Understanding a real estate investment trust (REIT) is a function of knowing how a REIT is formed and what it is designed to do as an investment vehicle. REITs tend not to be on the radar of the average investor because they are niche investments. Although REITs are straightforward and easy to understand compared to more complex investment vehicles, there are relatively few publicly traded REITs available to the average investor. Many REITs are non-traded, and an investor often needs certain connections to be extended an opportunity to invest.
A REIT is a corporation that is formed under state law with the specific authority to invest in real estate. The authorizing statute allows a corporation with a principal business of investing in real estate to sell shares of stock to the public with the caveat that the REIT distribute 90 percent of its income to investors as dividends and register with the U.S. Securities and Exchange Commission. This type of corporation is also given special status as a pass-through tax entity by the Internal Revenue Service (IRS). Consequently, a REIT is very much like an S corporation. It is an entity that receives all of the benefits of a corporation but does not have to pay corporate taxes. It passes its profits and losses through to its shareholders to be taxed on their personal tax returns at the individual rate.
The easiest way to understand the function of a REIT is to think of it as a mutual fund for real estate. Mutual funds allow people to invest in the stock of multiple corporations by buying shares of an aggregated fund. The fund holds the various individual corporate stocks and the investor holds shares in the fund. This enables the investor to easily diversify his investment with one expenditure, since losses in some of the stocks in the fund should be offset by gains in others. Likewise, a REIT holds various parcels of real estate. Investors hold stock in the REIT, and this enables them to share in the profits of a diversified portfolio of real estate at a cost the investor can afford.
The REIT corporation is a U.S. creation that has gained worldwide popularity. Many countries do not allow foreign individuals to own real estate, but they do allow the formation of domestic REITs. The REIT corporation can hold real estate in these markets, and foreigners can buy shares of stock in the REIT through international stock markets. The investor owns stock, not the real estate itself, so the country's rules regarding property ownership are satisfied.
Regular corporations make money on the sales of products and services. REITs make money on the operation of commercial real estate. REITs are landlords, and they collect rent from the commercial tenants that occupy the properties that the REIT owns. The rent is the REIT's gross income. Property management expenses are deducted from rent to arrive at a net operating figure. REITs can be easily understood if the investor keeps in mind their basic function as ordinary landlords.
Traded Vs. Non-Traded
Traditionally, stock in REITs is publicly traded, just like shares of stock in any public corporation, but the worldwide economic downtown in the first decade of the 21st century caused too much volatility in value as investors were able to dump their shares at will, despite knowing that real estate investments need to be made for the long term. Consequently, the non-traded REIT became popular. This type of REIT requires investors to commit money for a certain length of time, typically seven to 10 years. The investor receives a dividend during the term of the investment and his share of the value of the portfolio once it is liquidated or taken public.
Investing in REITs
Non-traded REITs are not available to the public. An investor would have to be invited to participate in a private REIT. Publicly traded REITs sold on stock exchanges and analyzed in the same way as mutual funds. Analysts measure the performance of individual REITs against a popular REIT index, such as the Morgan Stanley Capital International (MSCI) US REIT Index. Unlike stocks, the value of an REIT is not often tied to its earning per share or dividend payout. The investment in real estate often means that the best estimation of the value of a REIT is the type of real estate it holds and its potential to appreciate.
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