Understanding REITs

In the recent SavvyInterview with Brian, he mentioned planning to add Real Estate Investment Trusts (REITs) to his investment portfolio. That mention served as the impetus for this post. I have previously noted my belief that the primary home should be viewed as a place to live, enjoy friends and family and not viewed as an investment. I noted that if an individual wants to invest in real estate, they should consider purchasing a rental property. Another good option? REITs.Savvy REITs

Modeled after mutual funds, Real Estate Investment Trusts (REITs) are specific types of real estate companies. Created by Congress in 1960 to give investors the chance to invest in income-producing real estate in a manner similar to how many Americans invest in stocks and bonds through mutual funds.

REITs are generally classified in one of three categories: equity, mortgage, or hybrid. Equity REITs derive most of their revenue from rent. Mortgage REITs derive most of their revenue from interest earned on their investments in mortgages or mortgage backed securities. As the name suggests, hybrid REITS are a combination of the first two. The vast majority of REITs are of the equity type, perhaps ~80%, while the mortgage and hybrid REITs comprise the remaining ~20%.

So how does a company qualify as a REIT?  The Securities and Exchange Commission (SEC) notes that to qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. In addition to paying out at least 90% of its taxable income annually in the form of shareholder dividends, a REIT must:

  • Be an entity that would be taxable as a corporation but for its REIT status
  • Be managed by a board of directors or trustees
  • Have shares that are fully transferable
  • Have a minimum of 100 shareholders after its first year as a REIT
  • Have no more than 50 percent of its shares held by five or fewer individuals during the last half of the taxable year
  • Invest at least 75 percent of its total assets in real estate assets and cash
  • Derive at least 75 percent of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property
  • Derive at least 95 percent of its gross income from such real estate sources and dividends or interest from any source
  • Have no more than 25 percent of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries 

So how do REITs generate that taxable income?  As you research REITS, one of the most common phrases you are likely to hear is “income-producing real estate.”  That refers to land and the improvements on it.  Examples include office space, apartments, or hotels.  REITs may invest in the properties themselves, generating income through the collection of rent, or they may invest in mortgages or mortgage securities tied to the properties, helping to finance the properties and generating interest income.

So why should someone consider a REIT? Simply put, they help to diversify your holdings. Because REITs are based on real estate, they gain and lose value differently than other stocks. It is not unusual for stocks and REITS to move out of sync. In other words, when stocks are up, REITs might be down and vice versa.

As with all investments, I strongly encourage you to conduct thorough research and understand exactly how an investment fits into your overall portfolio and long-term retirement plans.

A good Glossary of REIT Terminology and Concepts can be found at REITs Week.

So what about you SavvyReader.  Do you already own a REIT or are you considering adding one or more to your portfolio?

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6 comments on “Understanding REITs
  1. Two experiences. I worked in investor reporting for Commercial Mortgage Backed Securities (CMBS) and my ex-wife was an apartment property manager for a group of investors. Seeing how both made money piqued my interest.

    Great information James, expands upon my own understanding of REITs.

    • SavvyJames says:

      Glad to hear it, Brian. While I do not currently hold any REITs in my portfolio, I have in the past, and they are certainly a viable way to invest in real estate and they add diversification.

  2. Ludovic Baratier says:

    Thanks a lot for this information. It adds to my understanding.

  3. SavvyJames says:

    A couple of comments from a reader on Google+

    “I think rental property is a lot of work and in many states the laws benefit the renters. I like REITs to get exposure to real estate without the day to day upkeep of actually owning a place and making it function.”

    “I looked into REITs a while I ago. I was interested in commercial real estate REITs, like hospitals and malls. My main reason was for income since most REITs pay a good rate of return. I ended up buying a BDC (Business Development Corporation). I know, it is not a REIT but BDCs provide a good, regular rate of return.”

  4. Karen says:

    I had never heard of these before reading Brian’s interview. Definitely something I will check into. Thanks for the explanation SavvyJames.

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  1. […] week James at RetirementSavvy helped us understand what a REIT is, the Dividend Ninja talked about a recent H&R REIT purchase he made and Tara Perkins at the […]

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