A real estate investment trust (REIT) is a form of collective ownership, similar to a mutual fund, in which a corporation offers securities representing an asset base of real estate properties. REITs can own residential and commercial property. Publicly traded REIT shares are sold on exchanges, whereas other types of REITs are offered via private placements, secondary markets or broker/dealer transactions.
Equity REITs purchase properties to generate rental income and capital gains on property sales. Mortgage REITs purchase mortgage notes to collect interest and principal payments, and which act as liens allowing holders to foreclose on properties in default. Hybrid REITs share characteristics of equity and mortgage REITs.
A REIT must meet the following standards:
- Must be organized in an entity that is taxed as a corporation, with a board of directors and at least 100 shareholders. No more than half of its shared can be held by five or fewer persons.
- REITs must pay at least 90 percent of their annual taxable income as dividends to shareholders.
- Invest at least 75 percent of its assets in real estate
- Earn at least 75 percent of its income from sales of real estate, interest on mortgages and rents.
- No more than 5 percent of income can be derived from non-qualifying sources, such as non-real-estate business or service fees.
- REITs can’t own more than 10 percent of the voting shares of non-REIT corporations. Such stock can’t comprise more than 5 percent of assets. Stock of taxable REIT subsidiaries cannot make up more than 25 percent of the REIT’s asset value.
- REITs must annually mail shareholders to gather information about beneficial ownership of shares.
Meeting these requirements allows REITs to avoid taxation, instead passing income and capital gains through to shareholders, avoiding double taxation.
Public, Exchange-Traded REITs vs Private REITS
Publicly traded REITs are registered with the Securities and Exchange Commission and are first distributed through an initial public offering (IPO). The shares trade on national stock exchanges and are available to the general public. These are not to be confused with unlisted REITs, which are SEC-registered but trade away from the exchanges, through broker/dealers and private treaties.
Private REITs are exempt from SEC Registration and are available via private placements and/or crowdfunding portals. SEC Regulations A and D provide mechanisms allowing sponsors to exempt securities from SEC registration requirements that apply to publicly traded securities.
Benefits of REITs
Some benefits include:
- Instant diversification: Shares represent a portfolio of properties that has little correlation with the S&P 500, thereby reducing overall volatility, increasing returns and decreasing risk.
- High yields: The MSCI REIT Index has provided an annualized return of more than 20 percent during this period, compared to a 15 percent annualized return by the S&P 500. Moreover, in the last 15 years, REITs have been the best performer, returning 12 percent per year on average.
- Simple tax treatment: These are pass-through securities that do not pay corporate income tax.
- Professional management: REIT managers are specialists who must provide competitive returns to attract shareholders.
- Liquidity: Public REIT shares are easy to trade, and stock is much more liquid than are the underlying properties. Non-listed and private REIT shares can trade on secondary markets, although private-REIT shareholders must wait a year before publicly selling their shares.