How REITs Work: Ultimate Guide
Real estate investment vehicles provide one of the surest ways of gaining access to reliable income-generating assets. However, investing in real estate, especially commercial real estate, can at times cost a fortune, beyond the reach of most people.
It is for this reason that Real Estate investment Trusts (REITs) came into being in the 1960’s, in a bid to make it possible for people to pool resources to invest in valuable real estate properties.
What is a REIT?
A Real Estate Investment Trust is essentially a corporation that pools investor’s capital to invest and manage real estate properties as well as mortgages. Considered as one of the most effective vehicles for investing in properties, REITs allow people to own properties the same way they would invest in other industries through stocks of companies.
The same way people benefit from holding company’s stocks, REITs stockholders are entitled to a share of any income produced through investments made in various properties.
How REITs work
REITs operate as externally managed trusts, whereby unit holders raise money by taking part in an Initial Public Offering. Real estate properties depending on area of specialization are normally bought using the funds bought from the IPO. For example, there are REITs formed with the sole purpose of investing in property types such as offices, hotels, apartments and shopping centers.
Tenants who lease or rent acquired property pay rent on a monthly or quarterly basis, thereby accounting for REITs Rental income. The amount of rental income raised is what goes to form payouts made to unitholders/ investors upon deduction of management costs.
Some of the costs that REITs incur include manager’s fees, property manager’s fees, and trustee fees. REITs that hold properties in foreign jurisdiction at times do bear some form of taxes, which account for some of the costs deducted from profits prior to distributions.
REITs are required to distribute at least 90% of their taxable income to shareholders upon deduction of all expenses. Unlike public companies, REITs cannot retain their earnings for whatsoever reason. In most jurisdiction REITs don’t pay tax. However, shareholders pay taxes on the dividends they receive as distribution.
Publicly listed REITs trade in the stock market just like other stocks. However, there are those that are registered by various regulatory authorities but don’t trade in the market.
Trustees act as custodians tasked with the responsibility of ensuring a REITs compliance to all applicable rules. Such individuals hold assets on behalf of unitholders and protect their rights. Trustee fees are some of the costs deducted from profits prior to deductions.
Upon the pooling of resources from investors, it is the work of REIT Managers/ Property managers to come up with ideas on where to invest the funds. Managers, in this case, manage REITs by setting and executing the strategic direction for generating a unit holder’s value.
For instance, they explore which properties to acquire as well as which to divest. For their services, they charge a fee which most of the time includes a base fee as well as a performance fee. In some instances, managers charge acquisition and divestment fees.
REIT Managers appoint property managers and task them with the responsibility of managing underlying real estate properties. Some of the responsibilities include renting out properties to achieve the desired tenancy levels as well as collecting rental income.
Property managers also carry out marketing campaigns to attract shoppers and tenants in addition to ensuring the well upkeep of properties. Property managers in return charge a fee for their services.
For a real estate investment vehicle to qualify as a REIT, it must have at least 75% of its total funds and assets invested in property or treasuries. A REIT must also generate at least two thirds of its gross income from rental income as well as interest in mortgages or from property sales.
A REIT must also distribute a minimum of 90% of its taxable income to shareholders or unit holders in the form of dividends each year. A REIT must have more than 100 unit holders and a Board of directors. No one investor should own more than 50% of shares of a REIT.
How to Invest In REITs
Income-focused investors can invest in REITs by simply purchasing shares of their favorite REITs directly on an open exchange. It is also possible to invest in such assets through mutual funds that specialize in a public real estate.
Before investing in a REIT, it is important to consider what the REIT invests in. Sector and geography are some of the important things to look at. It would also be wise to analyze a REITs structure taking into consideration the people managing underlying assets. In this case, one can look at the management quality as well as track record and strategy for growth.
Going through the prospectus, to understand the rights and interests of unit-holders should also come into play. One should also have a clear understanding of the expected frequency and timing of dividend payments
Just like other investments, REITs do come with their fair share of risks that any serious investor should take into consideration before making an investment decision.
Market Risk remains one of the biggest risks that face public REITs. The fact that these REITs trade in the stock exchange means their prices are always subject to forces of supply and demand.
Income Risk: Contrary to perception, REITs don’t make distribution all the time. Higher costs, as well as low tenancy level and market conditions, may significantly hurt REITs ability to generate profits for distribution.
Leverage Risk: REITs that use too much debt to finance acquisition always expose investors to greater risks in case things goes wrong. For instance, in times of insolvency, REIT assets are usually auctioned and the funds used to clear debts first.