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Understanding real estate investment trusts (REITs)

by Alliance America
October 31, 2023


Real estate has long been a popular investment avenue, known for both its income potential and its capacity for capital appreciation. However, direct investment in property comes with hurdles, including significant capital requirements and management challenges. Real estate investment trusts (REITs) have emerged as a compelling solution, enabling investors to enter the real estate market without actually purchasing property.

What is a real estate investment trust (REIT)?

A real estate investment trust, or REIT, is a company that owns and in most cases operates income-producing real estate. REITs own many different types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and timberlands. Some REITs also engage in financing real estate.

Most REITs are publicly traded on major exchanges, such as the New York Stock Exchange, and are bought and sold just like other stocks. In addition, most REITs are taxed as corporations, which means that they are subject to corporate income taxes.

However, there are also a number of REITs that are structured as trusts or partnerships, which means that they are not subject to corporate income taxes. Instead, the income of these REITs is taxed to the shareholders or partners.

The difference between a corporation and a trust is that a corporation is a legal entity that is separate from its shareholders, while a trust is an arrangement under which one or more persons hold property for the benefit of another person.

REITs were created by Congress in 1960 in order to give investors a way to invest in large-scale, income-producing real estate without having to go through the process of buying and managing property themselves.

REITs must meet a number of requirements in order to qualify for special tax treatment. For example, REITs must be organized as corporations or trusts; they must derive at least 75% of their gross income from real estate-related sources; they must derive at least 95% of their gross income from sources other than the sale of property; they must have at least 100 shareholders; and they must be widely held.

In order to qualify for special tax treatment, REITs must distribute at least 90% of their taxable income to shareholders in the form of dividends.

REITs are required to pay corporate-level taxes on their taxable income. However, REITs are not required to pay taxes on the income that they distribute to shareholders.

As a result of these tax rules, REITs tend to have high dividend yields. For example, according to the National Association of Real Estate Investment Trusts, the average dividend yield for REITs listed on the NYSE as of late October 2023 was 4.44%.

In addition to being a source of dividend income, REITs also offer investors the potential for capital appreciation. This potential for capital appreciation is due to the fact that REITs own physical real estate, which is a tangible asset that can increase in value over time.

REITs offer investors a number of advantages. First, REITs provide investors with a way to invest in large-scale, income-producing real estate without having to go through the process of buying and managing property themselves.

Second, REITs offer investors the potential for high dividend income. And third, REITs also offer the potential for capital appreciation.

Investors should be aware that there are a number of risks associated with investing in REITs. For example, REITs may be subject to changes in economic conditions that can adversely impact their business operations and financial condition. In addition, the value of real estate may decline in value, which would negatively impact the value of a REIT's shares.

Before investing in REITs, investors should carefully consider these risks as well as the investment objectives, risks, and charges and expenses of the REIT in order to determine whether an investment in a REIT is suitable for them.

What types of assets does a REIT hold?

person at laptop looking at different assets

A REIT is a real estate investment trust that owns, operates or finances income-producing real estate. REITs provide a way for individuals to invest in a diversified portfolio of income-producing real estate assets. There are three types of REITs: equity, mortgage and hybrid.

The most common type of REIT is the equity REIT, which owns and operates income-producing real estate. Equity REITs are typically organized as corporations or trusts. The properties owned by an equity REIT may include office buildings, shopping centers, apartments, warehouses, hotels and self-storage facilities.

Mortgage REITs invest in real estate mortgages and mortgage-backed securities. Mortgage REITs may be organized as corporations or trusts. Mortgage REITs typically use leverage to invest in real estate, which magnifies the return potential but also increases the risk.

Hybrid REITs combine the features of both equity and mortgage REITs. Hybrid REITs own and operate income-producing real estate and invest in real estate mortgages and mortgage-backed securities. Hybrid REITs are typically organized as corporations or trusts.

REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends. As a result, REITs offer the potential for high dividend yields. In addition, REITs offer shareholders the potential for capital appreciation and the ability to participate in the ownership and operation of income-producing real estate without the day-to-day management responsibilities.

Advantages of investing in REITs

If you're looking to add some real estate exposure to your portfolio, you may want to consider investing in a REIT. REITs, or real estate investment trusts, are special-purpose vehicles that own and operate income-producing real estate. In this article, we'll take a look at the advantages of investing in REITs.

One of the biggest advantages of investing in REITs is that they offer the potential for high distributions. Because REITs are required to distribute at least 90% of their taxable income to shareholders, they tend to have high dividend payout ratios. This can provide a nice boost to your retirement income.

Another advantage of REITs is that they tend to be less volatile than the stock market. While the stock market can be quite volatile, REITs tend to be more stable. This is due in part to the fact that REITs own physical assets, which are not as prone to the fluctuations of the stock market.

REITs also offer the potential for high capital appreciation. As the economy grows and property values increase, so too do the values of REITs. This can provide substantial gains for investors over the long run.

Finally, REITs offer tax advantages. The distributions from REITs are taxed at the lower capital gains rate, rather than the higher income tax rate. This can save you a significant amount of money in taxes over time.

What are the risks of investing in REITs?

While REITs can offer many potential benefits, they also come with some risks that you should be aware of before investing.

One of the biggest risks of investing in REITs is the potential for a sudden drop in value. Like any other type of investment, REITs can go up or down in value. However, because they are highly sensitive to changes in the real estate market, they can lose value very quickly if the market turns. This can be a particular problem if you invest in a REIT that owns only one type of property, such as retail or residential. If the market for that type of property weakens, the REIT's value will likely drop.

Another risk to be aware of is that REITs can be quite illiquid. This means that it can be difficult to sell your shares, especially if there are not many other investors interested in buying them. If you need to sell your shares quickly, you may have to accept a lower price than you paid for them.

Before investing in REITs, be sure to do your research and understand the risks involved. While they can offer potential rewards, they can also be risky investments. If you're not comfortable with the risks, you may be better off investing your money in other types of assets.

What are the future trends of REITs?

a model home being built with a stack of coins next to it

The landscape of real estate investment trusts is dynamic, shaped by shifting consumer behaviors, technological advancements and economic factors. Several trends in the real estate sector are poised to influence the performance and strategies of REITs. These trends include:

  • E-commerce expansion. The surge in online shopping, accelerated by the COVID-19 pandemic, continues to reshape the retail landscape. Traditional retail spaces, especially malls and department stores, have experienced decreased foot traffic, impacting the revenue of REITs focused on these areas. However, this trend is a boon for industrial REITs, as the demand for warehouses, distribution centers and logistics spaces increasing. Companies need these facilities to store, sort and ship a growing volume of online purchases.

  • Remote work revolution. The work-from-home paradigm shift is another trend with long-term implications for REITs. As companies embrace flexible work arrangements, the demand for expansive office spaces may decline. Office REITs will need to adapt to these changes, potentially by repurposing or restructuring spaces to meet new demands, such as increased need for shared, flexible office spaces or facilities that support digital infrastructure.

  • Sustainable developments. Sustainability is no longer just a buzzword; it's a business imperative. Both residential and commercial tenants are increasingly seeking properties with eco-friendly certifications, energy-efficient systems and green spaces. REITs investing in sustainable building practices and retrofitting existing properties to meet environmental standards may attract higher-quality tenants and, consequently, secure more stable revenue streams.

  • Urbanization to suburbanization shift. There has been a growing shift from urban centers to suburban areas, partially driven by changing lifestyle preferences and remote work flexibility. This trend affects residential REITs, as the demand for suburban housing, including single-family rentals, increases. Retail and health care REITs also need to consider this demographic shift in their long-term planning.

  • Technology integration. The future of real estate is digital. Smart building technology, the Internet of Things (IoT) and big data analytics are becoming integral to property management and development. REITs investing in technology to enhance tenant experiences, improve building efficiencies and streamline operations are set to outperform their peers lagging in digital transformation.

  • Health and wellness focus. The pandemic has heightened awareness around health and wellness, impacting real estate. Properties designed with wellness in mind, including features like improved ventilation, natural lighting and access to outdoor spaces, are becoming more attractive. REITs that prioritize the health and well-being of tenants could see enhanced property values and tenant retention rates.

  • Regulatory changes. REITs must also navigate an evolving regulatory landscape, including potential changes in taxation, zoning laws, rent controls and building codes, all of which could impact profitability.

The future of REITs will hinge on adaptability, foresight and responsiveness to these trends. Investors should keep a close eye on how different REITs adjust their strategies to meet these emerging demands and challenges.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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