Finance Basics

Real Estate Investment Trusts (REITs) – A Primer

Real estate is considered by many to be an essential part of any balanced investment portfolio. Why? Well, although far from perfect, there is somewhat of an inverse correlation between stocks and real estate. So when stock process slide, real estate often goes up giving us some protection from market downturns. Also real estate provides both income (e.g. rent) and capital appreciation; yet, most of us have no idea how to get started. Although seasoned investors get involved with investment partnerships and even the exciting new world of real estate crowdfunding (which will cover at a later date) for most of us, real estate investing means owning shares in a real estate investment trusts (REITs).

REITs came into existence in 1960 when congress created them as an amendment to the Cigar Excise Tax Extension (because that makes sense!). Essentially, a REIT is like a mutual fund. Remember, a mutual fund pools money from many different investors by selling shares and uses the funds to purchase a basket full of stocks and / or bonds. The fact that many stocks are held by the fund –in theory – minimizes the risk to the individual investor. A REIT is similar in that it allows individuals to invest a small amount and buy shares in an organization that in turn owns large income earning commercial real estate portfolios. Most REITs focus on narrow sectors of the commercial real estate market such as shopping malls, apartment complexes, office buildings or healthcare. Many times these funds will focus not only on a specific sector but a geographic are as well.  So a REIT might focus on sopping malls in the northeast or apartment buildings in Texas.

Because of their unique structure, the Securities and Exchange Commission (SEC) requires that REITs follow 2 important guidelines. First, the REIT must have the bulk of its assets and income connected to real estate investment (70% minimum). Secondly, they must distribute at least 90% of its taxable income to shareholders each year in the form of dividends. By following these two important guidelines REITs essentially avoid income tax and are therefore able to pass a greater amount to their revenue shareholders (also called unitholders). Historically, this was critically important to investors that own these shares. Let me explain.  When a stock, bond or mutual fund pays a dividend, in most cases the recipient of that dividend pays a capital gains tax, which is much lower than income tax -20%, 15%, or 0% depending on your tax bracket. This is because the money was already taxed when the corporation earned it and the investor receives them as “qualified dividends.” With a REIT, the dividends were never taxed when earned by the corporation so often these are considered “ordinary dividends” and the individual must pay taxes on the money at the individual investor’s current income tax rate. (note that some REIT distributions are considered capital gains or even return of capital – so its complicated).This is why many investors kept REITs in the tax-privileged accounts (IRA, 401K, etc) so as to avoid paying so much of the income at income tax rates. In 2018 an important but somewhat overlooked part of the new tax code allows for a 20% deduction on all pass-through businesses like REITs. So, for example, assume you earned $100,000 a year and you received $1,000 in REIT income. Under the old tax code you would owe 28% (2017 tax bracket) of $1,000 or $280 in tax. Under the new regulations you would owe 24% (new tax bracket) of $800 ($1,000 – 20% deduction) or $192 in taxes. That can add up to a lot of tax savings! Note, this is still more than if REITs were considered “qualified dividends.” In that case you would pay only $150; however, someone has to pay the tax on this income. Also note that REITs can

Why would we want to own a REIT if they are relatively tax inefficient? Well for starters, REITs are relatively low risk investments that provide both income and capital appreciation. According to one source, from 1977 until 2010, REITs on average returned over 12% per year, which is a darn good return. Like the property they own, there a (somewhat) inverse correlation between stocks and REITs. So as stock prices go down, REITs often remain stable or go up. Lastly, an active market means REITs are highly liquid when compared to owning actual property. Try selling someone 1/10,000 ownership in a shopping mall in Arlington TX, it might take a while to find a buyer. Not so for a shares in a REIT that owns the same thing.

REITS are not with out risk.  For example, interest rates are a big one. As interest rates climb, the cost of borrowing goes up, profitability and value go down. There are also sector specific risks. For example, a REIT that specializes in hotels might get hard hit in a recession as rooms go unrented and the possibility of default looms.

How can you get involved with REITs? For some it means calling an investment professional or using an App as REITs are listed on majorexchanges, just like stocks. Before you do, you will want to read this excellent article on evaluating REITs. While I’m always skeptical of “top ten investment lists”, the ones on this list are at least worth looking at (maybe).

For many of us, the easiest and least risky way of diversifying with real estate would be to buy shares in a REIT mutual fund. These funds own shares in a basket of REITs, which, in theory, minimizes risk and this might be the best place for the nubie to start. There is no shortage of top ten lists for this category either. They are a good place to start your investigation. Lastly, at least one advisor thinks that this Vanguard REIT fund is worth looking at. Anyone who knows me knows I always think Vanguard is worth look! And of course, before buying anything, you should consider speaking to an investment professional (that’s not a broker).

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