A Guide to Understanding REITs: Benefits and Risks

The real estate market can be a very lucrative space to operate in. There is always a reasonable level of demand for housing, and landlords can do very well for themselves by buying and holding property. Unfortunately, the high financial costs for individual pieces of real estate make it so many investors are shut out from this market. Luckily, a corporate vehicle exists that lowers the barrier for entry and allows a greater number of people to share in the gains that are available in the property market - the real estate investment trust.

What is a REIT?

A real estate investment trust, or REIT, is a company that owns and often operates income-producing real estate. REITs combine the resources of shareholders, allowing them to collectively invest in a portfolio of properties. A crucial part of what qualifies a real estate company to be a REIT is they are required by law to distribute no less than 90% of their income as dividends to shareholders. In return, REITs do not have to pay taxes at the corporate level, making them an even more attractive investment. Investors who receive these payouts can also hold certain tax privileges; these vary by jurisdiction.

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What are the different types of REITs?

REITs can be classified by the type of property they are invested in. Investors are spoiled for choice - there is a REIT for pretty much every class of property, ranging from residential and hospitality to commercial and health care. This allows investors to further target specific sectors of the real estate market they might think have good prospects.

REITs can be further classified by their investment mechanism. Equity REITs, the most common type, own and manage properties and distribute their income to shareholders. Mortgage REITs generate income from interest paid on loans that the company either issues to builders and buyers or purchases on the secondary market. There are also hybrid REITs that carry out a mixture of the two activities. Most of the REITs you will hear about are equity REITS.

Benefits to investing in REITS

There are a number of reasons why an investor might want to invest in a REIT. First, they offer unparalleled exposure to the real estate market at a fraction of the cost of actually purchasing a property. We have already noted this opens up the real estate market to a far greater number of people than otherwise might have taken part in it. But even larger investors can benefit from expanding the range of real estate markets they operate in.

Second, as REITs typically manage a portfolio of properties, they offer a greater degree of diversification than an investor could achieve by buying and letting a property of their own. This helps minimize the risk of tenant delinquency. Finally, as an asset class, REITs are quite transparent - many of them are traded on the major stock exchanges of the world. As such, they are subject to stringent rules concerning corporate disclosure and are highly liquid.

Summary

By gathering together the capital of a large number of smaller investors, a REIT enables each of them to own a piece of a portfolio they would not have been able to on their own. In this case, the whole is definitely more than the sum of its parts. In future installments, we will look at some of the metrics analysts use when comparing REITs and the techniques they use to pick winning investments in this space.

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