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.
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.
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 are legally required to:
There are many reasons why investing in a REIT may be beneficial to you:
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:
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.
[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.]
©All Rights Reserved. August, 2020. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…
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