What are real estate investment trusts (REITs) and how do they work?


What are real estate investment trusts (REITs) and how do they work?

 Real estate investment trusts (REITs) were created by congress in 1960s to give all Americans an opportunity to benefit from income producing real estates. Today, nearly 40 countries have REITs and is getting more popular day by day in different countries. If I talk about India, the first listed REIT was of the Embassy Office Park in 2019.

What are REITs and who can invest?

A common perception that people hold is that, investing in real estate is a costly affair and it is very difficult for most people due to the liquidity constraints. REITs is the one stop solution for this. They are a good alternative to owning real estate directly. Just like anyone can invest in shares, people can also invest in REITs to earn majorly two kinds of income i.e. rental income and interest income. You might wonder where the interest came from.

More often, REITs are classified into 2 categories, equity REITs and mortgage REITs. Equity REITs invest in wide range of properties including hotels, shopping centres, apartments, offices and much more. They derive most of their income from rent on those properties. Mortgage REITs also finance both residential and commercial properties. They derive most of their income from interest earned on their investments in mortgages or mortgage backed securities.

REITs can be listed publicly and traded on stock exchanges, they can also be public but non-listed and traded outside of stock exchange or they can be private companies not listed or traded within a stock exchange.

Rules drafted by Congress for the REITs:

  1. They need to be created like mutual funds just that they invest in real estate instead of stocks of companies.
  2. These organisations are to be treated as corporations.
  3. The securities under the REITs should be widely held by shareholders.
  4. Must primarily own or finance real estate (with a minimum threshold of 75%)
  5. They operate with a perspective of long term investment horizon, however they are volatile from day to day and may sometimes also have big waves in the returns chart.
  6. At least 75% of the real estate income must come from rent, interest or sale of real estate properties.
  7. REITs are required to distribute 90% if the taxable income annually to the shareholders as taxable dividends, therefore no taxes paid at the entity level.
Just like good and bad stocks. REITs also are good and bad. So try to invest in those REITs which have good properties and tenants. REITs are a good way to diversify your portfolio. They can be a good way to mitigate high risk in other investments. Be careful though, when you are investing in private REITs. You will have to incur a lot of due diligence before investing your money in them.

From a liquidity standpoint, publicly traded REITs are more liquid when compared to private ones. Also, the transparency in the investing process is more in the publicly listed REIT. This makes the fact very obvious that getting your money back may take some time in case of private REITs.

I hope you found this information useful.

Thanks for reading!

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Comment on any query you had like me to address.

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