REIT: The Financial Asset Acronym that Few Indulge

Building a winning investment portfolio requires shrewd decisions. Deciding the appropriate mix between bonds and equities is hard enough. It is even harder to decide which income-producing financial assets to include in a financial portfolio to generate capital gains alongside income growth. Most of us understand the basics of dividend-paying stocks. While their capital growth is tamer than that of a pure capital-appreciating equity, such as technology, their generous dividend payouts entice a large group of investors seeking beefy income streams.

Bonds are another example of a financial asset that preserves capital while generating income streams. At the end of a bond’s life, an investor receives the bond’s face value (i.e., the principal amount loaned at the outset). Along the way, a bond investor receives coupon payments (i.e., interest). This interest amount determines the bond’s overall return. Most bond investors are more concerned with juicy payouts than capital appreciation of the underlying bond investment.

Now, let’s discuss an interesting equity class that often doesn’t get its full recognition: Real Estate Investment Trusts (REITs). A REIT is a company that owns, operates, or finances income-producing real estate. Akin to a mutual fund, a REIT is an amalgamation of real estate properties owned by a single company that allows individual investors to buy shares in large-scale real estate portfolios without having to individually purchase or manage the properties.

REITs became a thing in 1960, when then-President Eisenhower signed Public Law 86-779 into effect. This legislation, commonly referred to as the Cigar Excise Tax Extension of 1960. Previously, only wealthy individuals and institutions could access a broad portfolio of income-producing commercial real estate. This law created a new series of trusts that could allow individual investors to purchase a piece of the action.

One reason REITs have a cult following among some investors is that they must distribute 90% of their taxable income to shareholders as dividends to qualify for tax-free status at the corporate level. This steady income stream makes it a popular choice for income-starved investors seeking yield.

In addition to the 90% payout requirement, REITs also must pass two other tests: 75% of a REIT’s investments must be in real estate, cash, or U.S. Treasuries; and 75% of a REIT’s gross income must come from real estate-related sources. REITs are taxable corporations managed by a board of directors or trustees.

There are three types of REITs: equity, mortgage, and hybrid.

Most investors prefer equity REITs. Equity REITs own and manage physical properties and generate revenue primarily through rent payments. A nice benefit of equity REITs is the diversification of commercial real estate opportunities available to investors. For instance, equity REITs are available in the following sectors: industrial, retail and shopping centers, residential, data centers, healthcare, self-storage, and infrastructure/office. Each sector offers advantages and disadvantages for investors seeking a diversified REIT portfolio. Equity REITs, ETFs, and individual equities can vary significantly depending on the REITs’ portfolio construction. Investors who are seeking yield from this asset class should carefully weigh their options before making an informed decision.

More sophisticated investors can dabble in mortgage REITs or hybrid REITs. Mortgage REITs provide financing for real estate by originating or purchasing mortgages and mortgage-backed securities. These securities generate income from interest payments from the mortgages held by the trust. Hybrid REITs combine features of equity and mortgage REITs. Due to their well-diversified nature, hybrid REITs are often more volatile than equity and mortgage REITs.

Investors interested in this asset class can learn more about public REIT options through their brokerage or retirement account. Investors may want to be choosier than normal about what type of brokerage fund to purchase a REIT. Due to their unique structure, REITs’ dividend payouts are subject to a higher tax rate than qualified dividends. REIT dividends are subject to a tax rate based on an investor’s ordinary income level, which is typically much higher than a qualified dividend. Working with a qualified financial planner can help you decide if this asset class makes sense for you.

Benefits and Risks of Owning REITs