producing real estate or real estate-related assets.
In order for a company to qualify as a real estate investment trust, at least 90% of its taxable income must be paid out to shareholders as dividends. This provides the company with tax advantages. It can avoid corporate income tax on the amount paid to shareholders. Taxes are instead paid by shareholders on dividends and any capital gains. These tax considerations play a big role when investing in REITs.
While all REITs are required to own real estate assets, this offers some unique possibilities. Generally, when we think real estate, we picture office buildings and houses. But that’s just the beginning.
Different Types Of REITs
We can break down the different REITs into three main categories.
Equity REITs
These are the investment properties, rental income producers and office buildings discussed earlier. Other equity REITs include:
- Commercial and industrial property
- Retail property
- Residential property
- Health care facilities
- Hotel and resort property
- Raw land
With all these possibilities, it’s easy to see why equity REITs are popular. It also allows for some diverse opportunities when investing.
Mortgage REITs
Like the name says, mortgage REITs, own mortgages. They loan money to real estate investors or buy existing mortgages or mortgage-backed securities. The bulk of their income is through loan interest.
There are added risks involved with mortgage REITs, specifically interest rate risk.
Hybrid REITs
A hybrid REIT falls into both categories, owning a combination of mortgages and real estate assets. This provides both rental and interest income generation.
Advantages of REITs
Like all investments there are advantages and disadvantages to owning REITs.
- Offer an easy way to diversify into real estate with a small amount of money.
- High dividend yields. Long term interest income and rental leases tend to offer stable dividends over time.
- Unlike real estate, REITs, generally, can be easily bought and sold through the markets.
- Taxation offer some advantages when used correctly. Specifically, depreciation can reduce a portion of the taxable income and lower cost basis. The reduction in cost basis is then taxed as a capital gain when the REIT is eventually sold.
Disadvantages of REITs
- Very sensitive to interest rates. In high interest rate environments, the demand for REITs can drop, having a negative effect on share prices. In low interest rate environments, the demand for REITs can rise, increasing share prices.
- REIT dividends are taxed as ordinary income, not at the dividend tax rates.
- Property tax risks with real estate. With budget short falls, local governments can turn to higher property taxes as one solution. This leads higher costs and lower dividend payouts.
- Mismanagement can lead to higher costs and lower dividend payouts.
Investing In REITs
A real estate investment trust can offer a great investment opportunity under the right economic conditions. This is why the popularity of REITs has spiked these past few years. We had falling interest rates, real estate values were stabilizing, and investors wanted safety in dividend yields.
Before investing in any REIT, take the time to research the assets each company holds. Is there an opportunity to make money? What are the risks? Real estate covers a range of possibilities and there are REITs representing all one of them. Make sure you know what you are getting into before investing.
