Real Estate Investment Trusts (REITs)

Fundamentals of Market Investing by Adam J. McKee

Real estate investment trusts (REITs) allow individuals to invest in large-scale, income-producing real estate.  A REIT is a company that owns and typically operates income-producing real estate or related assets.  These may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans.  Unlike other real estate companies, a REIT does not develop real estate properties to resell them.  Instead, a REIT buys and develops properties primarily to operate them as part of its own investment portfolio.

REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership–without actually having to go out and buy the commercial real estate.

Many REITs are registered with the SEC and are publicly traded on a stock exchange.  These are known as publicly traded REITs.  Others may be registered with the SEC but are not publicly traded.  These are known as non-traded REITs (also known as non-exchange traded REITs).  This is one of the most important distinctions among the various kinds of REITs.  Before investing in a REIT, you should understand whether it is publicly traded, and how this could affect the benefits and risks to you.  REITs offer a way to include real estate in one’s investment portfolio.  Many investors appreciate the fact that some REITs may provide higher dividend yields than some other investments (I care more about total return, regardless of where it comes from).

Nevertheless, there are some risks, especially with non-exchange traded REITs.  Because they do not trade on a stock exchange, non-traded REITs involve unique risks:

  • Lack of Liquidity: Non-traded REITs are illiquid investments because they cannot be sold readily on the open market.  If you need to sell an asset to raise money quickly, you may not be able to do so with shares of a non-traded REIT.
  • Share Value Transparency: While the market price of a publicly traded REIT is readily accessible, it can be difficult to determine the value of a share of a non-traded REIT.  Non-traded REITs typically do not provide an estimate of their value per share until 18 months after their offering closes.  This may be years after you have made your investment.  As a result, for a considerable period, you may be unable to determine the value of your non-traded REIT investment and its volatility.
  • Distributions May Be Paid from Offering Proceeds and Borrowings: Investors may be attracted to non-traded REITs by their relatively high dividend yields compared to those of publicly traded REITs.  Unlike publicly traded REITs, however, non-traded REITs frequently pay distributions more than their funds from operations.  To do so, they may use offering proceeds and borrowings.  This practice, which is typically not used by publicly traded REITs, reduces the value of the shares and the cash available to the company to purchase additional assets.
  • Conflicts of Interest: Non-traded REITs typically have an external manager instead of their own employees.  This can lead to potential conflicts of interests with shareholders.  For example, the REIT may pay the external manager significant fees based on the number of property acquisitions and assets under management.  These fee incentives may not necessarily align with the interests of shareholders.

Publicly traded REITs can be purchased through a broker.  Generally, you can buy the common stock, preferred stock, or debt security of a publicly traded REIT.  As with any exchange-traded instrument, brokerage fees will apply.  A broker or financial adviser typically sells non-traded REITs.  Non-traded REITs often have high up-front fees.  Sales commissions and upfront offering fees usually total approximately 9 to 10 percent of the investment.  These costs lower the value of the investment by a significant amount.

Most REITs pay out nearly 100% of their taxable income to their shareholders.  The shareholders of a REIT are responsible for paying taxes on the dividends and any capital gains they receive in connection with their investment in the REIT.  Dividends paid by REITs generally are treated as ordinary income and are not entitled to the reduced tax rates on other types of corporate dividends.  Consider consulting your tax adviser before investing in REITs outside of a tax-sheltered instrument like a 401(k).  Considering all of this, you may have already decided that investing in REITs is too much trouble.  Another approach, which we will discuss in the next section, is to invest in a real estate mutual fund.

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