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
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.
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.
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.
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.
- 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.
- If a fund successfully meets the REIT qualifications, then these earnings will not be subject to taxation at the company level.
- 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.
REITs are publicly traded, professionally managed companies that manage their businesses intending to maximize shareholder value. These companies engage in positioning their properties optimally to attract tenants and earn rental income. They manage their property portfolios and ensure the buying and selling of assets to cultivate value throughout long-term real estate cycles. Their efforts drive the total return performance for REIT investors, who benefit from a reliable annual dividend payout as well as the potential for long-term capital appreciation.
Liquidity and Transparency
For a great many years, investors considered real estate to be an illiquid asset, and rightfully so. However, the liquidity of REITs listed on major stock exchanges converts real estate investing into a simple and straightforward operation.
By the provision of real-time pricing and valuations, REITs also provide market transparency for investors.
How do REITs work?
Once a fund successfully achieves the qualification of a REIT, investors can buy shares in a variety of ways. The REIT pools this assimilated capital in order to make a great variety of real estate investments. Investments can include the REITs direct ownership of the real estate, real estate loans, or both.
REITs can be classified into three broad manners:
- By means of the types of investments they pursue (i.e. equity or debt).
- Howe their shares are traded (i.e. exchange-traded REITs or non-listed REITs).
- The sectors of real estate that they place a focus on (i.e. healthcare REITs or industrial REITs).
Each of REIT's represents partial ownership of every one of the individual assets held by the fund. Therefore, any fluctuation in the valuation of a REIT's shares reflects a change in the value of the overall collection of real estate properties the REIT holds. REITs are professionally managed by fund managers, who determine and execute the REIT's investment strategy.
Earlier, we established that one way to classify REITs is based on the financial structures of their underlying holdings: debt, equity, or a hybrid of both.
An equity REIT is one that participates in the direct ownership (and subsequently, the development and operation) of the real estate assets that it owns; these can include commercial real estate or for-sale housing. Equity REIT managers construct their investment strategies based on how much physical work and capitalization they deduce to be required to raise investment properties to their highest value and potential for producing income.
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Originally published 25 August 2020.
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.