Also known as REITs, real estate investment trusts are investment vehicles that permit regular investors to benefit from income and capital gains associated with various types of real estate. Although the world of real estate investment trusts appears complex and bewildering for most first-time investors, it's far less complicated than some corners of the financial world. An outline of the history and types of real estate investment trusts follows.
A Brief History of Real Estate Investment Trusts
Investors have been able to buy shares of real estate investment trusts since the early 1960s. During the post-war real estate boom, the federal government tweaked existing tax laws to create a new class of investment that provided clear tax advantages to owners of large-scale bundles of real property. Although commercial developers, holding companies and financial funds found these vehicles to be useful, they weren't available to rank-and-file investors until the turn of the 21st century.
During the real estate boom of the new century's first decade, public companies and fund managers bundled commercial and residential properties and mortgages into trusts that threw off predictable streams of income. In the past few years, many companies have converted their real estate holdings into separate REITs that confer significant tax advantages.
What Makes a REIT?
Under federal law, REITs are required to distribute 90 percent of their income to their stakeholders. Within this overarching framework, three main types of real estate investment trusts have emerged:
- Equity REITs that manage property portfolios that produce ongoing income from rental payments and sales proceeds
- Mortgage REITs that bundle existing property loans with a combination of cash and leverage
- Hybrid REITs that combine elements of equity and mortgage trusts
Commercial and Retail Trusts
Commercial and retail trusts generally own office and retail properties that produce regular, predictable streams of rental income. Trusts that are heavily weighted in favor of office parcels tend to be more stable than trusts that derive significant amounts of income from retail rent payments. This is primarily due to the fact that retail tenants pay lower rents and are typically unwilling to agree to long-term contracts. Since retail properties tend to become outdated rather quickly, retail property managers are often forced to invest substantial sums in infrastructure upgrades.
Mortgage and Residential Trusts
These real estate investment trusts directly or indirectly earn income from mortgage and rent payments. Residential trusts typically take part or all of the rent payments that multi-unit residential tenants make from month to month. Mortgage trusts tend to take a cut from ongoing mortgage payments or sell "bundled" mortgage packages to other firms. In either case, these trusts are particularly sensitive to the health of regional housing markets.
Healthcare Trusts
Healthcare trusts own hospitals, professional buildings, outpatient clinics and other healthcare-related properties. Since they're often managed by subsidiaries of individual healthcare companies, healthcare trusts tend to be more stable than mortgage or retail trusts. Additionally, they're less sensitive to economic fluctuations.
Advantages and Drawbacks to Investing in REITs
REITs offer predictable streams of long-term income. They typically have higher yields than savings accounts, CDs and dividend stocks. What's more, many real estate investment trusts outperform the broader market on a consistent basis. However, it's important to note that the tax benefits of real estate investment trusts accrue to the managers of the underlying properties. As such, investors must pay taxes on any capital gains or cash distributions that they receive from the trusts that they own.
Final Thoughts: Results May Vary
As with any investment vehicle, the performance of an individual real estate investment trust depends heavily on sector-specific economic forces as well as broader market movements. Additionally, a trust's past performance may not be particularly useful in predicting its out-year returns. Then again, these vehicles have served investors well for years on end. If you're looking to add a relatively stable component to your existing investment portfolio, you may wish to learn more about real estate investment trusts.
