If you're new to the investment game, you might have heard about real estate investment trusts (REITs) and how good they are at generating returns. Despite their popularity, many new investors don't even consider a real estate trust as part of their portfolio. Real estate trusts can seem like a more complex type of investment, primarily if you're used to stocks, bonds, and options. In reality, a real estate trust might be the best instrument that you're not currently involved in. In this article, we try to make it easier to understand how to leverage the financial stability and potential for return in REITs.
The Basics of a REIT
According to Investopedia, a REIT is a company that finances, owns, or operates real estate that generates income for its investors [https://www.investopedia.com/terms/r/reit.asp]. From an investor's perspective, it's an opportunity to get into business with others by pooling money to invest in real estate development and leasing. The closest analog you may encounter is thinking about a REIT as a mutual fund for real estate. This comparison has oversimplified the REIT, but it works as a base point to explain how REITs work. Developing a REIT is to allow everyday investors to get into the lucrative field of real estate investing.
In typical real estate markets, buying a property requires a lot of overhead. Mortgages for individuals can be a complicated minefield to navigate. REITs simplify the equation by allowing several individuals to form a single company that manages their real estate interests. The buying, selling, and renting of properties are the primary concern of a REIT. With enough skilled staff, it can be profitable without the owners worrying about getting involved in the trust's everyday business.
What Qualifies a Company as a REIT?
It takes more than having a company acquire real estate for it to be considered a REIT. The stipulations that underlie a REIT are as follows:
Ø REITs must derive at least three-quarters of their income from real estate or related assets. Their assets must also demonstrate investment in real estate assets, and at least three-quarters of those assets must be in real estate or associated elements. Real estate or derived payments include rents, mortgages, third-party fees for property management, or anything else associated with a property or real estate.
Ø REITs must have at least one hundred shareholders. Businesses that eventually become REITs typically start as partnerships and ultimately convert into REITs when they reach that 100-shareholder threshold.
Ø REITs are required to pay out 90% of their taxable income to shareholders at the very least. Most REITs typically have an above-average return on investment as a result, and they may actually end up paying out more than 100% of their taxable income since they earn money in other ways.
Ø A REIT has a requirement that five or fewer shareholders can own no more than 50% of its total holdings. To ensure this rule is obeyed, REITs typically limit a single shareholder's shares to no more than 10% of the entire REIT.
Why Would Businesses Prefer Being a REIT?
With all the stipulations surrounding REITs, why would a business even bother trying to pass off as one? The simple explanation is that REITs have pretty favorable taxation. However, as Simply Safe Dividends puts it, REIT taxation itself is a complex issue. REITs aren't treated as corporations when it comes to taxation. In fact, a business qualified as a REIT is likely to pay no corporate tax whatsoever. The previously mentioned 90%-payout stipulation comes into play here. Since they must pay 90% of their taxable income, the IRS treats them like a pass-through taxable entity, much like an LLC.
Corporations have typically had a bad rap when it comes to taxation. In many cases, corporations' members get taxed twice - once from the corporation's income and once from the dividends paid out to them as members. As a pass-through entity, only the members' dividend payments are subject to taxation. The only caveat is that REIT dividends tend to be taxed at a slightly higher rate than regular corporate dividends. However, the amount paid is typically less than having to pay taxes twice.
REITs as a Long-Term Income Generation
We've already covered how good REITs are with taxes. There are several other reasons they would make for profitable long-term income generation holdings, including:
Ø REITs have very low buy-ins. If you understand the profit potential of real estate, you'll quickly realize that you need a lot of capital to consider investing in it seriously. REITs are great for new investors since they provide a very low entry bar that most investors can afford.
Ø REITs are lovely for adding diversity to an investment portfolio. We all know the folly of putting all one's eggs in a single basket. Diversification of a portfolio allows you to weather market fluctuations far more securely.
Ø An REIT has the potential to be a source of long-term income that grows over time and avoids being hit by inflation. Since many REITs lease their properties over the long term, they generate income consistently on a month-to-month basis.
Risks of REIT Investment
As with all investment vehicles, there are risks that an individual interested in getting into them should be aware of. Rising interest rates can severely hamper your REIT's profit generation potential. If the market becomes oversupplied, rent values are likely to stop leading to a dent in income from the REIT. Real estate trusts also rely heavily on steady tenancy, and gaps can lead to falling revenue. Recessions hit REITs significantly as well as vacancies arise because people can't afford to rent anymore. However, if the REIT deals in commercial property, it may be less likely that a recession will affect them if it doesn't target their core property sector.
REITs are excellent tools to help diversify an investor's portfolio. Aside from that, they also provide a massive potential income boost over the long term. There are significant risks associated with investing in REITs, but they aren't any different from other income-generation engines. These trusts tend to be more stable investments over the long term. If you can afford to put your money in one, it may be worth the investment.
