One of the most notable investment opportunities available to investors looking to enter the real estate market is a REIT (Real Estate Investment Trust). A REIT is a publicly traded company that owns, operates, or finances income-producing properties and real estate investors are able to purchase shares in them (Ranchers, Investopedia). This contrasts to direct real estate investment, which is typically considered purchasing a property, then either managing it, renovating it, renting it out, flipping it, etc. The primary difference centers around whether you’d prefer a hands-on approach to real estate investing. REITs give you the opportunity to diversify your portfolio and more specifically, your investment portfolio within the real estate segment.
A typical REIT has publicly traded shares that can be purchased on a national exchange, however they often fund underlying properties directly. Such companies, known as Equity REITs, are typically involved in the construction of office buildings, or the management of apartments, hotels, etc. Conversely, Mortgage REITs may purchase asset-backed securities or make direct real estate loans. REITs must register with the SEC, and they’re subject to various regulations, most notably the requirement to pay 90% of the company’s taxable income in the form of shareholder dividends each year. Contrary to popular belief, there are also REITs that are not traded on an exchange, but they likely come with hefty fees, and far more limited liquidity options. Concisely, perhaps the most important takeaway from a REIT is that it provides access to a diversified pool of real estate investments that are essentially impossible for the typical investor, even a large-scale investor, to create on their own.
The Pros of a REIT
The biggest pro commonly referred to is a REIT gives a typical retail investor – who may not have enough liquid capital – to take a diversified approach to the real estate market. REITs may also be beneficial to investors that don’t have the expertise yet to assess the risks of a real estate investment. These investors may very well prefer a pooled approach to real estate. In case those cases, a REIT would be a great alternative to direct real estate investing, which would require a lot more experience and intricate knowledge of the real estate market. Investors not only get access to an income-producing product, but additionally to one that’s physically managed by a professional real estate market expert.
Equity REITs, which are traded on national exchanges, have low capital requirements because investors are only buying a share of the trust. Since it’s traded on a public equity market, an investor can buy and sell these assets with relatively few liquidity constraints.
Additionally, as we all know, investors are always cognizant of their tax rate, especially from capital gains investments. REIT investors are taxed more favorably on income from the investment because income is not typically taxed at a corporate level, due to the income from these pooled real estate assets being “passed through” to the investor. Contrary to a large corporation where all income is taxed before distributing dividends, REIT investors receive profits as ordinary income.
Lastly, real estate investors may not always have a bullish position on the overall market and even more so on a specific project or space. Taking a short position on a real estate project, without utilizing an Equity REIT, would require considerable savvy, as well as most likely the use of expensive derivative products. In contrast, REITs allow market speculators to go long or short, depending on their market view.
The Cons of a REIT
As this section will conclude, there are definitely more pros than cons to investing in a REIT. As is often the case, one of the primary cons is the opposite of one of the main pros. Since REITs are a massive pool of assets, this makes understanding the underlying risk quite difficult to an average investor in the real estate market. Though the properties are thought to be managed by seasoned professionals, they aren’t exempt from making errors on occasion. The average investor may overlook an essential aspect of the REIT because they’re working under the assumption it’s managed by real estate professionals, or they may struggle to gain a comprehensive understand of the portfolio beyond simple summary statistics.
Additionally, while this ties in partially with the investor’s preference of direct vs. passive real estate investing strategies, REITs can also be more expensive than a direct lending approach. As an example, fees charged for a REIT managers’ salaries can eat into the potential income gained from the investment. Savvy and wealthy investors with enough capital to diversify could definitely put themselves in a position to achieve higher returns by managing assets themselves. The issue becomes what constitutes “enough”. Should a single investor choose the path of diversification within the direct real estate investment market, “enough” would likely mean tens, if not hundreds of millions. Even so, they would have to incur management costs and while they may be lower than a REIT managers’ salary, the risk incurred would be unlikely to offset the potential capital gains benefit. This is why REITs are far more common and much more likely to be a better tool for investors who are seeking to diversify their portfolio, as opposed to diversifying their real estate portfolio with expensive and frequently reoccurring direct property investments.