What Is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.
How do REITs Work?
Congress established REITs in 1960 as an amendment to the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios—something that was previously available only to wealthy individuals and through large financial intermediaries.
Properties in a REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.
In general, REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties.
Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks throughout the trading session. These REITs typically trade under substantial volume and are considered very liquid instruments.
What Qualifies as a REIT?
Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders. Mortgage REITs don’t own real estate, but finance real estate, instead. These REITs earn income from the interest on their investments.
To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (IRC). These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a company must meet the following requirements to qualify as a REIT:
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
- Derive at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Be an entity that’s taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals.
Types of REITs
There are three types of REITs:
Most REITs are equity REITs, which own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties).
2. Mortgage REITs.
Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
3. Hybrid REITs.
These REITs use the investment strategies of both equity and mortgage REITs.
REITs can be further classified based on how their shares are bought and held:
Publicly Traded REITs. Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
Public Non-Traded REITs. These REITs are also registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs. Still, they tend to be more stable because they’re not subject to market fluctuations.
Private REITs. These REITs aren’t registered with the SEC and don’t trade on national securities exchanges. In general, private REITs can be sold only to institutional investors.3
Advantages of REIT
REITs offer a variety of advantages to different parties including the sponsor of the fund, the investor and the property developer. Here are some of the key advantages..
Since REITs are required to distribute nearly 90% of their earnings in the form of dividends to the REIT investors, they can be assured of a higher income ratio. This enhances the yield for investors in REIT funds.
REITs are designed to be tax efficient. The government has given them pass-through status. That means; when the REIT receives the rentals and distributes them to its shareholders, it will be treated as a pass-through flow and will not be taxed.
The REIT assets are normally secured by long term leases and therefore there is no risk to the REIT investor. The long term lease also ensures that the income flow to the REIT will continue in a more predictable manner.
What the REIT will bring in is professional management to the pool of real estate assets. Like mutual funds bring in professional management into equities and debt, REITs will bring in professional management into the real estate pool. This will permit them to bargain for better lease rentals, get a good price on trading real estate etc.
From an investor’s point of view, the REIT offers two distinct merits. Firstly, it offers an opportunity to buy real estate as a financial security. It is much cheaper and less cumbersome to transact in REITs than to transact in property. For investment purposes REITs make a lot more sense. Secondly, it offers a new asset class to investors outside of traditional equity, debt, cash and gold and thus helps diversify the risk.
Like mutual funds REITs are expected to become fairly liquid assets over a period of time. Since real estate is traded in the form of securities, the creation of demand and supply will be much easier in this case. Thus, investors in REITs will not have to worry much about entry and exit costs.
For real estate developers, REITs offer the benefit of monetizing their assets. This allows the realty companies to focus more on executing realty projects rather than owning the realty assets. This makes them asset-light and improves their ROI.
Finally, REITs will be regulated by SEBI since they will be a traded financial security and will be transacted through the secondary market. The SEBI regulation will come with stringent reporting and disclosure practices, which the REIT will have to adhere to. This will ensure greater transparency, which is good for the investor.
Challenges of REIT
There are also some key challenges that REITs face in India. While some are regulatory, others are driven by the business environment..
The key determinant of the success of REITs is the rental yield. In India, rental yields are not too attractive. Rental yields are the rents that one can receive compared to the price of the property. More attractive rental yields are only possible if property prices come down further from current levels.
REITs have a major growth challenge. They are required to distribute a chunk of their earnings as dividends to REIT holders. This stifles their ability to plough back money into the REIT business and enable it to grow.
Globally, REITs have had situations when they have relied extensively on debt and this created a major financial risk for them. In many cases, the REIT holders have ended up taking a loss due to this. That is something REIT investors need to be cautious about.
Finally, regulation is a major challenge. Real estate in India is still subject to state level regulation. Therefore, there is no national policy as far as real estate is concerned. Till the time that happens, the spread of REITs in India may be a challenge!
REIT in India
There are only 3 REITs in India as of now. The first and the most promising REIT in India is Embassy Office Parks REIT. Embassy has offered a good returns and was profitable to investors even in tough times like in middle of the pandemic.
You can get the unit info and other information related to investing and and you can do your own research on Embassy REIT’s website.