Imagine wanting something so desperately, but you cannot afford it. Well, that was the case of small scale investors more than half a century ago when they could only watch as the wealthy individuals invested in the real estate industry. Things changed in 1960 when real estate investments began operating as trusts, thus the rise of Real Estate Investment Trust (REITs). REITs are described as investment vehicles which facilitate collective investment in the real estate industry. Investors who buy shares in the trusts are the beneficiaries, and they earn income from the investments made by the trust. They are a great way to get passive income and are increasingly becoming popular. So if you are interested in investing in one, get to learn more about the history of REITs and the advantages you can accrue from it.
The Launching of REITs
In the mid-19th century, the industrial revolution resulted in the creation of business trusts in Massachusetts. The wealthy individuals who were interested in investing in the real estate used large financial intermediaries. However, it was unfair because it locked out the small-scale investors who wanted to have a piece of the real estate pie. Luckily, the unequal opportunity in the market came to an end when on September 14, 1960, President Dwight Eisenhower signed legislation allowing real estate investment trusts to be created. The concept was borrowed from business trusts such that the REITs were under equity ownership, meaning that investors could own shares in the trust and benefit from the profits; the same way company shareholders do.
In 1961, the first REIT was established in the United States, but by then they were run as mortgage REITs because the government did not permit the assets to be owned and managed by the same entity. Mortgage REITs remained the main types of REITs from 1965 to 1975, but in 1970, a different kind of REIT was launched –the healthcare REIT. The Tax Reform Act of 1976 helped fasten the evolution of REITs because it authorized REITs not only to be operated as business trusts but also as corporations. The real difference in how they worked was, however, facilitated by the Tax Reform Act of 1986, which allowed ownership and management of the assets to be under the same entity.
Growth of REITs in the United States
In the 1980s, investors sought tax shelters extended to limited partnerships. Consequently, the real estate market experienced inflation. By then too many properties had been built therefore the inflation and excessive supply led to a decline in the values of assets, but it was to the advantage of REITs because then they could buy lots of properties at low prices. REITs, therefore, experienced a market boom such that by the early 1990s they had already recovered from the poor market conditions they had undergone earlier.
With the green light for REITs to operate as corporations, the trusts changed from private entities to public companies, and in 1991, Kim Realty became the first one to go public. It was soon followed by Simon Property when in 1993 it raised $839.9 million; the largest amount from an IPO in those days. The REITs became more acceptable to investors resulting in growth. In 1994, the REIT market had a market capitalization of $44 billion which had grown to $938 billion by 2016. Today, the United States has over 200 listed REITs. The largest REIT globally is American Tower which has a market capitalization of $102.3 billion; second place goes to Crown Castle International with $58.9 billion while Prologis holds the third position with $56.6 billion.
Global Growth of REITs
After the United States introduced REITs, the second market to adopt it was Australia, where the first property trust to be listed was in 1971. Canada waited until 1993 while the U.K. delayed until 2007. In Africa, the first country to implement it was Ghana in 1994 by The Home Finance Company. The REITs are gaining pace globally and today, the market capitalization stands at $1.7 trillion. The report says that since 2013, seven countries that include Kenya, South Africa, Saudi Arabia, India, Vietnam, Bahrain and Ireland have implemented REITs.
However, despite REITs being in 37 countries, they are classified under different levels of maturity. The last entrants are considered to be nascent meaning that they are in their formative stages. However, South Africa and Ireland may have joined in the last seven years, but are developing at a fast rate since they are now in the emerging stage, along with other countries like Italy and Malaysia. Australia and Canada are among the established markets of course since they implemented it much earlier than the rest; others in this stage are the U.K., Japan and Singapore. As expected, the only market in its mature stage is the United States.
How Do REITs Make Money for Investors?
U.S. News describes REITs as big landlords. They operate by pooling together the investors’ money which is then used to own property. The company leases the real estate property to tenants who pay rent. In the case of getting income from rent, such REITS are referred to as equity REITs. Rent, in this case, can be from individuals, business or organization. The rent collected is then used to meet the operating expenses, and any surplus is considered the net operating income from which the investors are paid dividends. By owning shares in REITs, you indirectly become a landlord, receiving rent without having to stress yourself with the details of maintaining your property. Your peace of mind is all in the fact that the REITs are in the hands of expert money managers who understand the real estate market better than you.
REITs can also make debt investments by loaning the money out, and the income derived from the loan interest payments is distributed to investors. Since investors own shares in a REIT, sometimes they may not receive cash dividends. REITs own property which can increase in value, causing the value of shares to appreciate. On the other hand, if property invested in decreases in value, the shares will depreciate. In the case of appreciation of shares, investors can only benefit if they sell their shares. However, REITs can sell the property and distribute the income as part of dividends which an investor considers a capital gain.
What Qualifications must REITs Meet?
For a company to be classified as a REIT, it must meet specific criteria. First of all, it must be a pass-through entity meaning that it passes the responsibility of paying tax to its shareholders. REITs must distribute 90% of their income to the shareholders each year; therefore, they do not have to pay state income tax or federal corporate tax. If it operates at a loss, that loss cannot be passed over to the shareholders. This requirement is under dividend distributions according to Market Realist, which adds that if the REIT retains income, it must pay taxes like any other corporation.
Additionally, A REIT must invest 75% of its assets in real estate while 75% of gross income must also be derived from real estate related sources. An extra 20% of the gross income should be from real estate sources or interest and dividends from non-real estate source. The total of 95% is referred to as the 95-per cent income test which a corporation must pass. Non-qualifying sources should never go beyond 5% of REITs income while the stock value of Taxable REIT Subsidiary should not be above 25% of the REIT’s asset.
Regarding organization requirements, a REIT must be managed by a board of trustees or directors. It should have fully transferable shares, and shareholders must be at least 100, beginning from the second year of operation. In the last half of a taxable year, at most, 50% of its shares should not be held by five or fewer shareholders. Finally, it should be structured as a business trust or corporation.
Why You Should Consider Investing in REITs
The main reason we invest is to get some passive income. In the case of REITs, as discussed above, you not only have the advantage of earning dividends through distributions, you can also sell your appreciated shares for capital gain. The best thing about investing in REITs is that they must pay out at least 90% of the income as dividends which translates to more dividends compared to other investments where companies can forego paying out dividends to reinvest income to promote growth.
We have seen how much selling property can be challenging, considering that some houses take decades to find a buyer, yet you will still be incurring costs such as maintenance. Besides, you will be actively looking for a buyer, which can strain you. With REITs, such headaches become a thing of the past since the money managers left in charge do the heavy lifting for you. All you have to do is to wait for the financial year-end to have dividends deposited in your account.
Diversifying Your Income
According to Debt –Free Doctor, REITs provide a means of diversifying your portfolio by offering an asset class to act as a counterweight to bonds and equities. The correlation between REITs and other stocks is estimated at 55%. Any correlation between two assets below 100% irons out any changes in the value of the entire portfolio. The reason for this correlation is because real estate and other stocks have different cycles. While other stocks have cycles lasting four years, the real estate cycle can go up to 18 years. Therefore, during a recession, the value of other stocks depreciate, but those invested in real estate are not affected; thus, you do not experience a hit on your portfolio.
Looking for quick cash by investing in property is never a good idea because property takes a long time to sell; hence real estate is always described as a long-term investment. However, REITs enable those who want to invest in the industry but still get quick returns a chance. Since shares in REITs are traded in the stock exchange, you can sell and buy fast.
Low Minimum Investment
The main aim of the establishment of REITs was to offer small scale investors a chance to invest in real estate, which had, for a long time, been left to the wealthy individuals. Even today, you do not need to have a particular net worth for you to be a shareholder. However, the lack of minimum amount is mainly for publicly-traded REITs; those who prefer private traded REITS will usually have to invest at least between $10,000 and $25,000 as the minimum.
REITs Have Their Drawbacks
How Stuff Works explains that between the 1880s and 1930, trusts were not taxed at both corporate and individual levels because that would constitute double taxation. However, in 1930, things changed, and passive investments began being taxed at both levels. Fortunately, with the 1960 legislation by President Eisenhower, the double taxation was eliminated. However, that means even if they are not taxed at the corporate level, REITs dividends are taxed at individual levels. Thus, as an investor, you are at a disadvantage because the rate for REITs is above that of qualified dividends.
Some are Sensitive
Although we talked about REITs offering diversification due to their longer cycle, you should note that not all of them afford you that advantage. Since property invested in varies, REITs that own hotels are at a higher risk of recession than others. Therefore, before investing in any REITs, do your homework and find out which type of commercial property the trust invests in to cushion your portfolio against market fluctuations during a recession.
REITs may grant you high liquidity, but they also charge you high fees during trading, which you must pay upfront. The charges range between 20 and 30% of the REIT value, which can translate to quite a significant amount which reduces the returns you were seeking.
Written by Allen Lee
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