A Crash Course on the Benefits of REITs for Passive Investors

Property Ownership Without the Hassle: How REITs Work

Savvy investors make real estate part of a diversified portfolio to grow and preserve their wealth. The challenge with many real estate investments, however, is that they can require considerable work to operate and maintain, especially if they involve direct ownership of the property.

There are, however, some purely passive types of real estate investments that can provide diversification to your portfolio and the many advantages of property ownership without the corresponding management responsibilities. A real estate investment trust (REIT) is one such type of investment. We’ll discuss how REITs work, as well as the advantages and disadvantages of this investment opportunity.

Equity, Mortgage and Hybrid: How Different Types of REITs Provide Flexible Choices

There are a few types of REITs, but most REITs are equity REITs. This means that they own and typically operate a portfolio of cash-flowing real estate. REITs commonly focus on a specific class of assets that they develop or acquire, and then hold for profit during the life of the fund. For example, REITs may concentrate on industrial properties, medical office buildings, shopping centers or student housing. Other equity REITs focus on a geographic region and have greater diversity among asset types in that location.

An equity REIT’s goal is to generate cash flow by leasing the real estate, and to increase investor value through appreciation. A REIT may also create investor value by developing real estate. The underlying assets will not generate distributable cash flow while they are in the construction and lease-up stage, but there will be a greater opportunity for gain once the assets are built, stabilized, and sold.

Besides equity REITs, there are also REITs that invest in and own real estate mortgages, mortgage-backed securities and other types of loans collateralized by real estate. Mortgage REITs make profits by borrowing at lower, short-term interest rates and buying mortgages at higher long-term rates; the profits comprise the spread between these rates. Because interest rates and the corresponding spreads fluctuate constantly, mortgage REITs are generally a riskier investment than equity REITs.

There are also hybrid REITs, which invest in both mortgages and leased real estate.

Who Juggles the Balls in the Air?

One of the benefits of REITs is that the underlying properties they own are professionally managed. Major decisions such as acquisitions, financing, leasing and dispositions, are made by a board of directors or trustees, made up of industry and financial professionals. This can also be seen as a disadvantage, however, as individual investors in a REIT do not have a voice in property or asset management, financing or disposition. They also do not have any choice about the specific properties owned by the real estate investment trust, although the offering documents will identify assets currently owned and specifically contemplated by the REIT at the time of investment.

REITS can be privately held or publicly traded as securities on major exchanges. Public REITs function similarly to a mutual fund of real estate interests. Thus, publicly traded REITs provide a degree of liquidity not generally available for direct real estate investments or private syndications. Real estate investments involving private REITs are usually available through licensed securities brokers specifically authorized to sell the offerings. These investments are not necessarily liquid, and their maturities depend on the timing of the REIT’s disposition of the underlying assets.

REITs Must Comply with Specific Legal Requirements

REITs are legally required to:

• Distribute 90% of their taxable income to their investors on an annual basis.
• Invest at least 75% of their total assets in real estate, cash, or U.S. treasuries.
• Receive at least 75% of their gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate.
• Have at least 100 shareholders/investors, with no five shareholders owning more than 50% of the shares.

The Benefits of REITs in a Diversified Portfolio

There are many reasons why investing in a REIT may be beneficial to you:

• Real estate investments via REITs allow you to invest in a diversified real estate portfolio without any property or asset management responsibilities, and without any personal liability for financing. The work of due diligence, acquisition and disposition are all done for you.
• The underlying assets of a REIT tend to be institutional quality, and of greater size and credit than individuals can typically afford to acquire on their own.
• Properties owned by REITs are professionally managed by people with quantifiable experience and track records in commercial real estate.
• Publicly traded REITs have easy liquidity. Shares can be bought and sold readily on public exchanges. Financial reporting is provided on a regular basis as required by the SEC, audits are conducted annually by an established accounting firm, and financial results and history can be viewed online.
• REITs do not pay corporate tax, so investors are not “double taxed” (i.e, having responsibility for both the investment entity’s corporate tax plus their own personal tax on income generated) as they would be if buying stock in a company.
• Unlike private placements, which are often open only to “accredited investors” who satisfy specific minimum net worth requirements, public REITs are open to all investors. There is also a comparatively low minimum investment amount, as compared to a real estate private placement or outright ownership.
• Many REITs are industry-specific. This allows you to concentrate your real estate investments in a preferred asset class (e.g., medical office, apartments, industrial).

The Disadvantages of Investing in REITs

In spite of the benefits of REITs, they’re not an ideal option for every investor. Here are a few things to be aware of:

• The “load” (administrative fees and costs) tend to be higher for REITs than for other types of real estate investments. Expect your purchase price to include fees to REIT management and its board of trustees, management at the property level, and brokers who offer the REIT interests for sale. You will also share annually in the cost of a full audit by a nationally recognized accounting firm, in addition to the expenses of issuing annual tax reporting documents for individual investors. Outside professionals engaged to provide transactional services for REITs, such as attorneys, are typically members of larger firms with well-established national or international practices, with fees at the higher end of the pay scale.
• Private REITs do not have the same degree of liquidity as publicly traded ones, and they may have a higher minimum investment to participate. There is also less financial transparency, especially regarding market price, for non-traded REITs.
• Individual investors do not have any say in choosing the underlying properties or their ongoing management, financing, or disposition. You must rely on the experience and judgment of the REIT managers to perform thorough due diligence and make wise choices with respect to each underlying property.
• Interests in REITs are considered securities rather than fractional, direct ownership of real property. This means that REIT investors do not receive certain tax benefits that generally flow through to direct owners of real estate, such as depreciation and interest expense deductions. Additionally, interests in REITs cannot be used as replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code.
• Because REITs are required to distribute their cash as dividends, they typically have to sell more shares or take on additional debt in order to grow, rather than use their own profits to do so.

As with any investment, it is wise to consult with your financial advisor to decide whether an investment in a REIT may be beneficial to you. Your advisor can give further guidance on how REITs work as a potential income stream and when is the best time to invest in them. Depending on your investment goals and financial wherewithal, other types of passive real estate investments, such as real estate syndications, may be good alternatives for you to consider.

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[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basics of Real Estate Syndication and Investing in Real Estate through Equity Crowdfunding. This is an updated version of an article originally published on February 21, 2018.]

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