What is an REIT and why should you care?

REITs, or real estate investment trusts, allow you to easily invest in real estate.

This is a good tool to diversify your portfolio. Although not without risks, millions of Americans hold them through pension funds and pension accounts. If you want to enter the REIT market, here is a breakdown of what you need to know.

What is a REIT?

An REIT is a corporation that owns and (with some exceptions) income-producing real estate properties such as office buildings, shopping centers and car parks. Each share of the business distributes a certain percentage of the money that these properties report. The REIT model is built on the model of a mutual fund, with companies typically organized by category. For example, one REIT may specialize in health care, while another focuses on retail and shopping.

Unlike a development corporation, a real estate investment company derives its money from the proceeds of its assets. The company does not exist to sell the properties. On the contrary, it exploits them and collects the benefits of rent, direct payments or other forms of income generated by the property.

This also distinguishes an REIT from the shares. With equities and mutual funds, an investor typically derives profit from capital gains (the selling price of assets). Dividends, although real, are rarer.

REIT holders, on the other hand, derive most of their money from operating profits. They report these profits to investors based on the trust's accounting, many doing so every month.

Example of REITs in action

Take the case of a hypothetical REIT called Shop Co. This company focuses on retail properties in order to avoid assets such as office space, hospitals, storage units or the hotel industry. Shop Co.'s portfolio includes three storefronts rented to retail businesses. The company also owns 25% of a shopping center and three souvenir shops in New York.

The business model of Shop Co. is to exploit these different companies. Although it can develop them, it will do so to collect future profits from increased activity and not to increase the value of the property before the sale.

As a result, Shop Co. calculates its profit according to generally accepted accounting principles based on: rent paid by its retail tenants; 25% of the mall's operating profits; and the after-tax income of his gift shops. Each Shop Co. investor will receive a portion of this money, distributed on the 5th of each month.

REIT categories

There are five major classifications of REITs.

1. public

A public REIT is publicly traded. They are available to everyone and are subject to the same regulatory restrictions as any other publicly traded asset.

2. Private

Also known as non-traded REITs, these companies must be registered with the SEC (as a public fund) but are not available for public trading. Although these shares may have higher value because of their more exclusive nature, they are also much more difficult to sell and may involve far less transparency than a public REIT.

The risks to a retail investor are significant enough for the SEC to bother to clarify.

3. fairness

A public company is by far the most common type of REIT; so much so that when an investor refers to an "REIT", it almost always refers to the public equity model.

An equity trust owns and operates its properties. He gets his money from the income generated by these properties, such as rent, profits or other products.

4. Mortgage

A mortgage REIT has asset-backed debts, such as mortgages and mortgage-backed securities. Some will buy mortgages, while others will actively finance these loans themselves.

This trust derives its money from the debt payments that its properties generate, interest being the main form of profit.

5. hybrid

More rarely, a hybrid REIT holds both direct income generating properties and mortgages.

How does an REIT work?

A REIT works according to a few simple rules.

• Investors buy shares of the trust as a stock or mutual fund.

• A public trust must adhere to SEC guidelines for the disclosure and supervision of exchange-traded funds.

• The REIT must return at least 90% of its taxable income to its shareholders.

• The trust must have at least 75% of its assets in real estate, cash or cash equivalents.

• The trust must earn at least 75% of its income from real estate.

• And the REIT must have at least 100 shareholders, of which no more than half of the shares are held by five or fewer people.

These rules constitute a general principle: no cheating. An REIT can not simply call a real estate investment. The SEC allows for some diversification, but the main business of an REIT has to be real estate.

Example of REIT structure

Let's look at Shop Co. again.

This is an example of REITs of public actions in action. It is listed on the New York Stock Exchange and its share price is generally based on the opinion of investors in the retail market in Manhattan (where Shop Co. owns most of its properties).

It's an equity company because its money comes from property income and not from interest payments. It's a public company because it's traded in a market open to all buyers, not just skilled investors.

In a normal year, all profits of Shop Co. come from his property. Although she took short positions in the cotton market to cover her gift shops, the company suffered a loss on this investment almost every quarter. Otherwise, all assets of the company are in cash or real estate.

With the exception of 5% of the general expenses, the company transfers all of its income to the shareholders, who number 287. The three founders of the company hold 25% of the shares collectively. The rest is held by shareholders in general.

Benefits of an REIT

People invest in REITs for three main reasons.

1. Invest in diversity

An REIT is completely different from an action in that its profit model comes from real estate and not from the performance of the business. This often makes the value of REIT contra-cyclical with the broad, or at least unrelated, stock market and a very different type of asset in which to invest.

And it's not just that REITs add diversity to your portfolio, although they do. They are also typically diverse themselves. Built on the concept of a mutual fund, an REIT represents a set of real estate interests. This means that they are much more shock resistant because individual properties can fail without destroying the business.

2. High rates of return

REITs tend to have high rates of return relative to equities, mutual funds or other investments. A Forbes article revealed that, over 30 years, REITs' funds had an average annual rate of return of 12%, compared to the 10% of the S & P 500 index. Real estate continues to appear a good investment based on the numbers that these funds make.

3. Regularity of return

As noted above, this is not unique to this class of assets. Shares can produce and produce dividends, but rarely on a reliable basis. However, the very idea of ​​an REIT is to generate a regular income based on investments. In addition, in a healthy fund, this income increases steadily from year to year as the property appreciates.

Negative points of a REIT

So, why would not you invest in a real estate investment trust? Well, there are some good reasons for caution.

1. Private REITs and Mortgage REITs are totally different from publicly owned REITs.

Mortgage REITs generally have much higher levels of debt, with rates of return being much more sensitive to market shocks and interest rate fluctuations. Similarly, private funds can often offer higher rates of return than public equities, but they may also have much less transparency and will often use debt or operating capital to pay distributions.

Both have risk profiles that are significantly different from those of a public company.

2. REITs rely on more specialized knowledge

Any negotiation should begin with a serious search on the part of the investor. You should never go blind.

In the case of an REIT, it may be more difficult to fully understand what you are buying. This asset class is changing with the real estate market, as well as the market around which your REIT focuses (retail, foodservice, etc.). Therefore, you must understand commercial real estate to better understand the strengths and weaknesses of any offer.

It can be difficult. Real estate is a notoriously obscure market with many closed loops of information. Retail investors may have a hard time understanding fully what they are buying.

3. REITs may cause overconfidence

An REIT can actually lose money. If operating costs are lower than profits, let's assume that the storefronts of a business remain all empty for too long, trust will not fail to distribute distributions, it could even go bankrupt. (Take, for example, the extraordinary conditions of 2008, when REITs traded on the New York Stock Exchange had a negative return of 40%.)

They can also underperform the market. Although REITs have generally beaten the S & P 500 in recent decades, this is not always the case. Over the past 15 years, these funds have often been underperforming even outside the Great Recession.

As a blogger pointed out, the real estate market is getting smaller and smaller every year. With less competition between owners, REITs that appear competitive can often have many of the same managers with all the conflicts of interest that this entails.

All of this does not mean that REITs are not a smart choice for your portfolio, but rather that you take care of them. A good investment is not the same as a bulletproof.