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Real Estate Investment Trust (REIT): Criteria, Working, Types, Advantages and Limitations

Last Updated : 29 Dec, 2023
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What is REIT?

Real Estate Investment Trust (REIT) is an investing platform that enables investors to invest in real estate assets without actually buying, owning, or managing physical property. Based on the model of Mutual Funds, REITs also pool the money of many investors together and invest the fund collected into income-generating real estate assets like office buildings, shopping centres, apartments, hotels, energy pipelines, and warehouses. Commonly, a REIT is a company that owns, operates, and finances income-producing real estate assets and offers its shares to the general public on the stock exchange. REIT provides an opportunity to invest in a diversified portfolio of different classes of real estate assets with a motive to earn steady income in the form of dividends and ensure capital appreciation in the long run. REITs are listed on a stock exchange, which means shares of these companies can be easily traded publicly, making it a highly liquid investment.

Real Estate Investment Trust (REIT)

Qualifying Criteria

A company to be classified as a REIT is required to meet several provisions of the Internal Revenue Code (IRC). Here are the main requirements:

  • At least 75% of a REIT’s gross income shall come from real estate-related sources, such as rent or mortgage interest or real estate sales.
  • At least 75% of a REIT’s assets shall be real estate-related assets, such as real property, mortgages on real property, or shares in other REITs.
  • A REIT must have a minimum of 100 shareholders after its first year of existence, and no more than 50% of its shares can be held by five or fewer individuals. i.e., cannot be closely held.
  • A REIT must distribute at least 90% of its taxable income to its shareholders in the form of dividends.
  • A REIT shall be taxed as a corporation, but it can elect to be taxed as a pass-through entity if it meets certain requirements.
  • A REIT shall be managed by a board of directors and shall have at least one independent director.

However, meeting the above requirement does not necessarily make a company a good investing REIT.

How do REITs Work?

REITs pool up the fund of several investors with the same investing goals and then invest the fund into different real estate assets that generate income. Then the REIT manages the properties, collects rent, pays expenses, and distributes income generated to shareholders in the form of dividends. Investors can easily buy a share of these companies on the stock exchange. When they buy the shares of these companies, they are merely buying a portion of the underlying real estate assets owned by the REIT without actually owning the physical property themselves and vice versa. The value of a REIT’s shares is determined by the free forces of supply and demand in the market and by the performance of the underlying real estate assets. Besides this, REITs provide capital appreciation opportunities in the long run as the value of the underlying real estate assets owned by the REIT can appreciate over time.

Types of Real Estate Investment Trusts (REIT)

Real Estate Investment Trusts (REIT) can be classified as:

A. On the Basis of the Nature of the Real Estate Asset

Under this REIT can be classified into three categories:

1. Equity REITs: Equity REITs are the one that owns and operates income-producing properties like Healthcare infrastructure, warehouses, offices, and so on. The main source of earnings is the rent generated from the real estate assets.

2. Mortgage REITs: These REITs extend loans and finance to the owner of the real estate properties and operate through mortgages and the acquisition of the mortgaged securities. Their earning is a net interest income (the difference between the interest charged and the cost of funding) from mortgage loans.

3. Hybrid REITs: As the name suggests Hybrid REITs are a combination of both equity and mortgage REITs as they own properties as well as hold mortgages.

B. On the Basis of the Nature of Trading

There are three types of REITs under this head:

1. Publicly Traded REITs: Publicly Traded REITs are listed on public stock exchanges, and their shares can be easily bought and sold by the general public during trading hours. However, the share’s price is determined by the free forces of supply and demand in the market and by the performance of the underlying real estate assets.

2. Public Non-traded REITs: The shares of these REITs are not registered with public stock exchanges, and so cannot be traded on a stock exchange. The shares are generally sold to individual investors through brokers.

3. Private REITs: Private REITs are also not registered with public stock exchanges, rather the shares are allotted through private placements to institutional investors and high-net-worth individuals.

Advantages of REITs

REITs offer a number of advantages to investors which include:

1. Liquidity: The shares of REITs can be easily sold on the stock exchange market, making it easy for the investor to withdraw as per their will and need.

2. Diversification: REITs allow investors to diversify their portfolios by investing in different classes of real estate assets. This help investors scatter the risk into different categories of assets.

3. High Dividend Yields: As per the law, REITs are required to distribute 90% of their taxable income as dividends to shareholders making it a High dividend-yielding investment channel.

4. Access to Real Estate: REITs enable the investor to access the real estate without actually buying and owning the physical property. When an investor buys a share of REITs, they buy a part of the underlying property held by the REITs.

5. Professional Management: REITs are managed by professionals who are experts in real estate management, which leads to better investment decisions and higher returns.

6. Capital Appreciation: The value of properties held by REITs appreciates with time, giving an opportunity to the investors to grow the value of their capital in the long run. 

Limitations of REITs

Everything that offers advantages comes with limitations, and so do REITs. Some of such limitations associated with REITs are:

1. Dividend Fluctuations: The dividend distributed by REITs is highly uncertain based on the fact that the amount of the dividend depends on the performance and income of the REITs.

2. Taxation: Although REITs are tax-efficient structures, the income generated is taxable as regular income.

3. Low Re-investment: As per the law, REITs must distribute 90% of their income as dividends, so only 10% of income is available for re-investing in new real estate, restricting the growth of REITs.  

4. Interest Rate Sensitivity: Whenever interest rates rise, the cost of borrowing for REITs increases, which can lower their profitability and stock prices. REITs are highly sensitive to interest rates.

5. Limited Control: REIT shares are managed by professional managers, so the investors have very little control over the management and operation of the underlying real estate properties.

6. Market Risk: Like any other investment, REITs are subject to market risk. Any market downfall can adversely affect the prices of REITs shares and the value of the real estate. 

How to Invest in Real Estate Investment Trusts?

An individual can directly purchase the shares of listed REITs on a stock exchange like any other securities. Further shares in a REIT mutual fund or exchange-traded fund (ETF) can also be bought easily. However, investors may invest in public Non-Traded REITs and Private REITs through brokers and agents. The shares are managed by professional experts and are liable to some fees and commissions. However, some points should be considered before making such investments, like types of REITs, quality of real estate, diversification of portfolio to reduce the risk, commission associated with the investment and so on. Since REITs are subject to market risk, proper research and analysis should be done before making an investment decision.

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