What is a Real Estate Investment Trust?
Real estate investment trusts are companies that own, operate, and finance real estate. Multiple types of real estate are covered under the REIT universe. Some of these include hotels, shopping malls, data centers, and apartment complexes. Like standard trusts, REITs make regular payments, which is a share of their income, to shareholders. That income is generated through activities. For example, REITs may rent out space for shops in a shopping mall to tenants. Or they may be in the business of making loans to real estate developers.
The benefits of investing in REITs are that they are an opportunity for investors to diversify their portfolio by including real estate holdings in it. REITs also pay out regular income, generally quarterly, and can act as a hedge against inflation. The drawbacks of REIT investing are that they are low growth instruments as compared to stocks. Certain REITs are also illiquid. Finally, the performance of REITs is also tied to the performance of the broader economy and can be unpredictable.
Basics of REITs
Although they are trusts, REITs can be traded like regular assets. They are available in most 401(k)s and retirement account plans. REITs can also be purchased through brokerages. Popular indices, such as Vanguard, Dow Jones, and SPDR, have exchange-traded funds especially dedicated to REITs. The FTSE Nareit US Real Estate Index Series is considered a window into the state of US real estate market because it includes providers with multiple types of REIT products and indices.
REITs serve multiple purposes for their stakeholders. Investors in REITs can diversify their portfolio and obtain a share of unconventional real estate holdings, such as data center real estate, and those that might otherwise be unavailable to them, at a fraction of the overall cost. In fact, some of the biggest publicly-traded REITs operate in sectors as diverse as communications and data centers. (These sectors are not known for their real estate holdings even though it comprises a significant portion of the overall costs of operations for companies operating in the industry).
For REIT companies, the trust structure enables them to access public markets and raise funding for lucrative real estate projects by promising to share income proceeds with investors. Large corporations with significant real estate holdings also spin them out into separate REIT subsidiary entities that provide a secondary income to the parent entity and, at the same time, generate capital from investors. To qualify as an REIT, among other conditions, REIT companies must invest 75% of their funds in real estate and return 90% of their income back to shareholders in the form of a periodic dividend. This requirement helps companies avoid corporate taxes on their income.
REIT performance depends on several factors, such as the general state of the economy and real estate prices in a given geographic area. On the whole, however, real estate investment trusts are considered cyclical in nature and act as a hedge against price inflation. REIT returns are also affected by economic recessions, when consumers cut back on spending and real estate prices and demand falls. Interest rates are another factor that influence REIT returns. When interest rates rise, investors gravitate towards bonds because real estate financing becomes expensive. On the other hand, when interest rates fall, real estate trusts become an attractive income stream for them.
Types of REIT
Real estate investment trusts can be sliced and diced in various ways, depending on their characteristics. The primary form of distinction for REITs is whether they are publicly-traded or not. The former type of REITs is subject to various disclosures regarding reporting of their holdings as well as income generated from those holdings while the latter type is also public but only open to certain types of investors.
Regardless of whether they are publicly-held or not, both types of REITs must be registered with the Securities and Exchange Commission (SEC). A third-type of REIT is the privately-held real estate trust that is only open to institutional investor. It is not registered with the SEC and is not subject to any type of disclosure.
Beyond this form of primary distinction, REITs can be further classified as follows:
- Equity REITs: Equity REITs are directly own their real estate and generate income from it through rentals or other, similar arrangements.
- Mortgage REITs: Mortgage REITs are akin to financiers who provide loans to builders or real estate developers responsible for a given parcel of land. Alternatively, they may hold mortgages packaged into sophisticated securities and, thus, are indirect owners of the real estate holding. Their source of income is interest payments on the mortgages.
- Hybrid REITs: As their name denotes, hybrid REITs are combinations of mortgage REITs and equity REITs. Thus, they may own real estate directly and hold real estate mortgage securities (or actual real estate mortgages) as a source of financing.
REITs can be further classified based on the type of real estate holdings in the trust. Consider the Retail REIT. These are the most common form of REITs and they comprise as much as 24% of overall real estate investment trusts. The proliferation of this type of REIT is tied to the popularity of shopping malls as destinations for leisure and commerce. Retail giants like Walmart, Macys, and Sears have owned or rented some of the most expensive and prime real estate in America.
But the growth of e-commerce means that the tide is turning the other way now. One of the biggest names in retail, Amazon, does not operate out of shopping malls and is entirely based online. Retail REITs are also susceptible to price declines during a recession because consumers generally cut back on shopping spending in downturns, affecting income for shopping mall tenants. An example of this is General Growth Properties, which was one of the biggest retail REITs in America until the financial recession of 2008 and the e-commerce charge decimated its holdings. Examples of other kinds of REITs are Residential REITs (focused on residences and apartment complexes), Communications (focused on real estate in the telecom sector) and Data Center REITs (focused on real estate used to build massive data centers).
Pros and Cons of Investing in REITs
Like other financial instruments, REIT investing comes with own set of pitfalls and advantages.
Some advantages are outlined below.
- REITs can diversify your portfolio: Most modern theories for portfolio construction stress the need to have one that incorporate various types of assets. REITs can help you gain access to expensive real estate across industries at a fraction of their overall costs.
- REITs are an inflation hedge: Real estate is considered a hedge against price increases. Landlords and building owners can increase rents or tenancy costs and protect themselves against erosion of value. The asset, in this case real estate, becomes inflation-resistant in the process. According to research from investing firm Morningstar, inflation averaged 8% between 1972 and 2019. The FTSE Nareit US Real Estate Index Series returned an average of 10.6% during the same period.
- REITs have low correlation with equities: REITs are considered an alternative asset, meaning they have low correlation with assets, such as equities, that are favored by investors for returns. Therefore, they are attractive for investors looking for a place to park their funds during stock market downturns.
The disadvantages of investing in REITs are as follows:
- REIT returns are affected by economic downturns: REIT returns are dependent on economic cycles and, therefore, they perform badly during economic recessions. For example, real estate prices crashed after the 2008 financial recession. Commercial real estate bore the brunt of those losses because lender operations were hemmed in losses and increased regulatory oversight. As a result, the REIT market crashed in tandem with the broader economy. The FTSE NAREIT Index shed 17.8% and 37.3% of its overall value in 2007 and 2008.
- REITs have interest rate dependency: The interest rate risk in REITs is tied to their dependency to the overall economy. Thus, REITs fail to act as an appropriate hedge when the economy is undergoing a recession.
- Private REITs may be illiquid and fraudulent: Because they do not have disclose information to the SEC and are not traded at public exchanges, private REITs do not have a readily available market. The absence of disclosures can also mean that distributions or dividend payouts may not be made from income generated from operations.
- REITs are low-income growth instruments: As an asset, real estate does not have the returns or growth trajectory of stocks. Growth is generally slow and, in the case of REITs, measured as it is divided among multiple stakeholders.