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What is a real estate investment trust?

by Corben Grant on 02 Mar 2022

As we discussed in a recent article about low-cost ways to invest in real estate, there are many options to grow your wealth in the real estate market short of owning property yourself. One very popular option in this area is what is called a real estate investment trust.

These investment options, also known as REITs, have made real estate investing more accessible to those who do not have the capital to buy a property or those who simply do not want to manage a property and would prefer a more hands-off and passive investment.

But just what are real estate investment trusts? How can you invest in them and what kind of returns can you expect? Is it the right investment for you? 

What is a real estate investment trust?

In finance, a trust is essentially a legal entity that holds property and assets for a person or group. Trusts are used for things such as estate planning or trust funds used to transfer assets to a younger generation. When it comes to investing, a trust can allow third parties to buy shares in their trust, allowing them to collect a portion of the returns that the assets produce.

This is essentially how a real estate investment trust works. The assets in question are income-producing real estate, either in the form of purchased buildings or new developments. Unlike other real estate companies, REITs that develop new properties generally don't sell the properties they construct. The trust generates money through rental income, equity, or interest on loans and then distributes the returns to shareholders.

The types of properties that REITs hold can vary as well. Some own large numbers of residential homes while others invest in condominium buildings. Others work strictly in the commercial real estate market. This means that individual investors can add a commercial REIT to their investment portfolio for example, which can provide them with exposure to the commercial real estate market without having to shell out for a multi-million dollar asset directly.

REITs were first introduced to the Canadian market in 1993, but have existed in the U.S. for much longer. They have since become a popular option for investors thanks to their convenience and competitive returns compared to other investment products.

Types of REITs

There are various types of REITs that specialize in different areas of real estate. They are generally pretty easy to understand by their names alone. Residential REITs hold portfolios of residential properties. Other types of REITs include retail REITs, office REITs, and industrial REITs.

Each of these specialized REITs is going to be susceptible to fluctuation in their own market. For example, during the last two years, residential markets have exploded and seen all-time highs essentially across the country.

Meanwhile, retail spaces have seen a decrease in popularity. Now, as we look forward, retail seems on the recovery while some predict residential markets to cool off. This can be reflected in the performance of REITs in this market. When choosing to invest in a specific segment with REITs, you should be aware of the market conditions and future forecasts as these can affect your short-term performance.

The aforementioned REITs would be known as equity REITs. Equity REITs derive most of their gross income by owning properties and charging rents. Publicly traded equity REITs are the most common and popular REITs on the market. There are also mortgage REITs that do not own property, but rather collect on mortgage interest from borrowers and pay this out to their shareholders. There are also general or hybrid REITs that may hold property in multiple different areas. 

Finally, there are public and private REITs. Public REITs are traded on public markets, while private REITs restrict their shares to qualified investors and institutional investors and usually require larger investments. In general, publicly-traded REITs are more popular for their accessibility and liquidity, but private REITs have different benefits such as being sheltered from the fluctuations of the stock market and the ability for longer-term strategies that can lead to larger returns. However, private REITs have their own downsides, such as reduced liquidity and less frequently updated valuations.

How distributions work

As well as growing your money through their individual share values, REITs also pay out what is called distributions. Distributions are paid out either quarterly or monthly depending on the REIT, and come from the income the trust makes through its holdings. In general, REITS will pay out a large percentage of their income to shareholders, even as high as 100% in some cases. Distributions are similar to dividends on stocks, though there are some differences. For example, the distributions from REITs can come from multiple taxable income sources and percentages of the return will need to be taxed differently. Your REIT will provide a breakdown of these different sources. REITs follow special tax rules that means they do not pay corporate income tax on distributions they pass on to shareholders. This means when a shareholder receives distributions from a REIT, it is their responsibility to pay taxes for this income.

Buying and selling shares

One of the biggest advantages of REITs is their accessibility and liquidity. Shares in public REITs are traded on the open market much like stocks, mutual funds, and exchange-traded funds. This means that as long as the price is right, you can easily buy shares in REITs and begin growing your money. It also means that you can easily sell your positions as well and free up money to be used elsewhere.

Choosing the right REIT

There are many different REITs available on the market, so it may be hard to choose the exact right one for you. Ultimately, picking any REIT will come down to your own circumstances and investment goals, but this section should give you a good place to start in evaluating which REIT works best for you.

Diversification

REITs can hold a variety of different real estate assets in different areas. A more diversified REIT will have property in multiple geographic areas and multiple different segments such as commercial and residential. Diversification generally helps REITS to perform more consistently as individual markets fluctuate. This means good things for your returns, but it also means that the trust has a good base of capital that it can use to leverage future returns. You may want to consider a REIT that is less diversified if you believe the specific market will perform well, but this is overall a riskier investment.

Management

Behind every REIT is a team of experts whose job it is to make the decisions on how the REIT will use its money and pursue growth. It’s worth looking into the management of a trust, their experience, and their performance history before you buy shares. Also, consider how the management is compensated – if their compensation is based on fund performance, you can be sure they will be doing their best to make sure things succeed.

Earnings

The earnings of a REIT can be somewhat hard to pin down. This is because they hold large amounts of property whose values fluctuate all the time. This can reflect losses or gains in valuation depending on the state of the market.

Other indicators can tell you more about their performance such as Funds From Operations (FFO) or Adjusted Funds From Operations (AFFO), which essentially represent earnings and available cash flow respectively. You can also look at the trust’s capitalization rate. Overall, you want to invest in a REIT that displays consistent and sizable earnings for maximum returns.

Distributions

REITs pay out a portion of their earnings as distributions, however, they all work on different schedules and amounts. A REIT with frequent distributions means more regular payments, though they may be smaller. In addition, a REIT that pays out a smaller portion of their earnings to shareholders means that they have more profits they can work with to pay down debts and fund growth. This can mean good things for long-term REIT investors, with somewhat reduced distributions in the short term.

Is it right for me?

In general, REITs are a pretty good choice for investors. Assuming you do your research and choose the right REIT for you, you can easily take advantage of the growth in the real estate market without dealing with the hassle of property management yourself. For those just starting out in investing, REITs are a great way to gain exposure to real estate at a lower cost.

For established investors, even those who already own property, REIT investments can be a good way to benefit from different market segments such as the commercial sector that you may not yet have a stake in. As with any investment, the long-term play on REITs will get you the most reliable returns, however, regular distributions mean you can quickly start seeing results from your investments.



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