What is a Real Estate Trust [REITs]? How Do They Work?

Not everyone can own real estate properties. These days, owning a property means you have to get financing, renovate and manage the property yourself. This is often frustrating for someone who doesn't want to go into real estate full time or doesn't have enough funds to invest in the market. 

So what is a Real Estate Investment Trust? REITs were created to provide an answer to these problems. These innovative investment programs come with diverse opportunities for real estate investors to make profits. They are sort of like an indirect approach to real estate investing.

According to Fundrise, more than 87 million Americans own Real Estate Investment Trusts (REITs) shares. This only shows that REITs is an active industry that is yielding massive revenue for its investors. 

In this article, I will show you everything from what is a Real Estate Investment Trust (REITs) to its history, how it functions, various types, and some pros & cons.

What is a Real Estate Investment Trust [REIT]?

A Real Estate Investment Trust [REIT] is a company that invests in income-producing real estate. These firms make it possible for potential real estate investors to buy company shares. And through already purchased shares, ownership is vested to the investor, who then adds it to their portfolio. 

Investopedia describes Real Estate Investment Trusts (REITs) as companies that own, finance, and operate income-generating real estate. Real Estate Investment Trusts (REITs) help generate a steady income stream for real estate investors without necessarily having to buy, manage, control, or finance the properties themselves.  

Real Estate Investment Trusts (REITs) have existed for over 50 years! They were first invented in the United States under the Cigar Excise Tax Extension of 1960. REITs were made to provide investors of all capacities a way to invest in diversified cash-flowing commercial real estate portfolios. 

In the early 1960s, their property management functions were handled by external management companies and had combined assets of about $200 million. Further in the 1980s, when investors were looking for the tax shelters offered by limited partnerships, real estate prices experienced severe inflation, reducing REITs' ability to grow through attractive acquisitions. 

Real Estate Investments Trusts' (REITs) performance increased substantially in the early 1990s, as they picked up properties at bargain prices resulting from the bearish market in real estate that started in the late 1980s. 

Around 1997, institutional money managers started to invest in Real Estate Investment Trusts, and the trend of public securitization of real estate was established. REITs responded quickly to the great recession and troubled capital markets, raising equity, selling assets, addressing debt maturities, and positioning themselves well for the recovery. 

How do REITs Work?

Real estate investment trusts operate through funds raised by unitholders via an initial public offering, also called an IPO. These collective funds are then used to buy multiple real estate properties.

The purchased properties are subsequently leased out to tenants, and in return, income is sent back to the unit-holders or investors - this is similar to dividends. 

REITs usually come with a bunch of fees, such as annual REIT managers' fees, property manager's fees, and trustees' fees. Other minor expenses are also removed from income distributions before it is sent out to investors.

Advantages of REITs

REITs provide many benefits to their investors. Some of these advantages include;

1. Taxation benefits: REITs that distribute about 90% of taxable income annually tend to enjoy tax transparency treatment by the Inland Revenue Services (IRS), provided other conditions are met. This tax-exempt treatment flows to individual real estate investors who receive these distributions.

2. Liquidity:  In REITs, it is easier to buy and sell units than buy and sell properties. Various REITs are listed on the stock exchange, and you can trade units in a REIT throughout the trading day.

3. Diversification: Investing in REITs allows you to diversify. Usually, you bear all the risk alone, but in REITs, the risk that arises from personally owning a part of these properties is shared with other investors.

4. Affordability: Real Estate Investment Trusts are more affordable than buying and holding properties. Also, the expenses that come from building and renovating new properties are non-existent.  

Disadvantages of REITs

Real Estate Investment Trusts have some disadvantages. These do not outweigh the advantages, but it's essential to get an idea of the risk it poses.

1. Unequal Distribution of Income: REITs do not guarantee equal distribution of income. Besides this, risks, which are a result of debt-financed properties, can affect your income. 

2. Market Risk: REITs are listed on the stock exchange market, which has a history of volatility. So prices are subject to demand and supply conditions. This means that interests, profits, and other price rates are often affected.

3. Risk of Liquidity: When REITs cannot find more investors, they have a high chance of being liquidated. The REIT firm may also fail to diversify its portfolio, leaving existing investors stranded.

What Qualifies as a REIT?

All REITs have some fundamental qualities by which they can be identified. Here are some requirements an investment has to meet for it to be classified as a REIT;

1. Comprise of Real Estate: The firm must comprise at least 75% of real estate. 

2. Rental Income Portfolio: The company's gross income must come from a rental portfolio.

3. Returned Dividend to Shareholders: At least 90% of the taxable earned income must be returned to shareholders. 

4. Shareholders must be Present: The firm must have up to 100 shareholders have up to 50% shares in the company.

5. Taxable Entity: The firm must be structured as a taxable entity with a board of directors and trustees.

Types of REITs

REITs are divided into three types, and these classifications are based on the kind of market they operate in. Below we discuss these classifications;

Equity

Equity REITs are the most common type. They buy, own, and purchase income-producing properties like multi-family buildings, retail centers, and office spaces. One thing to note is that Equity REITs are not the same as Equity Investments mainly because of the amount of time needed to yield profits. Common forms of Equity REITs include Health Care REIT, Residential REITs, and Office REITs.

Mortgage

Mortgage REITs are prevalent among companies that loan money to real estate developers. These REITs are not direct owners of real estate properties. They generate revenue after the real estate developer or mortgagee repays loans. 

Hybrid

This is a combination of both equity and mortgage REITs. In such cases, one can own real estate properties and give loans to real estate developers. 

There are other types of REITs; however, these are more of a broader classification. They include;

1. Publicly Traded REITs: These types of REITs are registered with the Securities Exchange Commission (SEC), and they can be bought or sold on the stock market.

2. Publicly Non-Traded REITs: They are different from publicly-traded REITs because the risk of liquidity is not shared. Here, after an investor places the capital, there are no other means of selling. They usually have "buy-back shares" provisions. 

How to Invest in REITs

As earlier stated, there are three main categories of REITs. And to invest in any of them, you have to understand the processes or requirements involved. Mortgage REITs hold mortgage-backed securities and mortgages on their company balance sheets, and they fund investments with debts and equity capital. So, your profits will be made from the net interest margins or spread between funding cost and interest. 

For Equity REITs, invest in companies or real estate developers that buy and hold real estate properties. The profits made from investments are sent back to you based on the number of shares you hold. For Hybrid REITs, you can combine both investment strategies. 

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