Real Estate Investment Trusts (REITs): Meaning, Types and How REITs Works

By Writer Last updated Feb 15, 2022

Are you looking for answers to how and whether you should invest in Real Estate Investment Trusts (REITs), then this is the right place for you? A Real Estate Investment trust is a company that owns and operates income-generating real estate.

However, in this article, we provide information in detail about the meaning of Real Estate Investment Trusts (REITs), their types, how to invest in REITs, the advantages and disadvantages of REITs, and other additional information on Real Estate Investment Trusts.

Meaning of Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-generating real properties or estate. However, income-generating real estate refers to commercial property or real estate in which the REITs invest and own different types of them such as apartment buildings, offices, hotels, shopping malls, warehouses, stores, etc.

Moreover, Real Estate Investment Trusts (REITs) just like mutual funds, provide an investment opportunity that makes it possible for every individual investor to earn a share of income or dividend produced from real estate without direct investment in any property. A REIT company does not invest in real estate to develop and make a profit from its sale. Rather, they invest in the property by buying and developing it so they can operate the property as one of their investment portfolios.

How a Company Qualifies as a REITs

However, in order to qualify as a REIT, a company must be in compliance with certain provisions in the Internal Revenue Code (IRC). Also, a company must meet the following requirements below in order to qualify as a REIT:

A company must invest at least 75% of its total assets in real estate, cash, or U.S. Treasuries
A minimum of 90% of the company’s taxable income must be paid to shareholders or stakeholders as dividends each year
Generate at least 75% of gross income from property rents, mortgage interests, or real estate sales
Must be managed by a board of directors or trustees
The REIT must be a body or entity that is taxable as a corporation
Have a maximum of 50% of its shares held by five or fewer individuals
The REIT must have a minimum of 100 shareholders

Types of Real Estate Investment Trusts (REITs)

However, REITs come in a variety of classifications. They can be classified based on how their shares are transacted:

Publicly Traded REITs: In publicly traded Real Estate Investment Trusts, shares are listed on a national securities exchange and transactions (buying and selling) are done by individual investors. Moreover, publicly traded REITS are regulated by the U.S. Securities and Exchange Commission (SEC).
Public Non-Traded REITs: Are also registered with the SEC but they are traded on the stock exchanges. Therefore, they have lower liquidity but are more stable than the publicly-traded REITs because they are not affected by market fluctuations.
Private REITs: Otherwise called private placement REITs are not registered with the SEC and are not traded on national securities. However, this type of REIT is only available to institutional investors and is not liquid.

Moreover, Real Estate Investment Trusts are also classified into three categories based on business structures through which they can invest. The three main types of REITs are as follows:

Equity REITs: This is the most common form of REITs under this category. They typically own and manage income-producing real estate. They generate revenue in form of rent, mainly from leasing offices, hotels, warehouses, etc.
Mortgage REITs: Mortgage REITs provide financing or lend money to real estate operators either directly through a mortgage or by purchasing existing mortgage-backed securities. Their earnings are generated from the interest in these investments.
Hybrid REITs: These REITs combines investments in properties and mortgage by owning and also lending money to real estate investors. In other words, hybrid REITs use the investment strategies of both equity and mortgage REITs. Therefore, they generate revenue from both interest and rental income.

How to Invest in Real Estate Investment Trusts (REITs)

However, an individual can invest in publicly traded Real Estate Investment Trusts by buying shares in REITs that are listed on major stock exchanges. You may also invest in REIT mutual funds and REIT exchange-traded funds (ETFs), by buying shares through a broker.

A broker or financial advisor can help in purchasing shares of a non-traded REIT, as well as help analyze your financial objectives and recommend the suitable REIT investments

Benefits of Investing in Real Estate Investment Trusts (REITs)

However, here are the advantages of investing in Real Estate Investment Trusts(REITs):

Liquidity: REITs shares can easily be bought and sold as most trade on public exchanges. This is a good advantage as buying and selling real estate often takes a while.
Portfolio Diversification: Another good advantage of REITs is portfolio diversification. However, this advantage comes in handy when other stocks are down due to the fact that REITs have a poor correlation to the performance of other assets. Also, REITs provide the general public the capability to purchase a piece of commercial real estate in order to generate income without going out.
Transparency: Moreover, REITs that are traded on the major stock exchanges operate under the same rules that guide other publicly traded stocks or securities for regulation.
High Dividends Yield: REITs offer a stable source income flow to investors. As they are required to pay out 90% of taxable income to shareholders as dividends.
Performance-wise: Moreover, REITs provide attractive risk-adjustment returns and the potential for long-term capital appreciation. Which in other words has proven to be performance-wise.

Risks of Investing in Real Estate Investment Trusts

However, just like any other investment REITs have their advantages as well as disadvantages that come with it. They include:

Low growth: Only 10 % of REITs taxable income can be reinvested back into purchasing new properties, as they are required to pay 90% of income back to investors as dividends.
Higher tax payment: REITs dividends are taxed as normal income. Whereas a 15 % rule for most dividends exists.
Subject to market risk: However, factors like interest rates, tax laws, debt, property valuation are considered as investment risks as they might cause REITs prices to fall.
High management and transaction fees
Less control of investors when it comes to operational decisions
Risks associated with specific properties
Sensitivity to interest rates

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Additional Notes on Real Estate Investment Trusts (REITs)

In conclusion, REITs can be considered a good investment because of their strong stable dividends and long-term appreciation. But also note that each type of REIT has its own specific risk when it comes to the disadvantages of investing.