Discover what Real Estate Investment Trusts (REITs) are and whether or not they are good for you to invest in. Plus, learn the pros and cons, advantages and disadvantages of investing in Real Estate Investment Trusts (REITs) versus actual commercial properties.
What is a Real Estate Investment Trust (REIT)?
A Real Estate Investment Trust is a company that owns and manages income producing commercial real estate such as apartment buildings, self-storage facilities, office buildings, shopping centers, and industrial buildings or even commercial real estate mortgages. There are both publicly traded REITs and unregistered, private REITs.
How Do Real Estate Investment Trusts (REITs) Work?
REIT are basically dividend paying commercial real estate mutual funds. When you invest in a Real Estate Investment Trust, you are buying shares of a company that owns a real estate portfolio. Much like a mutual fund, money is pooled together in order for a fund manager to acquire and manage cash flow producing commercial property. The money that investors pay into a REIT is used for down payments and renovation expenses to acquire more real estate. The SEC requires that 90% of net cash flow generated by the REIT must be disbursed to the shareholders so some REITs are considered income producing securities. However, some REITs focus on buying distressed commercial property and therefore generate less cash flow but gain in value. There is no set time for a REIT to end, but when the properties in the portfolio are sold, the REIT distributes the equity to the shareholders and it ends.
The 75-75-90 Rule
To qualify as a REIT, a company must follow the 75-75-90 Rule:
- A REIT is required to invest 75% of its assets in real estate.
- Must derive 75% of the gross income from the real estate itself. It can be rental income, mortgages, or the sale of the property.
- Must pay a minimum of 90% of their taxable income in the form of a shareholder dividend.
4 Advantages of Investing in REITs
1. Passive: You don't need to do any work as a REIT investor. As a shareholder, your involvement is completely passive. This makes a REIT attractive to those who don't want to actively be involved in commercial real estate investing. Although this is both a pro and a con, as you will soon see.
2. Liquid: REITs are a liquid investments because if you want out, you can sell your shares and get your money back. When you own a commercial property, you don’t have that level of liquidity. To get your money out, you would have to refinance or sell the property. However, this liquidity has a drawback too, as you're about to learn.
3. Diversification: REITs are typically diversified across an entire portfolio of properties, rather than just one property. But this can also be disadvantage, since diversification can be investor ignorance too.
4. Decent Returns: REITs can produce decent returns depending on the type of REITs and where we are in the economic cycle and economy. Reit.com is a good resource to see dividend yields and to get a sense of recent trends.
5 Disadvantages to Investing in REITs
1. Volatile: Shares in REITS are subject to the same erratic market fluctuations as all other publicly traded stocks. Therefore, the trade off of having liquidity is that the value of your REIT shares can change dramatically based on the public sentiment.
2. Impacted By Interest Rates and Inflation: All investors are being impacted by rising interest rates and inflation and REITs are no exception. Commercial real estate investors are paying higher interest rates on conventional loans which means our returns are lower than they were two or three years ago. REITs are also affected by the interest rates. When interest rates were lower, the dividends were higher. Now that interests rates are high, the returns are lower. And REIT investments are also subject to inflation. Property taxes, insurance, utilities, and labor cost have increased which impacts the income of all real estate holdings.
3. Tax Treatment: Since REIT dividends are paid out like income there are no write-offs on taxes to investors. One way around paying taxes on every dividend is to invest it from a 401(k), IRA, or maybe a 403(b). Talk to your tax advisor about how to avoid or defer paying taxes on your dividends from your REITs.
4. High Fees: When you invest in a REIT you pay high fees for property management of the asset and transactional costs. This is how they make their money, so you need to pay attention to the cost of these fees.
5. No Control: The trade off for being a passive investor is that you have no control over the performance of the REIT. You are putting all of your trust in a fund manager who may or may not have aligned incentives with you.
Real Estate Investment Trusts vs Multifamily Investing
How does investing in a REIT compare to multifamily investing?
Start Up Capital: Purchasing a small 12-unit apartment requires more capital than investing in a REIT. To purchase a commercial property from a lender you need a down payment of 25%. Whereas with a REIT, you can invest as little as $1,000 to get started.
Qualifying for a Loan: When you purchase a commercial property like multifamily, to get financing the lender will check your credit, net worth, and qualify the property. Typically with a REIT there is no credit check, although some REITs do require your income and net worth. And there’s no property to inspect or financials to approve.
Creative Financing Commercial Real Estate
Although these two financing hurdles make investing in REITs appealing, there are creative financing techniques that enable you to do deals when traditional commercial real estate financing isn't an option. You can structure your deals using creative financing strategies like a Master Lease, Seller Carry, Sale Leaseback, or Seller Equity Participation. These techniques will allow you to purchase commercial property when you can't qualify for a traditional loan, you don’t have all the money for the down payment, or a property is distressed.
Asset Management: When you purchase multifamily real estate, you need to manage that asset by improving the property management and property to maximize the Net Operating Income (NOI). That means you need to find a good property manager. And even though hiring a really good property manager is important, as the owner, you still need to manage the manager. Because investing in a REIT is passive, you don’t have any landlord or accounting duties, but you also don’t have control over the management and implementing ways to improve performance and increase cash flow.
Tax Benefits: Again, for REITs there are no tax benefits for investors because the dividend from a REIT is treated like income. On the other hand, when you purchase a commercial property there are huge tax benefits. Also, as a real estate professional you have a powerful tax saving tool: cost segregation. I have a video calledCost Segregation Made Simple that explains how cost segregation allows you to accelerate the amount of depreciation you can claim on your taxes in the first few years you own the property. Simply put, it adds up all the parts of the apartment building, from appliances to draperies (even if they were there when you purchased the building), and instead of writing them off over 27 and a half years, you can write them off over 5 years.
Exit Strategy: There are only two ways you can get your money out of a REIT. You can either wait until the REIT ends (the fund sells the properties), or you can just withdraw your money and zero out your balance.
Commercial real estate investors have multiple exit strategies:
- Maximize the value then flip the property for a profit and pay the taxes.
- Hold long term for cash flow
- Do a cash out refinance, pull the money out to invest in another property or make improvements, and hold the property long term for cash flow.
- Sell the property and trade up into another property using a 1031 Tax Deferred Exchange. This is an effective strategy to build your commercial real estate portfolio and defer capital gains tax.
Potential Returns
Risk/Benefit Analysis: Which is riskier, investing in a REIT or buying your own commercial property? Well, REITs are not risk free. Any commercial real estate investment has risks. What if the interest rates go through the roof and they can't refinance the property and they default? Fluctuations in the market have caused office REITS to underperform. And bank failures are also a risk factor and have caused REITs to disappoint, if not fail.
That said, investing in a 12-unit apartment building has it’s own risks, although smart investors implement systems that help to mitigate those risks. For example, instead of personally guaranteeing a loan, you can get a non-recourse loan which is available for commercial real estate. But ultimately as a property owner you are personally responsible for structuring and funding the deal, operating the property, meeting with management, keeping track of the bookkeeping, and implementing value-add strategies. You can’t off load the responsibilities onto someone else.
Both have their advantages and risks, but which has more potential? Although with a REIT there is less risk, there is also less potential for growth. The returns are anywhere from 2% to 10%, depending on how well the REIT is performing. On the other hand, commercial real estate investing can give you ten times the returns. Through our mentorship, some of our mentees have achieved up to 100% returns investing in multifamily real estate!
Which is best for you? Do you prefer the passive income of a REIT, or investing in your own commercial property where you control the asset and benefit from the tax benefits and depreciation?
