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    Offbeat Offerings: REITs

    by Cara Scatizzi

    Offbeat Offerings: REITs Splash image

    A real estate investment trust (REIT) is a corporation or trust that purchases and manages income property and/or mortgage loans. REITs were created by the U.S. Congress in 1960, with the intention of making large-scale, income-producing real estate accessible to small investors.

    REITs are similar to traditional stocks in that the securities are traded on major exchanges. However, unlike a company that manufactures, markets or distributes goods or services to customers, a REIT owns and operates income-producing real estate, such as apartments, shopping centers, offices, hotels and warehouses.

    In the early 1990s property owners turned to the public to raise capital, and REITs gained popularity. In 2001, Standard & Poor’s began including REITs in its S&P 500 index. Currently there are about 180 REITs registered with the Securities and Exchange Commission (SEC).

    How They Work

    REITs are traded on an exchange and can be purchased and sold through a broker. Shares are listed on the New York, American and NASDAQ stock exchanges as well as some over-the-counter markets. REITS must follow all of the rules of the stock exchange as well as file quarterly and annual financial statements with the SEC.

    Like publicly traded companies, the corporate officers who manage the REITs are accountable to creditors and shareholders as well as a board of directors that is elected by shareholders.

    As with traditional stocks, shareholders gain investment value in REITs in the form of share price appreciation and dividend payments. Dividends are traditionally very high because a REIT is required by law to distribute 90% of its taxable income to shareholders each year in the form of dividends. Most of the income from a REIT is from rent and other earnings that do not qualify for the lower tax rates; therefore, most of the distribution to shareholders is taxed at ordinary income tax rates.

    Types

    There are three major types of REITs:

    • Equity REITs own and operate income-producing real estate;
    • Mortgage REITs directly lend money to real estate owners and operators or indirectly acquire loans or mortgage-backed securities;
    • Hybrid REITs own both income-producing properties and make loans to owners and operators.

    How to Invest

    Shares of a REIT can be purchased through a broker. In addition, some REITs offer direct stock purchase and dividend reinvestment programs. Also, a variety of closed-end and non-exchange-traded REITs exist.

    In addition to buying individual REITs, you can also invest in a diversified portfolio of REITs through mutual funds and exchange-traded funds that focus on REITs.

    Investor Suitability

    Any investor looking to add real estate to a portfolio for diversification purposes may find REITs an attractive option. There are over 180 individual REITs to choose from and a variety of mutual funds that specialize in REITs.

    Because REITs have such high dividend payouts that are not subject to the lower qualified dividend tax rate, this investment may be better suited for a tax-sheltered account such as an IRA, a Roth IRA or a 401(k). However, some investors have found a lack of REIT investment choices available through typical 401(k) plan offerings.

    Tax Consequences

    Because REITs must distribute at least 90% of their taxable income to shareholders annually, shareholders will have to pay taxes on dividends received in any account that is not tax-sheltered. In addition, REIT dividends are taxed as ordinary income; the lower tax rates available for qualified dividends do not apply to REIT dividends.

    Distributions are allocated as ordinary income, capital gains and return of capital. Each of these distribution classifications has different tax rules and rates. The REIT will provide shareholders with a Form 1099-DIV each year detailing how the distributions have been classified for tax purposes. A return of capital distribution is not taxed as ordinary income, but reduces the shareholder’s cost basis of the investment by the amount of the distribution.

    When shares are sold, any capital gains are taxed.

    The Pros

    Portfolio Diversification

    REITs tend to have a low correlation with the stock market and can therefore add significant diversification benefits to a portfolio’s asset mix.

    Highly Liquid

    Investing in individual real estate properties has high liquidity risk because it can be difficult to sell quickly. REITs provide a means of investing in real estate, yet are traded on an exchange like stocks and therefore are highly liquid.

    Professional Real Estate Management

    A REIT provides you with professional management of a more diversified portfolio of real estate holdings than would be available to you if you invested in individual properties on your own.

    High Dividend Payments

    REITs are required by law to distribute 90% of their taxable income to shareholders each year in the form of dividends. Because income comes from a fairly stable and predictable stream of rent payments and because rental rates tend to rise during periods of inflation, the dividend payment tends to be protected from inflation.

    Low Initial Investment

    Unlike traditional real estate investments in single properties, which can have huge initial investment costs, REITs have no minimum investments. Additional investments can be made in any dollar amount and shares can be purchased as often as you like.

    SEC Regulation

    All publicly traded REITs must file quarterly and annual financial statements with the Securities and Exchange Commission; these reports are available to all investors.

    The Cons

    Risk

    REITs can be more risky than owing a typical stock index fund, such as a fund investing in the S&P 500 index. Individual REITs are highly specialized and often have erratic performance. REITs can be a good way to add diverse investments to your portfolio, but should not make up the majority of any investment portfolio.

    Taxes

    All dividend payments tend to be high, and they are not qualified for the lower qualified dividend tax rates.

    Additional Information

    National Association of Real Estate Investment Trusts

    www.nareit.com

    The National Association of Real Estate Investment Trusts (NAREIT) is the trade organization for real estate firms. The site offers performance and industry data as well as links to other helpful sites.

    Invest in REITs

    www.investinreits.com

    Sponsored by NAREIT, Invest in REITs is a free database for REIT investors. The site has a “First Time Visitor” section for new REIT investors that contains a wealth of data including frequently asked questions, a glossary of terms and a guide to REIT basics. You can also search the database for REITs by category, type, exchange, company and state. A list of mutual fund companies that offer REIT mutual funds is also provided with links to the fund company site for further information.

    A Guide to Investing in REITs

    www.aaii.com/journal

    In the November 2000 issue of the AAII Journal, Michael Grupe and Charles DiRocco discuss investing in REITs (“A Guide to Investing in Real Estate Investment Trusts”). They give a brief history of REITs, explain how REITs work in detail, and then discuss their investment risks and how to evaluate a REIT. To read, download or print the article in PDF format, choose November 2000 from the “Past Journal Issues” menu and then click on the article title.


    By Cara Scatizzi
    AAII Associate Financial Analyst


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