A real estate investment trust (REIT) is a corporation that invests in commercial real estate. The REIT raises capital from a group of investors. And then uses it to buy buildings if it’s an equity REIT or loans on buildings if it’s a mortgage REIT.
Hybrid REITs typically own both properties and mortgages on properties.
A REIT’s goal is to provide a steady stream of income and potential capital gains to its shareholders. With an equity REIT, the income comes from the rent its buildings’ tenants pay. A mortgage REIT generates income by collecting interest and principal payments on the loans it owns.
A REIT overview
Most REITs are public corporations that register with the SEC. Also, they file regularly updated quarterly and annual financial reports. A smaller number are private companies. Some public REITs are traded. In other words, they’re listed on a national exchange or sold over-the-counter (OTC) after listing on an exchange. You can buy and sell shares at any time for the current market price.
Other public REITs are non-traded. It means they aren’t listed or sold OTC. And there’s no IPO. Instead, they’re offered to investors by prospectus. It is an official document that explains the REIT sponsor’s investment strategy. Additionally, it describes the types of properties it will buy, and how it will finance its investments.
These REITs, which you buy through a broker-dealer or financial advisor, are available during a multi-year offering period. A distinguishing feature of non-traded REITs is that there is no formal secondary market where you can sell your shares. Since a REIT’s investment term is typically at least 5 years and may be longer, you must be able to commit the capital you’re investing for that period.
The only possible exception to this illiquidity is that the REIT sponsor may offer a limited share redemption program. However, even if redemption is you’re unlikely to recover the amount you paid to buy.
On the plus side, though, non-traded REIT returns tend to be non-correlated with returns on conventional investments. In other words, it helps to diversify your portfolio.
REIT returns and risks
One significant feature of the REIT structure is that it must distribute at least 90% of its taxable income to shareholders every year as monthly or quarterly distributions. As a result, investment income from a REIT may be higher than most other corporations provide. But, of course, this income isn’t guaranteed.
Equity REIT distributions depend on having a full complement of paying tenants, operating efficiently, and being able to increase rents. There are risks, however. Rents, and therefore distributions, may drop in a market downturn if rental space remains empty. Distributions may also be disappointing if the properties the REIT owns aren’t attractive to potential tenants. Or if the market for a particular type of property is saturated.
Income is only part of the total picture. The total return is a combination of current income and any capital gain on the principal you invest. With a non-traded REIT, whether or not there’s a capital gain depends on the liquidation event. That event occurs at the end of the multi-year investment term. The REIT typically has three alternatives for liquidation:
- Converting the REIT to publicly traded status using a listing on an exchange.
- Participating in a merger with or acquisition by another REIT.
- Selling off the properties the REIT holds individually or in small lots.
The preferred exit strategy, which would produce the greatest gain, may or may not be feasible at the time REITs are ready to liquidate. Among the factors that come into play are the current market interest in traded REITs, the marketability of the properties the nontraded REIT owns, and the general state of the economy. These are things that can’t be predicted at the time you buy REIT shares, also known as units.
Before you invest in REIT
As with any other investment, you and your broker-dealer or financial advisor should research a non-traded REIT before you make a decision. This process includes reviewing the experience and track record of the management team, the REIT’s business plan, and its sources of outside capital.
Some of your evaluations will be facilitated by new FINRA rules governing the responsibilities of a non-traded REIT sponsor. Specifically, the sponsor must:
- Report the net investment value of a REIT to provide a more accurate on-going sense of its actual value. Among other things, this means accounting for the impact of commissions and fees.
- Disclose that distributions may include the return of capital and so reduce the per-share value.
- Clarify that, if redemptions are allowed, the share redemption price may be less than the per-share estimated value provided in your account statement.
The tax you owe on REIT distribution income is figured at the same rate you pay on your ordinary income, not at the lower long-term capital gains rate that applies to qualified dividends. But you should consult your tax advisor about the possibility of claiming depreciation of real estate assets against REIT income or other tax-saving opportunities.
Alternatively, you may hold the REIT in a tax-deferred account, so that tax rates are not an issue.
What Is REIT And How Does It Work? by Inna Rosputnia
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