Real Estate Investment Trust or REIT is a company that owns or finances income-generating real estate. Investors invest money to purchase and manage commercial as well as residential buildings. REIT then collects rent from the tenant and passes the income to the investors by high dividends.
Type of REITs
There are mostly 2 categories of REITs, Equity, and Mortgage REITs. Mortgage REITs are also known as mREITs.
Equity REITs: Most REITs are equity rates, this means they own or operate income-producing properties or real estates, for example, apartment buildings, offices, etc. This type of REIT invests in those income-producing real estates. Equity REITs can be split into more types:
- Lodging and resort REITs
- Self-storage REITs
- Data Center REITs
- Infrastructure REITs
- Industrial REITs
- Timberland REITs
Mortgage REITs: Mortgage REITs finance commercial and residential real estate by investing in mortgage and mortgage-backed bonds. These can be agency mortgages, non-agency mortgages, or commercial mortgages. These Mortgage REITs mostly deal with commercial or residential mortgages but some can invest in both. REITs like this borrowed money to buy mortgages and pay a higher interest rate.
How REITs work
Qualifying as REITs needs to meet certain guidelines set by Congress. Here are some guidelines to follow:
- A company should a corporation under the IRS revenue code
- A company must be managed by a board of directors
- A company should invest at least 75% of the assets
- 90% of the company’s taxable income should be paid out to shareholders through dividends
- A company must be held by at least 100 shareholders
Note that unlike a typical corporation that pays taxes on earnings, a REIT’s income is not taxed. This leads to more money to pass on to the shareholders. Investors can access REITs by means of an ETF or mutual fund. The fund merges the investors’ money to purchase REIT stocks. It is necessary to keep in mind that not all real estate funds invest in REITs exclusively. Hence, researching the fund’s holdings and investment strategy is important before you make a purchase.
Making money on a REIT
Making money includes combining two things: dividends and share price appreciation. They produce higher than average dividends because the investors need to be paid a minimum of 90% of taxable income to make the yield averages greater than returns. According to LaForge, the total return can create problems for some investors as they tend to choose REITs with the highest dividend yield because that would seem like a good income. “Usually, the higher the yield, the worse the financial situation of the company,” he says.
Dividend yields differ across the REIT sector, so those who want an income from REITs, need to make sure they look for safe dividends that have the potential of exceeding market averages. REITs that have consistently maintained or increased dividends have still had market demands that are more stable than the others.
Choosing a REIT
While choosing a REIT you should identify REITs with a growing cash flow profile and a good price. To determine the price of a REIT, look at its price and subtract the net asset value or per-share value of each of the holdings, called the P-NAV. A positive P-Nav means you could purchase all the REIT’s properties at a cheap price outside of the REIT (this suggests it’s overvalued). If the P-NAV is negative, the properties are worth more outside than the REIT and hence could be called undervalued. A simpler method of valuing REITs is, comparing their dividend yields to corporate bonds or other asset classes. By comparing them, you can calculate the market values for the yields. A higher yield means that a particular dividend is streamed for a lower price. Other factors to consider while evaluating a REIT are supply and demand, geographical location, and other causes that might impact rent and occupy levels.
So how much of a portfolio should be invested in REITs? There are no strict rules for that but starting with 5% to 10% is considered good. There are studies that show that the optimal exposures fall between 5–10 % and some research shows the optimal exposures can even fall between 20%.
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