Real Estate Investment Trust Investments
Real estate investments are often rewarding, offering average annual returns of around 10.6%. That’s better than the average stock market return which stands at just under 9% annually over the past 20 years.
However, not all real estate investments are equal. Commercial real estate typically produces around 9.5% returns, while real estate investment trusts REITs are known for an average return well in excess of 11.5%. So, it’s not surprising to see so many investors making their way into REITs.
Below, we’ll explain what a REIT is, the benefits of investing in them, and the different types of REITs to consider.
What is a REIT?
A real estate investment trust is a company that engages in purchasing, managing, and selling real estate on behalf of the investors that fund it. REITs are similar to mutual funds in that:
- Both REITs and mutual funds manage investment dollars for a large group of investors.
- Both REITs and mutual funds work to produce a diversified portfolio of assets.
- Investors in both of these asset classes enjoy fractional ownership of the underlying portfolio.
The biggest difference between the two is the type of assets they invest in. While ETFs invest in stocks, bonds, and derivatives, REITs invest in a diversified portfolio of real estate. Moreover, REITs are required to give at least 90% of their profits to their investors in the form of dividends at least once annually.
How REITs Build a Portfolio
Most REITs build a diversified portfolio consisting of several different types of real estate. These include, but are not limited to:
- Commercial real estate (strip malls, office buildings, manufacturing facilities, and more)
- Residential real estate (homes, condos, and apartment buildings)
- Telecommunications real estate (cellular towers, data centers, and other real estate associated with the digital transmission of data)
However, there are also REITs that have a core focus on one of the strategies above. When you choose the REIT that’s best for you, it’s important to look into its portfolio and make sure that the portfolio diversification and asset allocation align with your strategy.
How Investors Get Involved
You can get involved in a REIT in one of three ways:
- On the Open Market: Some REITs are publicly traded. That means they trade like stocks on the open market. Simply use your brokerage account to purchase shares.
- Private Purchase: Some REITs are non-traded, meaning they don’t trade on the open market. As such, you’ll typically need to work with a broker or financial advisor to access a non-traded fund. However, more recently, crowdfunding websites have begun to offer access to these funds as well.
- 721 Exchange: If you have a property you’re interested in selling, consider a 721 exchange. This exchange gives you the ability to trade your property to a REIT in exchange for shares of the REIT. The move doesn’t just get you into a REIT, it also defers capital gains taxes on the property you relinquish control of as part of the process.
How Investors Generate Passive Income
REIT investments are prized for the passive income they generate. These companies are legally required to share 90% of their profits with investors at least once per year. As a result, REIT investors get regular dividend payments from the trusts they invest in, producing passive income.
How the REIT Generates Income
As with any other company, REITs are in the business to make money, but how exactly do they generate their profits?
It all starts with the proper acquisition, management, and sale of properties. As REITs collect rent and sell properties, they produce profits. As mentioned above, 90% of those profits are returned to investors as a legal requirement. However, that leaves 10% of the profits in the REIT for things like new acquisitions. The REIT may elect to pay out more than 90% as many pay out all or more of their income. Income paid above 100% will result in less equity in the REIT.
Who Should Invest In REITs?
REITs are the perfect option for beginner investors who want to get involved in real estate or real estate investors who would like to take a hands-off approach. Moreover, REITs are a compelling option for investors who are looking for increased cash flow or more diversification.
Do REITs Qualify for 1031 Exchanges?
1031 exchanges give real estate investors a way to exit property investments while deferring capital gains taxes that could amount to more than 20% of their profits. To do so, you must purchase a like-kind property with the proceeds from the original property you sell.
Unfortunately, REITs aren’t considered like-kind investments and will not qualify for 1031 exchanges. However, there is an option to use an existing property to purchase REITs while deferring taxes. That’s known as the 721 exchange, or UPREIT.
Under the 721 exchange, you can trade your real estate for shares of a REIT. If you don’t have real estate that’s desirable for a REIT, you can do a 1031 exchange to purchase fractional shares of real estate a REIT would be interested in acquiring, then move forward with a 721 exchange to convert the real estate into REIT shares.
What Are the Benefits of REIT Investments?
REIT investments come with several benefits. Some of the most important include passive income, tax advantages, diversification, and estate planning benefits. Read on to learn more details about these benefits.
As mentioned above, REITs are legally required to pass at least 90% of their profits down to their investors, though many REITs pass 100% of their profits down to avoid taxes. That means when you own a REIT, you can expect to generate income at least annually. In some cases, REITs may pay profits to investors on a monthly, quarterly, or semi-annual basis.
Regardless of how you get paid, you can rest assured that, with the right REIT, you’re going to generate meaningful passive income.
Most REITs are structured in a way that allows them to avoid corporate taxes altogether or reduce them significantly. That’s great news for investors, because the money the company would generally have to pay as part of their corporate tax obligations is paid to investors as a dividend instead. This investment’s structure also means investors can take advantage of a depreciation tax shelter on the portfolio’s income since a REIT is able to pass depreciation down to investors.
Moreover, REITs are an option for deferring capital gains taxes you earn on a real estate investment. You can do this through a 721 exchange since REITs don’t qualify for 1031 exchanges.
When you purchase a piece of real estate, you may add it to a relatively diversified portfolio. However, the vast majority of individual investors simply don’t have the funding it takes to create a significantly diversified real estate investment portfolio.
That’s not the case for REITs.
These companies often raise hundreds of millions, or even billions, of dollars for the procurement of real estate. As a result, everyone involved in the trust typically benefits from a high level of diversification within its portfolio.
Moreover, REITs help bring another level of diversification to your personal portfolio. If you currently have a portfolio made up of stocks and bonds, you may want to consider adding REITs to improve your portfolio’s diversification and generate meaningful passive income.
REITs are also a tool for real estate investors who are interested in estate planning. The truth is that a piece of property in an estate can cause significant headaches. When you pass, your family may fight over whether to sell or maintain the property. If they sell it, there may be price and share disagreements.
However, if you do a 721 exchange into a REIT, you can avoid this headache for your family altogether.
Each share of a REIT has a minimal value when compared to the total value of a piece of real estate. This makes it easy for you to split these assets among heirs and ensure that everyone gets what you believe they deserve from your estate.
Are there Different Types of REITs?
Every REIT is different. They come with differing fee structures, class focuses, and management teams. So, it’s important to compare all of your options carefully before you choose one to invest in.
Nonetheless, there are two primarily different categories of REITs. Those include publicly traded REITs and Non-Traded REITs. Read below to learn more about the differences between the two.
Publicly Traded vs. Non-Traded
There are a few core differences between publicly traded and non-traded REITs. The biggest differences include:
- Trading: Publicly traded REITs typically trade on the open market, making it easy to purchase them through an online broker. You typically need to work with a financial advisor to purchase a non-traded REIT. Although, some non-traded REITs are structured in a way that will allow them to become public once they grow large enough.
- Liquidity: Publicly traded REITs are typically highly liquid since they trade on the public market. On the other hand, non-traded REITs lack liquidity since there’s rarely a secondary market where you can exit your investment if you choose to.
- Volatility: Publically traded REITs are subject to a significant amount of volatility not tied to the value of the real estate. Events on the other side of the world may have a global effect on stock markets causing share values of REITs to drop, even though the underlying value didn’t change. Non-traded REITs have a static value, most updating the share price only once a year.