For individual investors who want to participate in the real estate space, real estate investment trusts (REITs) have generally been the best available option. There are attractive elements to this model of investment, but also considerable downsides, which have limited the accessibility and appeal of REITs.
Today we’ll take a look at what REITs are, how they work, and where they fit as the real estate investment landscape evolves — and perhaps reaches the precipice of a revolution.
What Are REITs (Real Estate Investment Trusts)?
REITs are companies that own or operate income-generating commercial real estate, be it equities, mortgages or securities. Under this model, numerous investors are able to collectively pool their capital in a REIT, thus earning dividends without the complexities and commitment of actually buying and managing property. Functionally, it is quite similar to a mutual fund.
REITs were first created all the way back in 1960, when President Dwight D. Eisenhower signed into law the Cigar Excise Extension Tax, containing within it the initial provision authorizing REITs in the United States.
“Eisenhower helped to pave the way for REIT to own in large-scale, diversified portfolios of income-producing real estate in the same way they typically invest in other asset classes – through the purchase and sale of liquid securities,” writes Brad Thomas at Forbes. “Eisenhower fully intended to encourage the investment in real estate—and inspire investors to join the party by cleverly enhancing a new kind of investment.”
And so the party started. REITs became an increasingly popular investment option for portfolios over the decades, and today there are nearly 500 stock exchange-listed real estate companies, representing some $1.8 trillion in equity market capitalization.
Is a REIT a Good Investment: Benefits of REITs for Investors
Why have REITs become so popular in the mainstream investment community? There are some undeniable advantages, including:
Ease of Buying and Selling. Because they are (mostly) traded on public stock exchanges, REITs offer a level of convenience that was previously impossible to find in commercial real estate investment. As their own distinct asset class, these investments also bring diversification to a portfolio.
Simple and Straightforward. The model upon which REITs operate is not terribly complicated or confusing, even for inexperienced investors. As rent is collected on a commercial lease, the REIT generates income, which is then distributed among shareholders in the form of dividends.
Reliable Cash Flow. This basic system leads to stable and dependable returns. By law, REITs must pay 90% of net profits back to investors. REITs are also historically strong performers compared to stocks, outpacing the overall S&P 500 in total return over the past 50 years.
Tax Benefits. Unlike public corporations, REITs don’t pay corporate income tax. While taxation is typically passed on to the shareholders, there are some nuances and techniques that can lead to lower tax rates, owing to the dynamics of property ownership.
In spite of these perks, REITs do leave much to be desired in some ways, which is why new methods are emerging to help regular investors really join the party.
Downsides of REITs for Investors
Some of the disadvantages of REITs are set aside easily enough when balanced by the positives.
No, they don’t offer great upside, and can be somewhat limited in growth and appreciation due to the mandated regular 90% payouts. But then again, they’re also pretty steady and safe.
No, shareholders don’t have the same level of control over performance or returns as direct real estate investors. But then again, they don’t have to deal with the headaches that approach entails.
The real downsides of REITs are in the details. For example:
REITs must have asset managers or fund managers, who draw a percentage of the income.
REITs must be run by a board of directors, further limiting your control.
Burdens such as origination fees, performance fees, disposition fees, and construction management fees are taken on by investors, to varying extents.
All of these factors can limit your flexibility and earning potential. Nevertheless, REITs present an intriguing method for allowing individual investors to participate in the commercial real estate space and tap into some of the appealing benefits. Other innovative methods are emerging to address some of the inherent drawbacks of this model. Stay tuned.