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What is a REIT?

By Adam Gower Ph.D.

A common question that arises when investors first discover the option of investing in syndications via online crowdfunding websites is how they differ from Real Estate Investment Trusts, or REITs.

 

One of the best comparisons to a REIT is a mutual fund; specifically, an equity mutual fund.

 

With an equity mutual fund, you save yourself the trouble of having to compare and pick individual stocks by paying money to a mutual fund manager to make those decisions and who will pick out a portfolio of investments for you.

 

REITs function similarly in that they are a collection of real estate properties controlled and operated by a dedicated, professional management team into which you can invest directly.

 

In contrast to having to choose an individual property to invest in, by selecting a REIT investors can diversify their capital across a broad range of properties, and paying the management team a fee for their services, can realize passive income from real estate without any of the direct hand-on management responsibility.

 

REITs are usually structured to specialize in a particular type of real estate; from multi-family housing, to office buildings, cell-phone towers and everything in between.

 

All the investor does is to decide what kind of real estate they have an interest in, look into their brokerage account and choose what REITs specialize in that asset class and to invest in that.

 

In essence, investors buy into a portfolio of office buildings, apartment buildings, or any type of commercial real estate they deem viable.

Two large real estate buildings suggesting assets in a REIT for investment

How REITs Work

 

In short, when someone purchases a REIT, they are buying a share of the company that owns and manages income-producing property, either a single asset or more often, a portfolio of assets. The individual investor does not own an equity share in the property, but rather, in the company that owns the property – an important distinction to make. The REIT then uses these funds to continue to invest and grow their portfolios.

 

REITs will usually have predefined criteria for investing. For example, a REIT might only invest in grocery-store anchored retail centers located in New York, New Jersey and the surrounding area. Understanding the REIT’s investment parameters is important for any investor considering buying a share in the company.

 

Then, by law, the REIT must return 90% of its profits to shareholders in the form of dividends.

 

REIT shares can be easily purchased and sold, just as easily as traditional stocks. As a result, it is not uncommon for a REIT’s share price to fluctuate throughout the day as trading occurs.

What Qualifies as a REIT?

 

In order to qualify as a REIT, a company must meet the following criteria:

 

  • Real estate must comprise at least 75% of its total assets;
  • At least 75% of the company’s gross income must come from that rental portfolio, including both rents and sales of property;
  • At least 90% of taxable income earned must be returned to shareholders in the form of dividends;
  • Must have at least 100 shareholders with no more than 50% of total shares being held by five or fewer of those investors; and
  • Be structured as a taxable entity that is overseen by a board of directors or trustees.

 

For some real estate corporations seeking to obtain REIT status, the biggest barrier to overcome is the requirement to have at least 100 investors. As a result, many real estate companies will start out as management companies that later restructure as REITs.

REIT Comparison: Types of REIT

 

There are three primary types of REITs: Equity REITs, Mortgage REITs and Hybrid REITs.

 

Equity REITs are the most common form of REITs. They purchase, own and manage income-producing property such as multifamily buildings, retail centers and office parks. Equity REITs are different than other equity investments in that the companies typically purchase and hold their assets over a long time. Equity REITs are attractive to investors who want the benefit of both long-term capital gains as well as dividends in the interim.

 

Meanwhile, Mortgage REITs are companies that loan money to real estate developers. Mortgage REITs do not own real estate directly. Often, mortgage REITs will purchase existing mortgage or mortgage-backed securities. Mortgage REITs generate income through the repayment of interest owed on these loans.

 

The third type of REIT is a Hybrid REIT, which, as the name implies, is a combination of Equity and Mortgage REITs. Hybrid REITs will own real estate directly, as well as make loans (or invest in loans) to third parties.

What is a REIT: Traded vs. Untraded 

 

There are two kinds of REITS, traded and untraded.

 

Publicly traded REITs are registered with the SEC and can be bought and sold on the stock market through brokers and are subject to usual brokerage fees.

 

Different kinds of investments can be made in REITs ranging from common or preferred stock, or debt.

 

Untraded REITs are different from publicly traded REITs in that there is a lack of liquidity; once an investor places their capital, there may be no way to sell those shares.

 

That said, some non-traded REITs do have share buy-back provisions, but these programs are often offered at the discretion of the REITs management, can be rescinded at any time, and therefore cannot be counted on for liquidity.

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What is a REIT Fee?

 

One concern often expressed when it comes to REITs, as opposed to crowdfunding or similar options, is the extent to which they incur fees relative to each other.

 

For REITs the soundest comparison to make is that fees are typically going to be the same as paying a normal fee to any broker for other stock investments.

 

In non-traded REITs these fees can be substantial totally 9-10% which immediately and significantly reduces the value of the investment.

 

That said, it is difficult to compare fees associated with REIT versus those associated with crowdfunded real estate deals because crowdfunding is still in its infancy, making it harder to compare fees to something like REITs which are more established.

 

Fees in real estate crowdfunded deals can be extensive also and in both cases, investors often need to dig deep into offering documents to uncover their true extent.

REITs Advantages and Disadvantages 

 

While there will be unique circumstances for each investor and each REIT, there are a few common things to keep in mind.

 

First, REITs offer the opportunity for investors to solidify their foothold in many specialized and nontraditional types of real estate.

 

One of the largest REITs on the market, for example, specializes in owning cell towers.

 

Others include billboards, prisons, senior housing, etc.; you’d be surprised by the variety of properties represented.

 

Many of these kind of investments are otherwise unavailable to investors.

 

This also goes hand-in-hand with another advantage of REITs: helping small investors access a strong, diversified portfolio.

Liquidity Premium

 

Another factor that drives the decision to invest in a REIT is what is known as the “liquidity premium.”

 

The Liquidity Premium is the amount above the actual value of a non-liquid asset i.e. real estate, that the investor is willing to pay in return for converting that investment into a liquid asset.

 

Put another way, commercial real estate is illiquid – it can takes months to sell a building – but a share of a REIT is a liquid asset that can be bought and sold instantly.  This is a great advantage of investing in real estate through a REIT.

 

But the liquidity premium can also be seen as a disadvantage depending on who you ask.

 

Why, for example, would long term investors want to pay a liquidity premium for real estate, if they don’t actually need liquidity?

 

This is how Ben Miller, co-founder and CEO at the marketplace Fundrise puts it:

Ben_Miller_Fundrise_Liquidity_Premium

Ben_Miller_Fundrise_Liquidity_Premium This transcript may contain errors. . .

I think it did more 50 50 100 percent but it's at least 20 30.

I mean the three simple reasons is one, in a public context, you are getting daily liquidity. Right, you get liquid assets. I can guarantee you that liquidity is not free.

The building you own is not liquid.

There is no way people pay the same price for a building that's illiquid and a piece of paper that liquid. We just think about intuitively. How much more would you pay for something that was totally liquid.

A lot more than 1 percent, right; a lot more. What's interesting about this idea of this liquidity premium which is so, it's such a natural assumption people no longer see it, is clearly it's valuable. Clearly it's expensive.

I'm going to say I'm going to use a rule to say this and then we can talk about it, I'd say 20 20 percent minimum because you would say how much more would you pay for a building that's that's like would you say 20 percent for sure.

If you're talking about not liquid, the transaction costs on that piece of paper is almost zero.

The cost to sell a building is much much higher than the cost to sell a piece of paper.

It's a derivative of the building.

There's a lot of reasons why 20 30 percent or more but that's significant.

So the question I ask you is if you are going to buy something and hold it for retirement or for 5 7 year, if you're a buy and hold investor, why are you paying a liquidity premium?

Listen to the entire conversation with Ben Miller by clicking here.

REITs Behave Like Stocks

 

Another difference between investing in REITs and investing in a syndicated real estate crowdfunded deal is that REITs trade on the stock market and are subject to market volatility, whereas a direct investment in a real estate project is not.

 

With stocks, day by day, month by month, prices fluctuate.

In some cases, prices may increase or decrease more than the true value of the underlying assets due to the nature of the market - something that you wouldn’t see with actual physical properties.

 

This could lead to a sort of “double whammy” where if the market goes down, not only does your stock go down, but your dividend goes down as well.

 

We saw this play out on a massive scale in the 2009 financial crisis, with the REIT index dropping over 80% at one point.

 

Hindsight is, of course 20:20, and a lot of what happened during the financial crisis was due to panic, which drove down the values of REITs way too far.

 

For investors at the time the reality of the collapse in REIT values was exacerbated by the bear on the stock market and their ability to sell their shares super quickly.

 

While there was a drop in the underlying values of actual properties, it wasn’t responsible for the full 80% plummet.

 

Since people had the ability to sell so quickly, they used that freedom to sell faster than they needed to and this placed disproportionate downward pressure on publicly traded REIT pricing.

 

Conclusion

 

REITs offer an alternative to investing to either direct acquisition and management of real estate or investing in a syndication via a crowdfunded deal, and vary in these three distinct ways:

 

1. They can behave more like stocks than real estate in terms of pricing fluctuations

2. there is likely a liquidity premium for converting an inherently non-liquid asset (commercial real estate) into a liquid asset, and,

3. especially with non-traded REITs investors should pay close attention to REIT management fees.

If you enjoyed reading this article and would like access to more real estate investing resources, check out the links below.

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