How REITS Work
How REITS Work
A Real Estate Investment Trust (REIT) is a passive form of investment that is growing more popular, especially for investors who want to limit their risk. While owning property that can be rented offers considerable advantages, there is considerable risk involved with running rental space for residents or businesses. A REIT offers a different approach that may reap larger rewards depending on the intent of the investor.
Established in 1960, the REIT was created to allow investors to purchase shares of commercial real estate properties, something that only the very wealthy could do before. The properties themselves vary considerably, but the result is that lower-income investors have a way to build their portfolios with less investment capital.
What is a REIT?
A REIT is run by a company that controls real estate that generates money, normally by renting the property to individuals or businesses such as apartments or storefronts. A REIT is a type of capital pool consisting of investors that earn dividends from their real estate investments, but do not have to purchase, operate, or finance the properties which are being controlled.
This means that a REIT will generate a monthly income for investors, although capital appreciation is quite small. The REIT can be traded like stocks which provides for greater liquidity, and they include a wide range of properties.
While many REITs directly own property, some are known as mortgage REITs which instead finance the real estate much like a standard loan. As the loan is paid off, the investors collect their share of the returns. And, there are hybrid REITs which are a combination of mortgage and leases for real estate.
How a REIT Works
A REIT is normally focused on a single type of real estate, such as apartments, healthcare facilities, and so forth. However, there are REITs that also have diversified properties, such as offices and retail for example. You can find REITs on security exchanges, which means that you can purchase or sell them just like stocks.
The goal of a REIT is to generate cash flow for the investor. With a group of investors, the cash flow will be spread out to each individual investing in the property. A REIT can also be used to enhance value by developing the property even further. For example, a REIT may be used to modernize an office space which in turn attracts more renters which provides greater profits and cash flow for the investors.
The cash flow generated by the REIT does not occur until the property is rented. This means that during the construction or building period, you are not going to generate any cash flow from them.
How REITs Work: Benefits & Risks
There are several advantages to investing in REITs, especially if you are trying to diversify your portfolio. The most obvious is the diversification itself, as you can choose between many different REITs to invest with. But there are other benefits that you can enjoy.
- High Returns
- Stability in Cash Flow
- Highly Liquid
Real estate tends to be more transparent because the properties can be evaluated from the outside, letting you see their value from an independent point of view. The high returns are also quite attractive as they help you to boost your retirement savings. The stable nature of successful REITs provide security while their liquid nature thanks to being on the stock market lets you get out and reinvest in other areas as you see fit.
However, not all investments are 100% perfect and REITs have their issues as well. The most apparent is the low growth rate which means that the capital appreciation of the properties tends to be rather small over time. Other issues include the following.
- Dividends Taxed Like Standard Income
- Possible High Transaction & Management Fees
- Market Risk
In other words, REITs still have the capacity to be risky, even if the investment seems quite sound on all counts. You should be concerned about the fees being paid to manage and make transactions with your REITs as that can lower the amount you keep.
Investing in REITs
REIT mutual funds, exchange-traded funds, and those traded in public represent investment opportunities. You can use a broker or financial advisor to purchase REITs that are on the market. Plus, you can invest in REIT investment plans for your retirement savings if you wish. With over 225 publicly traded REITs, finding one is not the issue.
However, finding the right one that fits your budget and meets your needs will require some research. Keep in mind that as with most investing there will be some risk involved. This is true for properties that have yet to be developed and occupied, so what may seem like a sure thing may go bust. To help limit the risk, you should look at the following.
- Potential Growth Numbers
- FFO: Funds from Operations
- Current Yields in Dividends
The Funds from Operations is calculated by adding the amortization and depreciation to the earnings, then subtracting whatever gains are earned on the sales side. This will help you see the overall picture first before making the decision to invest.
REITs can be quite profitable if you do the research and find the right ones to invest. Given how easy they are to purchase and sell, they help to diversify your portfolio while still being quite liquid in nature when you need cash on hand quickly. However, the best reason is the potential high returns on your investment when you use REITs.
How REITs Work, ©Sophisticated Investor 2021
How REITS Work