Real Estate Investment Funds: How Do They Work?

Real estate investment trusts (REITs) are companies that own, operate, or finance income-producing real estate. They allow individuals to invest in large-scale, income-producing real estate without having to buy, manage, or finance properties themselves. REITs are traded on major stock exchanges and are an excellent way to diversify one's portfolio. They are required to meet certain standards set by the IRS, including returning a minimum of 90% of taxable income to shareholders as dividends.

What are Real Estate Investment Trusts (REITs)??

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate. They were created by a 1960 law to make real estate investing more accessible to smaller investors. REITs are structured as corporations and are not typically taxed at the entity level, which allows investors to avoid double taxation on dividends.

REITs invest in a wide range of property types, including offices, apartment buildings, warehouses, retail centers, medical facilities, data centers, cell towers, infrastructure, hotels, and timberland. Most REITs focus on a particular property type, but some hold multiple types of properties in their portfolios.

REITs make money by leasing space and collecting rent on their real estate, and they must pay out at least 90% of their taxable income to shareholders as dividends. This pass-through structure can result in higher dividend yields for investors, but REIT dividends are typically taxed as regular income.

There are two main types of REITs: Equity REITs and Mortgage REITs. Equity REITs own and manage income-producing real estate, and they generate revenue primarily through rent. Mortgage REITs lend money to real estate owners and operators directly through mortgages and loans or indirectly through mortgage-backed securities. Their earnings are generated by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans.

REITs offer benefits such as growth, income, diversification, and inflation hedging. They have historically delivered strong results and provided attractive income relative to other asset classes. However, they are often low-growth investments with little capital appreciation.

How do REITs make money?

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate. They were established in 1960 to make real estate investing more accessible to smaller investors.

REITs make money through rental income and/or interest on mortgages. They lease space and collect rent, which is then paid out to shareholders as dividends. REITs must pay out a minimum of 90% of their taxable income to shareholders, and most pay out 100%.

Mortgage REITs (mREITs) don't own real estate directly but instead finance it and earn income from the interest on these investments. They are popular because they return relatively high-interest payments collected on commercial mortgages.

REITs also benefit from special tax considerations. They are structured as corporations and are not typically taxed at the entity level, which allows investors to avoid double taxation on dividends.

Why invest in REITs?

Real estate investment trusts (REITs) are an attractive investment opportunity for several reasons.

Firstly, they have historically delivered competitive total returns, based on high and steady dividend income, and long-term capital appreciation. The dividend yields of REITs have produced a steady income stream through various market conditions. This is because REITs are required to distribute at least 90% of their taxable income to shareholders annually, and these dividends are fuelled by stable rents paid by tenants.

Secondly, REITs are an excellent portfolio diversifier due to their low correlation with other assets. They can help reduce overall portfolio risk and increase returns. They are also a good counterbalance to stocks, bonds, and cash.

Thirdly, REITs offer liquidity, transparency, and inflation protection. Shares of publicly listed REITs are easily traded on major stock exchanges, providing investors with liquidity. Additionally, REITs are monitored by independent directors, analysts, auditors, and the financial media, providing transparency and a measure of protection for investors. Furthermore, REITs can serve as a hedge against inflation.

Lastly, REITs provide access to the real estate market without the complexities and headaches of directly owning property. They allow investors to benefit from valuable real estate and access dividend-based income.

In summary, REITs offer a range of benefits, including competitive returns, portfolio diversification, liquidity, transparency, inflation protection, and access to the real estate market. These factors make them an attractive investment option for individuals seeking stable income and long-term capital appreciation.

What are the different types of REITs?

Real estate investment trusts (REITs) are companies that own, operate, or finance income-generating real estate. They sell shares to raise capital to do so, and they are designed to make real estate investing more accessible to smaller investors. There are two main types of REITs: equity REITs and mortgage REITs.

Equity REITs

Most REITs are equity-based and own and manage income-producing real estate. They generate revenue primarily through rent, rather than reselling properties. Within equity REITs, there are subcategories based on the types of properties held in the REIT. These include:

• Commercial properties such as shopping malls, office buildings, and data warehouses.
• Residential housing properties, including multi-family apartments, student housing, and single-family homes.
• Healthcare properties, such as hospitals, medical centres, and nursing facilities.

Mortgage REITs

Mortgage REITs lend money to real estate owners and operators directly through mortgages and loans or indirectly by acquiring mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them sensitive to interest rate increases.

Hybrid REITs

Hybrid REITs mix strategies from both equity and mortgage REITs. However, after the 2007–2008 Financial Crisis, these trusts largely disappeared as regulations changed and REITs became more specialised.

In addition to these three main types, there are also public non-listed REITs and private REITs, which are not traded on national stock exchanges.

How to invest in REITs

Real Estate Investment Trusts (REITs) are an excellent way to invest in real estate without the complexities of directly owning property. They are a great way to diversify your portfolio and offer the potential for steady income through dividends.

• Understand the Basics: Familiarize yourself with how REITs work, their benefits, and their risks. REITs are companies that own, operate, or finance income-producing real estate. By investing in REITs, you can earn a share of the income generated from these properties without the hassle of managing them.
• Choose Your REIT Type: There are different types of REITs, including Equity REITs, Mortgage REITs, and Hybrid REITs. Equity REITs focus on owning and managing income-producing real estate. Mortgage REITs lend money to real estate owners or invest in mortgages and mortgage-backed securities. Hybrid REITs combine strategies from both Equity and Mortgage REITs.
• Assess Your Investment Goals: Consider your financial goals, risk tolerance, and investment horizon. Determine how much you want to invest and whether you want to invest in a REIT directly or through a fund.
• Research and Analyze: If you're investing in individual REITs, research specific REIT companies. Analyze their financial performance, dividend history, management team, debt levels, and the types of properties they invest in.
• Choose a Brokerage Account: Open a brokerage account with an online broker that offers access to REITs. Compare different brokers and their fees to find one that suits your needs.
• Make Your First Investment: With your brokerage account set up, you can start investing in REITs. Use the research tools provided by your broker to identify REITs that align with your investment strategy. Carefully review the fees associated with each investment.
• Monitor and Diversify: Regularly monitor your REIT investments to track their performance. Consider diversifying your portfolio by investing in different types of REITs, such as residential, commercial, or healthcare REITs.
• Consider Funds and ETFs: Instead of investing in individual REITs, you can opt for REIT mutual funds or exchange-traded funds (ETFs). These provide instant diversification and are managed by professionals.
• Be Mindful of Taxes: Keep in mind the tax implications of investing in REITs. Dividends from REITs are typically taxed as regular income, so consult a tax professional to understand how this will impact your overall tax liability.
• Long-Term Perspective: REITs are generally considered a long-term investment strategy. Remember that real estate markets can be cyclical, so be prepared to hold your investments through market fluctuations.

Remember to do your due diligence before investing, and if you're new to REITs, consider starting with publicly traded REITs, as they offer an easy and accessible way to get familiar with the process.

Frequently asked questions