A Commercial Real Estate Investors Guide to How REITs Work

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Key Takeaways

  • Real Estate Investment Trusts are companies that finance or own income producing real estate. They give investors the opportunity to pool resources to own a share of stock that’s underlying value is tied to the performance of the real estate owned.
  • Investors like REITs for their dividend income, strong total returns, low barriers to entry, and ability to provide access to a diverse real estate portfolio of income producing assets.
  • There are numerous types of REITs such as equity REITs, mREITs, and hybrid REITs that invest in a variety of real estate property types from self storage facilities to single family homes.
  • REIT shares can be bought and sold on publicly traded stock exchanges or through private, non-public channels.
  • REITs are often compared to a real estate syndication, which allows individuals to invest in a single property as opposed to a portfolio of them. There are risks and benefits to both approaches.
  • Any investor considering a REIT investment should carefully evaluate the details of the opportunity to determine they are a good fit for their own risk tolerance, time horizon, and return objectives.

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There are many individuals who want to invest in commercial real estate assets, but they often face two challenges. First, commercial properties are very expensive and often out of reach for all but the most well funded individual investors. Second, it takes a significant amount of time and expertise to manage a commercial property effectively, another thing an individual investor may not have. Fortunately, there is a popular solution that allows individual investors to both get the income and tax benefits of real estate ownership while lowering the financial barriers to investment – a Real Estate Investment Trust or REIT for short.

In this article, we are going to define what a REIT is, what they do, how they work, the various types available to investors, and the pros and cons of investing. By the end, investors will have the information needed to determine if a REIT investment is a good fit for their own preferences.

At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers.  If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.

What is a Real Estate Investment Trust (REIT)

A REIT is an investment company that owns, operates, or finances income producing commercial real estate assets. By definition, these companies can invest across multiple property types or specialize in one specific asset class depending on their investment strategy.

How Does a REIT Work?

REITs work by giving investors the opportunity to invest in real estate assets by buying publicly traded shares on the open market or through private investment vehicles. Each share represents a small percentage of ownership in the portfolio of real estate assets and entitles investors to their proportionate share if the income and profits it produces.

REITs of all types own a combined ~$4.5 trillion in assets in the United States of which ~$3 trillion is available through publicly traded channels while the remaining ~1.5 trillion is managed through privately traded vehicles.

REIT Assets

REITs can invest in a variety of commercial real estate assets such as office buildings, apartment buildings, retail shopping centers, industrial warehouses, healthcare facilities, data centers, hotels, infrastructure, and self-storage. Because each of these property types have their own operational quirks, REITs tend to specialize in just one or two of the aforementioned types.

REIT share ownership gives individuals the opportunity to invest in trophy real estate assets like the Empire State Building in New York by pooling their resources, which makes them a very popular investment option. To provide a sense of scale for their popularity, U.S Public REITs own an estimated 535,000 properties and 15 million acres of timberland across the country.

REIT Income

REITs produce income by leasing space to and collecting rents from tenants. This rental income is used to pay for the property’s operating expenses and anything left over is distributed to REIT shareholders in the form of regular dividends. As a result, owning shares in a REIT creates opportunities for investors to generate passive income that is traditionally less volatile than investing in other assets like stocks or bonds.

REIT Dividends

As described above, REIT income is used to pay for a property’s operating expenses and anything left over is distributed to shareholders in the form of dividends – usually monthly or quarterly.

Under IRS rules, REITs must pay out a minimum of 90% of the taxable income generated to investors. As a result, they typically come with attractive dividend yields, making them a popular choice for investors looking to generate passive income from their investment portfolio.

REIT Taxes

By definition, REITs have a tax advantaged structure because they are not taxed at the corporate level as long as they comply with a number of IRS rules. Instead, income and profits are “passed through” the REIT entity to investors, where they are taxed at the individual level. This is a tax advantage because it avoids the double taxation of a traditional corporation.

Although REITs avoid corporate taxes, investors should carefully consider their own dividend taxes before investing. More specifically, there are three main types of distributions REITs make: ordinary income, long-term capital gains, and return of capital, each of which has a specific tax treatment.

Ordinary income taxes result from any distributed funds from operations which are then taxed in correspondence with the investor’s personal income tax bracket.

Long-term capital gains occur when a REIT sells a property that it has held for over a year, and then distributes that income to shareholders. These gains are taxed at lower rates than ordinary income and range in percentages from 0% to 20% depending on the taxpayer’s income.

Lastly, a return of capital lowers the investors cost basis and is not immediately taxable. For example, if an individual invests in a REIT at $100 per share, and it distributes $2 as non-taxable return of capital, their cost basis is reduced to $98. While this form of distribution will eliminate an immediate tax for the investor, it can increase the capital gains tax when an investor sells the REIT shares in the future.

Corporation Structure

Under IRA rules, REITs must be formed as a corporation for tax purposes and shares must be transferable. In addition, they must comply with a number of rules to maintain their tax advantaged status:

  1. It must have at least 100 shareholders;
  2. Five or fewer individuals may not own more than 50% of the shares during the last half of its taxable year.
  3. They are required to mail annual letters to shareholders requesting details of beneficial ownership of shares.
  4. They must derive at least 75% of their gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate.

Due to the complexity of their organizational structure, most REITs rely on outside counsel to ensure their compliance with Securities and Exchange Commission (SEC) rules as well as those imposed by other regulatory agencies. 

Types of REITs

There are three types of REITs: equity REITs, mortgage REITs, and hybrid REITs. As described above, within each of these types, there may be property level specialization. For example, within the Equity REIT category, there could be residential REITs, healthcare REITs, retail REITs, or office REITs. 

Equity REITs

The most common type of REIT is the equity REITs, which are companies that own and manage real property. They operate like a mutual fund in that investors can purchase shares which allow them to invest in a diversified portfolio of real estate assets without the worry of day-to-day maintenance, vacancies, and property taxes.

Most revenues are generated through rents rather than the sale of property, which means that equity REITs tend to favor strong cash flow producing assets rather than targeting a long-term capital appreciation strategy. Investors can deploy capital to REIT indices as well, such as exchange traded funds (ETFs) to better diversify their portfolio holdings.

Publicly traded equity REITs tend to be a good fit for beginners because they require a low minimum investment, can easily be liquidated, and the business strategy is fairly straightforward.

Mortgage REITs

Mortgage REITs lend money to real estate owners and operators either directly or indirectly.

Direct financing occurs as the result of issuing mortgages and loans, while indirect financing occurs from the acquisition of mortgage-backed securities (MBS). Mortgage REITs essentially act as lenders and play a crucial role in providing liquidity in the real estate market.

The goal of these REITs is to earn income based on the interest charges they receive on the loans. Like an equity REIT, mREITs disperse earnings to shareholders in the form of dividends. Because mortgage REITS have a more complex business model, they tend to be a better fit for more experienced REIT investors.

Hybrid REITs

A hybrid REIT is exactly what it sounds like – a hybrid of the two options above. As such, they are structured in a way that allows investment into physical property as well as mortgages and (MBS).

Investors often choose to invest in hybrid REITs when they are unsure about what type of REIT they would like to invest in. A major benefit of hybrid REITs is their diversifiable nature while a downside is that investors have less control of what the fund invests in and how it fits into their portfolio. 

How REIT Shares Can Be Bought & Held

Shares of REITs may be acquired from several sources and the structure of the REIT affects the regulatory guidelines of the company. These structures include publicly-traded REITs, public non-traded REITs, and private REITs.

Publicly-Traded REITs

Publicly-traded REITs are registered with the SEC and must comply with their regulatory provisions. These companies are listed on major stock exchanges such as the New York Stock Exchange (NYSE) and the NASDAQ. As a result, the shares of these REITs are subject to the volatility of the stock market. and their performance information is easily accessible by the public.

Any individual may invest in a publicly traded REIT and upfront fees are usually charged by the broker at the time of purchase. Publicly traded REITs are more liquid than private, and public non-traded REITs, because the REIT shares can be traded every business day.

Public Non-Traded REITs

Public Non-Traded REITs are still subject to SEC oversight, but their shares are not traded on national stock exchanges.

Because they are registered with the SEC, performance metrics are still easily accessible by the public and public non-traded REITs are not susceptible to the price volatility of the stock exchanges which can allow managers to better focus on long-term objectives rather than short-term quarterly earnings.

Public non-traded REITs often have higher upfront fees (as large as 15% of the share price), as well as sizable investment minimums. Similar to private REITs these investments are less liquid than publicly-traded REITs although anyone that meets the investment minimums may invest. 

Private REITs

Private REITs are not registered with the SEC and thus are not subject to SEC oversight. As such, there is minimal publicly available information which makes judging performance metrics more difficult to acquire and interpret.

These REITs have the highest barriers for investment entry and are only available to accredited investors, who must either have over $1 million in net worth or make at least $200,000 annually for the past two years.

Due to the lack of SEC oversight, regulators want to ensure that only experienced investors with high disposable income invest in these REITs. Retail investors are usually subject to investment minimums ranging anywhere from $10,000 to $100,000, and upfront fees vary across companies. Similar to public non-traded REITs, these investment vehicles are less liquid than publicly-traded REITs and may require holding periods of up to ten years, during which time investor funds are illiquid.

REITs vs Real Estate Syndications

Real estate syndications are similar to REITs in that they allow investors the opportunity to pool resources to invest in real estate assets. However, real estate syndications allow investors the opportunity to invest directly in a specific property.

Recall the example above about investing in the Empire State Building. The Empire State Building is owned by the Empire State Realty Trust which is a self-managed, publicly-traded REIT, that operates a portfolio of office, multifamily, and retail properties around New York City. While investors can invest in a REIT that owns the Empire State Building, they are not only investing in the Empire State Building.

Real Estate Syndications on the other hand aggregate funds to invest in a specific property as noted above. As a result, these investments are less diverse in nature and on the higher end of the risk spectrum, but may offer higher returns for investors. In addition, real estate syndications require two groups of partners: general partners (GPs) and limited partners (LPs). General partners are often referred to as sponsors and typically underwrite and manage the property while limited partners offer their capital in return for a share of the cash flows and profits associated with the property in a passive investment strategy.

Summary of How REITs Work

Real Estate Investment Trusts are companies that finance or own income producing real estate. They give investors the opportunity to pool resources to own a share of stock that’s underlying value is tied to the performance of the real estate owned.

Investors like REITs for their dividend income, strong total returns, low barriers to entry, and ability to provide access to a diverse real estate portfolio of income producing assets.

There are numerous types of REITs such as equity REITs, mREITs, and hybrid REITs that invest in a variety of real estate property types from self storage facilities to single family homes.

REIT shares can be bought and sold on publicly traded stock exchanges or through private, non-public channels.

REITs are often compared to a real estate syndication, which allows individuals to invest in a single property as opposed to a portfolio of them. There are risks and benefits to both approaches.

Any investor considering a REIT investment should carefully evaluate the details of the opportunity to determine they are a good fit for their own risk tolerance, time horizon, and return objectives.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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