There are many forms of real estate investment. From owning individual properties to large conglomerate holdings with multiple investors, there are possibilities for nearly all preferences and portfolios. One such larger form of investment is known as a REIT. Are you looking for a high return with an investment and want to get into owning real estate property?
REITs might be a suitable investment vehicle. All investments come with their own risks and benefits, so it is important to understand the fundamentals before jumping in. With this in mind, what are realistic expectations a beginning investor should have of REITs?
What Are REITS And How Do They Work?
A real estate investment trust or REIT is a company responsible for financing or owning real estate that is income-producing. Investors can earn income with a REIT and are not responsible for purchasing, managing or financing real estate property.
REITs must meet multiple requirements and the majority trade on stock exchanges. Investors have the opportunity to own shares of a company’s stock, have access to dividend-based income and more. Anyone can invest in a REIT in a similar way as they would with mutual funds, exchange traded funds or through buying individual stock.
Different categories of REITs include:
- Private REITs
- Public Non-listed REITs
- Mortgage REITs
- Equity REITs
A REIT typically leases spaces and collects rent. Shareholders receive dividends based on this income. Typically, 90 to 100 percent of taxable income generated is paid out to shareholders.
When shareholders receive dividends from a REIT, they are responsible to pay required income taxes. This is important to note for those looking to get into real estate investment for the first time. REITs operate under guidelines that require that the structure work like mutual funds, is treated as a corporation, primarily deals with owning and financing real estate property, has a long-term investment horizon, and is widely held by shareholders.
Potential Risks Of REITs
Investors should be aware that investing in real estate comes with risk just like any form of investment. Poor management may cause issues with renting out properties and maintaining tenants and this can interfere with a consistent rental income stream. It may be necessary to periodically update properties and make repairs.
While REITs will typically hold enough properties to reduce the impact of such costs, it’s important to always remember that money must be allocated toward the upkeep of any building, and it is possible to mismanage these expenses.
Know that REITs may grow at a slower rate than other companies as only up to 10 percent of profits can be reinvested into their business. Earnings may be reduced when management chooses to expand real estate holdings through higher leverage. Income streams are not guaranteed and one may want to acknowledge the possibility of cyclical downturns in the market. Increases in property taxes on a property can decrease the earnings of an affected REIT.
Potential Benefits Of REITs
Investors who do not want to deal with the issues of scouting for properties, purchasing and/or managing properties often appreciate the opportunity to earn income from REITs. While returns may not be as large, the effort involved is considerably less, allowing for more time for other things – including other investments.
Investors who prefer to be more hands-on in owning and managing property may want to look into other traditional methods of real estate investment. REITs provide an initial entry point that is accessible for the majority of those looking to invest or diversify their portfolio. Investors can expect higher yields than what would be received in a traditional fixed-income market.
Less volatility is often seen with REITs when compared with traditional stocks. As REIT shares are traded on the stock exchange, it is easy for investors to buy and sell shares – especially when compared to the effort it takes to sell commercial or residential real estate.
How Taxation Differs With REITs
As mentioned earlier, REITs need to meet certain requirements, such as distributing a minimum of 90 percent of taxable income as dividends to shareholders. They work similarly to a mutual fund. When the entity distributes 100 percent of income, they are not responsible to pay tax at the entity level. REITs are taxed at the trust level and at the beneficiary level.
Cash flow is directly passed to shareholders. Rental activity expenses may be deducted like business expenses. Shareholders are responsible to pay taxes at ordinary rates on their dividends. They may pay capital gains tax if dividend payments are considered qualified dividends. Non-resident beneficiaries are subject to a 30 percent withholding tax on dividends, unless otherwise noted.
REITs may be an intriguing choice for investors looking to receive a high yield and be exposed to relatively little volatility. After getting a grasp of what makes them different from other types of investments, it may be beneficial to take a look at different REITs on the market and their historical performance in order to visualize how they work in practice. Not all companies are the same, and many will specialize in a specific part of the real estate market. Investors should always do their due diligence and gain an understanding of where these markets are and where they are projected to go in the near and distant future.