A real estate investment trust (REIT) is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, including office and apartment buildings, warehouses, hospitals, shopping centers, hotels and commercial forests. Some REITs engage in financing real estate.
Most countries’ laws on REITs entitle a real estate company to pay less in corporation tax and capital gains tax. REITs have been criticised as enabling speculation on housing, and reducing housing affordability, without increasing finance for building.
REITs can be publicly traded on major exchanges, publicly registered but non-listed, or private. The two main types of REITs are equity REITs and mortgage REITs (mREITs). In November 2014, equity REITs were recognized as a distinct asset class in the Global Industry Classification Standard by S&P Dow Jones Indices and MSCI. The key statistics to examine the financial position and operation of a REIT include net asset value (NAV), funds from operations (FFO), and adjusted funds from operations (AFFO).
This type of REIT is among the most popular ones. Typically, it is concerned with operating and managing income-generating commercial properties. Notably, the common source of income here is rents.
Also known as mREITs, it is mostly involved with lending money to proprietors and extending mortgage facilities. Further, REITs tend to acquire mortgage-backed securities. Mortgage REITs also generate income in the form of interest accrued on the money they lend to proprietors.
This option allows investors to diversify their portfolio by parking their funds in both mortgage REITs and equity REITs. Hence, both rent and interest are the sources of income for this particular kind of REIT.
These trusts function as private placements, which cater to only a selective list of investors. Typically, private REITs are not traded on National Securities Exchanges and are not registered with the SEBI.
Public traded REITs
Typically, publicly-traded real estate investment trusts extend shares that are enlisted on the National Securities Exchange and are regulated by SEBI. Individual investors can sell and purchase such shares through the NSE.
Public Non-traded REITs
These are non-listed REITs which are registered with the SEBI. However, they are not traded on the National Stock Exchange. Also, when pitted against public non-traded REITs, these options are less liquid. Plus, they are more stable as they are not subjected to market fluctuations.
They Diversify Your Investment Portfolio
One of the essential considerations you make when investing is how to minimize your risk. REITs enable you to diversify your investment portfolio hence minimizing your risk. The prospect of reducing your risk makes this one of the more prominent REIT Advantages and Disadvantages.
High Earning Potential
One of the REIT Advantages and Disadvantages comes from the fact that the underlying asset in REITs is real estate. When the underlying asset’s value increases, your earning potential follows suit.
The value of real estate investment often increases in the long run. With this knowledge, most REITs employ strategies to create additional value for their shareholders. For instance, they could sell off properties that have appreciated significantly to generate capital for new projects, which might provide higher short-term growth. The underpinning reason is that most real estate projects grow fastest when they are newly completed, but the rate of growth levels off and might eventually stagnate.
Above Average Investment Returns
REITs are an excellent way for people to build their passive income. Returns are a critical part of most REIT Advantages and Disadvantages. For starters, REITs must disburse a minimum of ninety percent of their taxable income to investors. Therefore, the dividend yield to shareholders is above average for most REITs.
There are many REITs with more than a 5% dividend payout, while the average yield for stocks is two percent or lower. REITs are therefore ideal for people who wish to reinvest their dividends. In the past 20 years, the return for REITs has outperformed the S&P 500 Index and the inflation rate.
Minimal Management and Acquisition Headaches
Most people who have invested in physical properties know the pain involved in buying, selling, and managing properties.
The truth is that nobody wants tenants calling them at 3 AM to complain about blown fuses. Furnaces like to break down at the worst times, and termites might be eating your investment without your knowledge. All these are annoyances that most investors do not want.
Disadvantages of REITs
REITs suffer from some of the drawbacks of investing in stocks. These are the most significant disadvantages of investing in REITs.
REITs that trade on the stock exchange disburse a large proportion of their income to investors. Unfortunately, very little money is left to allow a REIT to grow its portfolio. Fortunately, private REITs do not follow the same rules and may be able to retain more earnings for further investment.
High Taxes on Dividends
The dividends you earn from REITs are subject to higher taxes than other investments.
You are usually only supposed to pay a capital gains tax on dividends. However, REIT returns do not qualify they are subject to ordinary income tax rates. Of course, this largely depends on the country you live in.
Potentially High Fees and Risk
Even if a REIT is SEC-registered, it doesn’t mean it is low-risk. Investors should consider factors such as interest rates, the real estate market, tax laws, geography, etc., before investing in REITs.
Some REITs may use these factors to justify charging high management fees and transaction fees. The result is a lower payout to investors.
Trends Affect the Performance of REITs
Compared to other investments, REITs are vulnerable to the goings-on in the real estate market. For instance, if a REIT has a significant investment in rental properties in a location with diminishing rental income, the returns for shareholders are likely to trend downwards.
Fluctuations linked to the real estate market are more problematic for REITs to avoid because it is their sole investment destination.
Little Control over Performance
The level of control of the investment is one of the REIT Advantages and Disadvantages that favours people who invest in physical properties. If you invest funds by yourself, you can cherry-pick properties with high returns, aggressively promote vacant rental spaces, and thoroughly screen applications for rental agreements to maximize revenue and minimize risk. You have much tighter control of how you implement real estate best practices.
On the other hand, if you invest in a REIT, you can’t do anything to influence the performance of your investment. If you don’t like its returns, your only viable option is to sell it. Another downside is that some private REITs don’t allow you to sell your shares for several years after buying them.