REAL ESTATE INVESTMENT TRUSTS (REITS): MEANING, TYPES, ADVANTAGES AND DISADVANTAGES

What Is a Real Estate Investment Trust (REIT)?

Real estate investment trusts (REITs) refer to companies that own and operate real estates in order to generate income. Some REITs specialize in a specific real estate sector, and focus all that they have got on that particular segment of the entire real estate sector, while others focus on all segments of the sector. Properties included in a REIT portfolio may include apartments, health care facilities, hotels, infrastructure (for instance fiber cables, cell towers, and energy pipelines) office buildings, retail centers, self-storage, timberland, and warehouses. 

REITs was established by the U.S. Congress in 1960 as an amendment to the Cigar Excise Tax Extension of 1960; of which the provision allows individual investors to buy shares in commercial real estate portfolios that receive income from a variety of properties.

For a company to qualify as a REIT, it must meet the requirements contained in the Internal Revenue Code. These requirements include primarily owning income-generating real estate for the long term and distributing income to shareholders. Investopedia outlines other requirements to include:

• Investing at least 75% of its total assets in real estate, cash or U.S. Treasuries.

• Receiving at least 75% of its gross income from real property rents, interest on mortgages financing the real property, or from sales of real estate.

• Returning a minimum of 90% percent of its taxable income in the form of shareholder dividends each year.

• Having a minimum of 100 shareholders after its first year of existence. 

• Having not more than 50% of its shares held by five or fewer individuals during the last half of the taxable year.

Types of Real Estate Investment Trusts REITs

Several types of REITs exists and can be classified based on the business they engage in, and how the shares are bought and sold.

1. Based on the business engaged in:

• Equity REITs: these are entities that buy, own and manage income-producing real estate. The revenues are derived from rents and not from the reselling of the portfolio properties. It is widely known.

• Mortgage REITs: these REITs, lend money (directly via mortgages or indirectly through the acquisition of mortgage-backed securities-MBS) to real estate owners and operators. Mortgage-backed securities are investments holding pools of mortgages issued by government-sponsored enterprises (GSEs) and their revenue comes from the net interest margin. Mortgage REITs are sensitive to increased interest rates due to its mortgage-centric focus.

• Hybrid REITs: these enterprises contain both physical rental property and mortgage loans in their portfolios. They may weigh the portfolio to focus more on property or mortgage holdings, depending on the type of REITs  to be focused on at a particular time.

2. Based on how the shares are bought and sold:

• Publicly Traded REITs: these REITs offer shares of publicly traded REITs that list on a national securities exchange, where individual investors can buy and sell; and are regulated by the U.S. Securities and Exchange Commission (SEC).

• Public Non-traded REITs: they are registered with the SEC, however are not trade on securities exchanges. This makes them less liquid and stable than publicly traded REITs. 

• Private REITs: this REITs are not registered with the SEC and are not traded on national securities exchanges. They are offered as private placements to a selected list of investors.

Advantages and Disadvantages of Investing in REITs

Advantages

• REITs are easily liquefied.

• Serve as a means of diversified investment.

• REITs are transparent due to their regulation by the SEC.

• REITs pay out steady dividends.

• REITs offer risk-adjusted returns and stable cash flow.

Disadvantages

• REITs are associated with little capital appreciation.

• REITs require high transaction and management fees.

• REITs are affected by market risks.