Real Estate Investment Trust (REIT) - Types, Advantages & Limitations (2024)

What are REITs?

REITsor real estate investment trust can be described as a company that owns and operates real estates to generate income.Real estate investment trust companiesare corporations that manage the portfolios of high-value real estate properties and mortgages. For instance, they lease properties and collect rent thereon. The rent thus collected is later distributed among shareholders as income and dividends.

Typically, REITs offer investors an opportunity to possess high-priced real estate and enable them to earn dividend income to boost their capital eventually. This way, investors can utilise the opportunity to appreciate their capital and generate income at the same time.

Both big and small investors can park their funds into this investment option and reap benefits accordingly. Small investors may attempt to pool their resources along with other investors and invest the same into large commercial real estate projects. Properties included in REITs comprise data centres, infrastructure, healthcare units, apartment complexes, etc.

How Does a Company Qualify as a REIT?

To qualify as aREIT,a company has to meet specific requirements as mentioned below.

1. The entity needs to be structured as a business trust or a corporation.
2. Extends fully transferable shares.
3. Is managed by a team of trustees or a board of directors.
4. Must have a minimum of 100 shareholders.
5. Less than 5 individuals should not have held 50% of its share during each taxable year.
6. Is required to pay at least 90% of the taxable income as a dividend.
7. Accrue a minimum 75% of gross income from mortgage interest or rents.
8. A maximum of 20% of the corporation’s assets comprises stock under taxable REIT subsidiaries.
9. A minimum of 75% of investment assets must be in real estate.
10. A minimum of 95% of REITs total income should be invested.

Types of Real Estate Investment Trust (REIT)

In a broader sense, the types of business REITs are involved with tend to help classify them better. Also, the methods devised to sell and purchase shares further help classify REITs.

The following is a list of the different types of REITs.

• Equity

This type of REIT is among the most popular ones. Typically, it is concerned with operating and managing income-generating commercial properties. Notably, the common source of income here is rents.

• Mortgage

Also known as mREITs, it is mostly involved with lending money to proprietors and extending mortgage facilities. Further, REITs tend to acquire mortgage-backed securities. Mortgage REITs also generate income in the form of interest accrued on the money they lend to proprietors.

• Hybrid

This option allows investors to diversify their portfolio by parking their funds in both mortgage REITs and equity REITs. Hence, both rent and interest are the sources of income for this particular kind of REIT.

• Private REITs

These trusts function as private placements, which cater to only a selective list of investors. Typically, private REITs are not traded on National Securities Exchanges and are not registered with the SEBI.

• Publicly traded REITs

Typically, publicly-traded real estate investment trusts extend shares that are enlisted on the National Securities Exchange and are regulated by SEBI. Individual investors can sell and purchase such shares through the NSE.

• Public non-traded REITs

These are non-listed REITs which are registered with the SEBI. However, they are not traded on the National Stock Exchange. Also, when pitted against public non-traded REITs, these options are less liquid. Plus, they are more stable as they are not subjected to market fluctuations.

Advantages of REITs

Investors who park their funds in a REIT can benefit in these following ways.

• Steady dividend income and capital appreciation:Investing in REITs is said to provide substantial dividend income and also allows steady capital appreciation over the long term.

• Option to diversify: Since most REITS are traded frequently on the stock exchanges, it provides investors with an opportunity to diversify their real estate.

• Transparency in dealing:Being regulated by the SEBI, REITs are required to file financial reports audited by professionals. It provides investors with an opportunity to avail information on aspects like taxation, ownership and zoning, hence making the entire process transparent.

• Liquidity:Most REITs trade on public stock exchanges and hence are easy to buy and sell, which adds on to their liquidity aspect.

• Accrues risk-adjusted returns:Investing in REITs offers individuals risk-adjusted returns and helps generate steady cash flow. It enables them to have a steady source of income to rely on even when the rate of inflation is high.

Limitations of REITs

• No tax-benefits:When it comes to tax-savings, REITs are not of much help. For instance, the dividends earned from REIT companies are subjected to taxation.

• Market-linked risks:One of the major risks associated with REITs is that it is susceptible to market-linked fluctuations. This is why investors with weak risk appetite should weigh in the return generating capacity of this investment beforehand.

• Low growth prospect:The prospect of capital appreciation is quite low in the case of REITs. It is mainly because they return as much as 90% of their earnings to the investors and reinvest just the remainder 10% into their venture.

The accompanying table highlights the pros and cons of investing in top REITs.

Who Should Invest in REITs?

Since REITs own and manage high-value real estate properties, they are one of the most expensive avenues of investments. Consequently, investors who park their funds in REITs are those who have substantial capital at their disposal. For example, big institutional investors like insurance companies, endowments, bank trust departments, pension funds, etc. can suitably invest in these financial tools.

Role of REITs in a Retirement Portfolio

Including REITs in one’s retirement portfolio tends to prove beneficial for investments in several ways. The following pointers help gain valuable insight into the same.

Exposes portfolio to a diverse mix of properties

By including real estate, one can diversify his/her asset classes significantly and does not require managing them personally. Additionally, with diversification, price fluctuation of other investment options would not have an impact on REITs. Rather, it can be said that in a falling market, the value of REITs does not drop as fast as stocks.

Opportunity to generate earnings

When the value of REIT appreciates, investors tend to earn substantial returns. Also, these companies are required to distribute as much as 90% of their taxable earnings to their shareholders, serving as an avenue to generate steady income.

Suitable for the long run

Unlike stocks and bonds which follow a business cycle of 6 years, REITs are more in sync with the movement of the real estate market. Notably, such movement tends to last for over a decade and hence further suitable for investors who are looking for a long-term investment horizon. In turn, it proves to be a profitable investment avenue for retirement planning.

Helps hedge inflation

As per research, REITs enables investors to hedge the effects of inflation in the long run. For instance, by staying invested for a term of 5 years, investors can protect their funds from inflationary effects more effectively as compared to stock options.

How to Invest in Real Estate Investment Trusts?

Like popular public stock, investors may decide to buy shares in a particular REIT that is enlisted on the major stock exchanges. They may do so in the following three ways.

1. 1. Stocks:Individuals who are looking for a more direct way to invest in REITs should consider doing so through stocks.
   2. Mutual funds:By choosing this option, individuals would be able to diversify their investment portfolio significantly. As it is an indirect investment method, investors would be required to invest in such a fund through a mutual fund company.

• Exchange-traded funds:With this particular investment option, investors would avail indirect ownership of properties, and would further benefit from its diversification.

Notably, REIT as an investment option tends to resemble mutual funds, the only difference being that REIT holds properties instead of bonds or stock options. Additionally, REIT investors are entitled to avail the assistance of financial advisors to make more informed decisions in terms of investing in an appropriate REIT option.

Tips to Assess Real Estate Investment Trusts

Investors can assess the merit of a particular REIT effectively if they factor in these following tips.

• Before investing in any particular REIT, investors should look for corporations who have a positive record when it comes to offering high dividend yields. Also, they analyse the company’s role in facilitating capital appreciation in the long run.

• Investors can diversify their investment portfolio by purchasing shares through stock exchanges without the need to stay invested for the long term.

• Investors should park funds into REITs that hold diverse properties and tenants.

• They should opt for ETFs and mutual fund options that invest in REITs. Since these funds come with professional assistance; investors would be able to manage them more proficiently.

• Opting for companies that have been active in the field for several years and have an experienced core team would prove more beneficial.

Lastly, individuals should make a point to find out how their investments would be compensated. For instance, they should scrutinise the management team of REIT and their performance record with the help of metrics like fund from operations or financial management rate. Similarly, it would prove beneficial to factor in a REIT’s growth in EPS and current dividend income before investing to maximise returns.