Many financial experts recommend having some of your investment portfolio in real estate. For most individuals that would only include their home, as buying an investment property is either out of the range of the average individual, or isn’t something the average investor wishes to deal with. Thankfully, there are other options that allow the average investor to get some exposure in the real estate market without having to manage a rental property or sink a large portion of their portfolio into one investment.
A Real Estate Investment Trust (REIT) is similar in some ways to a mutual fund. Where a mutual fund allows a number of investors to pool their resources to purchase stocks, investors working with a REIT pool their resources to invest in the real estate market. This allows the average investor to maintain a small portion of their portfolio in real estate and still have a diversified real estate holding. Anyone interested in adding real estate to their portfolio should familiarize him or herself with REITs and the advantages and disadvantages associated with this type of investment.
What Are Real Estate Investment Trusts (REITs)?
To put it simply, a REIT is a corporation that invests in a variety of real estate assets while enjoying preferential tax treatment from the IRS (corporate income taxes are substantially reduced or even eliminated). Most REITs focus on a specific area of real estate such as properties or mortgages. REITs make it possible for individual investors to own shares of large scale real estate assets without spending millions of dollars.
How REITs are bought and sold. REITs are bought and sold similar to stocks on the major exchanges. You can purchase them through most online brokerage firms and through mutual fund houses and other brokerages.
What conditions qualify a corporation as a REIT?
To qualify as a REIT, the corporation must distribute to its shareholders at least 90% of its annual taxable income. In addition, the following conditions must be met each year:
- At least 75% of assets must be invested in real estate, shares in other REITs, government securities, cash or mortgage loans.
- At least 75% of gross income must come from mortgage interest, rents or gains from the sale of real property
- A minimum of 100 shareholders with less than 50% of outstanding shares held by five or fewer shareholders.
- Must have transferable shares or transferable certificates of interest.
When all of these conditions are met, corporate income taxes are reduced or eliminated. (There more conditions which must be met, but they are more academic in nature and don’t really apply to individual investors).
Benefits of REIT
By investing in a REIT, investors benefit in many ways, but the two most important are making real estate investments accessible to virtually anyone, and investors don’t have to perform any property management. Let’s look at these two benefits individually:
- Accessibility of real estate as an investment. An individual would need to invest millions of dollars in real estate to have a diversified portfolio, which is out of the reach of most individual investors. REITs offer an average investor to buy into a diversified real estate portfolio for much less than they would be able to on their own.
- Management. Unlike a landlord who is directly responsible for rental property, the REIT is managed by a professional real estate team. These individuals handle all aspects of the industry.
Drawbacks of REIT
As with other investments, there are drawbacks to consider before investing in a REIT. The first is the obvious – the last few years have proved that real estate is not a guaranteed investment and it is possible to loss a substantial amount of money in the real estate market. Another disadvantage of REITs is that in most cases, a single REIT concentrates on a specific kind of real estate (usually either properties or mortgages) in a specific geographic location or area. This means investors may need to invest in several different REITs to get the benefit of true diversification.
REITs as an investment option
REITs are a popular investment option for individuals interested in getting a piece of the real estate pie without the risk and hassle of privately owned real estate. Investors who would otherwise be unable to invest in large real estate projects can do so through a REIT with a much smaller investment. Due to the very specialized nature of an individual REIT, it may be best for investors to buy shares of several different REITs to ensure diversification. You also want to ensure that REITs don’t make up too much of your portfolio. Real Estate Investment Trusts are often considered an ideal investment strategy for individuals looking for a fairly predictable stream of income while maintaining the freedom to get in or out of the investment with relative ease.