20 August 2020

A Guide On Real Estate Investment Trusts

STA Law Firm


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Since time immemorial, real estate has been acknowledged as a historically significant investment class- one that offers increased portfolio diversification, low volatility, and optimally...
United Arab Emirates Finance and Banking
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Since time immemorial, real estate has been acknowledged as a historically significant investment class- one that offers increased portfolio diversification, low volatility, and optimally risk-adjusted returns. A Real Estate Investment Trust (REIT) is a financial instrument that not only allows investment in real estate but an instant investment in a multitude of real estate assets by means of the purchase of a single REIT's shares. While not all REITs are affordable, many are. On account of their accessibility and general universality, a REIT can often present an immensely appealing route for an individual looking to become a real estate investor.

A REIT is a company that places investments in income-generating real estate, of the commercial variety in addition to others. Investors that yearn for access to real estate can accordingly purchase shares of a REIT; through that share ownership, they would be effectively adding the real estate owned by the REIT to their portfolios. This provides investors with exposure to all the properties owned by the fund, simultaneously.

REITs - Background

Why were REITs created?

REITs first came to be in the United States under President Eisenhower when he signed the REIT Act in the Cigar Excise Tax Extension of 1960. These were intended to give commonplace investors a means of investing in a diversified portfolio of income-churning real estate through a share-based model.

What makes REITs unique?

They are mandated by law to follow a highly specific set of operating requirements to receive and retain the qualification of a REIT. What sets REITs apart from other investment vehicles is the fact that REITs are mandated to derive a minimum of 75 percent of their gross income from real estate-related sources, and correspondingly invest 75 percent or more of their total assets in real estate.

Another significant distinction lies in the fact that the law requires REITs to distribute 90 percent or more of their income from their real estate investments directly to investors. Owing to these operating requirements, REITs offer investors a plethora of reasons to invest in real estate via this conduit, some of which shall be delved into below.

Coveted Characteristics of REIT Investment

Dividend Income

The high dividend payout requirement for REITs translates into a larger share of REIT investment returns coming from dividends as opposed to other stocks. For this very reason, many financiers and advisors unequivocally recommend REITs to be well-suited for income-seeking investors, as well as for long-term investors seeking both income plus capital appreciation.

In the United States, REIT dividend yields have historically been higher than the average yield of the S&P 500 Index. As a matter of fact, long-term calculations display that more than half of equity REIT total returns have come from dividends.

Portfolio Diversi¬cation

As discussed before, REITs have provided significant diversification benefits for investors on account of their relatively insignificant correlation with other assets, including other stocks and bonds.

Diversification is an ideal sought to reduce portfolio volatility - the risk that investors will be subject to tumultuous oscillations in the value of their portfolio holdings. The remedy that some investors implement to evade volatility preemptively is the diversification of the portfolio, e.g., between small-cap stocks and large-cap stocks.

However, it must be noted that this strategy only divides a portfolio between different parts of the same asset class and fails to achieve the full benefit of diversification. Another means to approach portfolio diversification would be to diversify amidst asset classes.

REITs, for instance, have had less of a tendency to move synchronously with other equities when stocks fluctuate. Between 1992 and 2016, large-cap and small-cap equity total returns bore an 83 percent correlation, while large-cap equity and Equity REIT total returns bore a mere 56 percent correlation. This goes to show that the combination of a large-cap portfolio with listed equity REITs would certainly bear more fruit, with regards to achieving diversification.

Inflation Hedging

A key concern for several investors today is how to secure enough income to tide them by for a decade-long retirement period. Even in an environment with minimal inflation, the cumulative effects of inflation over long periods can erode the purchasing power of portfolio assets. The dilemma that retirees often encounter is that it can be tough to stay ahead of inflation with fixed income securities. In contrast, equities (the traditional inflation hedge) are usually trimmed back to reduce investment risk.

REITs are structurally possessive of a natural hedge against inflation in a fashion that matches up exceedingly well with the needs of investors. The commercial real estate rents and values have tended to increase when prices do; this has, in turn, supported REIT dividend growth, and provided retirement investors with reliable income even during inflationary periods.

Tax Bene¬ts

Adding to the standard benefits available to investors who have access to REITs by means of traditionally tax-advantaged accounts (i.e. retirement accounts), REIT investors encounter several additional, critical upsides. The most well-known tax advantage is actually related to an investment fund's basic ability to be classified as a REIT.

  1. To receive the official REIT stamp and designation, one of the most fundamental requisites is that a fund distributes a minimum of 90 percent of its (taxable) income every year to its shareholders.
  2. If a fund successfully meets the REIT qualifications, then these earnings will not be subject to taxation at the company level.
  3. Earnings are distributed to investors and are only taxed at the individual investor level. This eliminates the brunt of the burden of double taxation that many face with traditional company stocks. The absence thereof of a company level tax enables investors to keep the lion's share of their overall returns.

Total Return Performance

REITs' reliable track record of growing dividends, combined with long-term capital appreciation through stock price increases, has gifted investors with an attractive total return performance for many periods over the past 45 years, especially when compared to the broader stock market.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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