Understanding REITs: What They Are and How They Work

A Real Estate Investment Trust (REIT) is a company that invests in commercial real estate and generates income for its shareholders. By pooling capital from various investors, a REIT can purchase physical properties if it’s an equity REIT or invest in real estate loans if it’s a mortgage REIT. Some REITs even adopt a hybrid model, owning both properties and mortgages.

Contents hide

1. The Purpose of a REIT

2. Overview of REITs

3. Investment Focus of REITs

4. Benefits and Risks of Investing in REITs

5. Liquidation Options for Non-Traded REITs

6. Due Diligence Before Investing in REITs

7. Tax Implications of Investing in REITs

The Purpose of a REIT

The primary objective of a REIT is to provide a steady stream of income and the potential for capital appreciation to its shareholders. For equity REITs, income is primarily derived from rent paid by tenants of the properties they own. Conversely, mortgage REITs earn income by collecting interest and principal payments on the loans they provide.

Overview of REITs

Most REITs are publicly traded companies registered with the Securities and Exchange Commission (SEC), regularly filing detailed quarterly and annual financial reports. However, some REITs operate as private entities. Public REITs can be further categorized into:

Traded REITs: Listed on national exchanges or sold over-the-counter (OTC), allowing investors to buy and sell shares at any time at market prices.
Non-Traded REITs: Not listed on exchanges, these REITs are offered through a prospectus and are available during a multi-year offering period. Unlike traded REITs, they typically do not have a formal secondary market for selling shares, requiring a longer-term commitment of capital, often at least five years.

Investment Focus of REITs

Most equity REITs focus on specific types of real estate, such as hotels, shopping centers, self-storage facilities, office buildings, or medical properties. They may also target particular geographic regions.

While some non-traded REITs may offer limited share redemption programs, investors should be aware that recovering the initial investment amount can be challenging.

Benefits and Risks of Investing in REITs

One key advantage of the REIT structure is the requirement to distribute at least 90% of taxable income to shareholders as regular distributions. This can lead to higher income for investors compared to traditional corporations. However, it’s important to note that this income is not guaranteed; it depends on factors such as tenant occupancy, operational efficiency, and the ability to increase rents.

During economic downturns, rental income and distributions can decline if properties remain vacant or fail to attract tenants. Overall, the total return from a REIT combines current income with potential capital gains upon liquidation.

Liquidation Options for Non-Traded REITs

At the end of the investment term, typically spanning several years, non-traded REITs may pursue one of three liquidation strategies:

Going Public: Converting the REIT to publicly traded status through an exchange listing.
Mergers and Acquisitions: Merging with or being acquired by another REIT.
Selling Properties: Liquidating properties individually or in smaller groups.

The optimal exit strategy will depend on market conditions, property marketability, and the overall economy, which can be unpredictable at the time of your investment.

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Due Diligence Before Investing in REITs

Before investing in a non-traded REIT, thorough research is crucial. Consult with your broker or financial advisor to evaluate:

The management team’s experience and track record.
The REIT’s business plan and investment strategy.
Sources of external capital.

New FINRA regulations require non-traded REIT sponsors to disclose critical information, including the net investment value of the REIT and any potential impacts of fees on share value. It’s essential to confirm the REIT’s policy on share redemptions, including any applicable lock-up periods or fees.

Tax Implications of Investing in REITs

REIT distribution income is generally taxed as ordinary income rather than at the lower long-term capital gains rate. Consulting with a tax advisor can help you explore options for maximizing tax efficiency, such as claiming depreciation on real estate assets or holding the REIT in a tax-deferred account.