REIT stands for Real Estate Investment Trust, a form of corporation that allows large numbers of investors to make large real estate investments that they couldn’t make individually, in a way that avoids corporate tax.
You buy and sell shares in REITs as you would common stock. So one of the differences, one of the advantages, of investing in REITs compared to buying real estate directly is liquidity. You can get in and out of REITs as easily as buying and selling stock, whereas buying and selling real estate is a much more grueling, complicated process that can take an indefinite amount of time.
The assets of a REIT consist primarily of real property, interests in other real estate companies, and mortgages. A REIT’s profit comes from collecting rent, buying and selling property, the appreciation of value of real estate companies, and borrowing money at lower interest rates to buy mortgages with higher interest rates.
Specifically, in order for a corporation to qualify as a REIT and avoid having to pay corporate income tax, it must meet the following conditions:
* It is not a financial institution or insurance company.
* It has at least 100 shareholders.
* No more than 50% of its shares are held by five or fewer shareholders during the last half of the tax year.
* At least 75% of its gross income is derived from property income.
* At least 95% of its gross income is derived from property income, dividends, and interest.
* At least 75% of its total assets are in real estate.
* At least 90% of its income is distributed as dividends to shareholders each year.
Though fulfilling all these conditions means the corporation is not subject to corporate tax, the individual investors must still pay their usual taxes on the income they derive from the REIT.
The overwhelming majority of REITs are equity REITs with an emphasis on investments in real property that provide rental income. About 10% are mortgage REITs that participate in the secondary market in mortgages. (This is the market that came under fire when real estate prices collapsed. Bundled mortgages of dubious and uncertain value were being traded back and forth, and whoever was left holding the bag when all the foreclosures hit was in big trouble, while everyone else had made a tidy profit.) An even smaller number of REITs are hybrids, with substantial equity and mortgage investments.
Historically, REITs have been seen as valuable diversification and hedges in that they tended to do especially well when the stock market struggled and not as well when the stock market was strong. This does not always hold true, however. The financial collapse of 2008 saw stock, bond, and real estate values all tumble, and the recovery since then has seen each of them moving back upward to varying degrees.
Because REITs must distribute so much of their income each year to shareholders, they are attractive to investors looking for a steady and generous dividend income. On the other hand, their value tends to be quite volatile compared to many more conservative investments, due to fluctuations in real estate values, interest rates, and foreclosures.
Sources:
David Harper, “What are REITs?” Investopedia.
Lee Ann Obringer, “How REITs Work.” How Stuff Works.
Henry W. Schacht, “Why Investors Should be Fearful of REITs, Despite Their Relatively High Dividend Yields.” Seeking Alpha.