What are Real Estate Investment Trusts and How Do They Work?

When it comes to real estate investments, you'll see a lot of people talking about REITs, or real estate investment trusts. Some people call them "real estate investment stock."

There are a lot of advantages to REITS (pronounced like the word "treats"), but if you're new to investing, you may not know what they are. We're going to take a look at how REITs work, how they make you money, how you join one and how you analyze their performance.

How Do REITs Work?

REITs were first introduced in 1960. Congress wanted to make commercial real estate investments more accessible to the average investor. To accomplish this, they created the REIT model of investing, which allows you to purchase equity.

REITs allow you to invest in real estate without having to deal with all of the headaches that come along with owning property.

For the average investor, commercial property is typically way out of reach financially. Essentially, a real estate investment trust allows you to pool your money with other investors to invest in large-scale commercial real estate projects.

REITs are comprised of corporations that own and manage a portfolio of mortgages and real estate properties. Any investor can purchase shares in publicly-traded REITs, which makes them very similar to stocks.

The nice thing about buying shares in an REIT is that you can sell them quickly and easily. That's something that can't be done when purchasing actual real estate. You also take on less risk when investing in REITS because they contain a portfolio of properties. In other words, you're not putting all of your eggs into one basket.

In order for a company to qualify as an REIT, they must distribute at least 90% of their taxable income to investors every year. Most pay out 100% of their taxable income.

REITs are pass-through entities, which means they pass the responsibility of paying federal or state income tax to shareholders. In order to qualify as a pass-through entity, these companies deduct dividends from their corporate taxable income.

In addition to distributing their taxable income to shareholders, REITs must:

• Offer fully transferable shares
• Be structured as a business trust, corporation or another similar entity
• Have a minimum of 100 shareholders
• Have a board of directors or trustees
• Have at least 75 % of their total investments in real estate
• No more than 50% of their shares can be held by five or fewer people
• Obtain at least 75% of their income from mortgage interest or rent

A minimum of 95% of the REIT's gross income must be derived from financial investments, which can include dividends, rent, capital gains and interest. A minimum of 75% of the REIT's income must derive from real estate sources.

REITs have boards of directors, which usually include real estate professionals. These professionals are responsible for hiring management and choosing the investments.

How Do You REITs Make You Money?

To understand how REITs make you money, you have to understand the three types of REITs available.

3 Types of REITs

1. Mortgage

A Mortgage REIT loans money for mortgages, or for purchasing mortgages or mortgage-backed securities. These REITs generate revenue through interest earned on mortgages, and they are more vulnerable to changes in interest rates.

Mortgage REITs are ideal investments when interest rates are expected to drop.

2. Equity

As its name implies, Equity REITs purchase and manage real estate properties, which generate income for the company. These properties are typically commercial in nature, and might include office buildings, malls and apartments.

With Equity REITs, properties are developed and operated as part of the company's portfolio instead of being resold.

If you're looking for a long-term investment, Equity is the best option because you will earn dividends from rental properties and capital gains when properties are sold.

3. Hybrid

Hybrid REITs are a mixture of Mortgage and Equity. Property is owned and loans are distributed. These REITs generate income through both rent and interest.

How Do You Join and Earn from an REIT?

Anyone can purchase shares in an REIT.

Real estate investment trusts can be either open-ended or closed-end. With closed-end REITs, shares are issued to the public once. Additional shares can only be distributed if shareholders approve of the action. An open-ended REIT can issue shares anytime.

When it comes to joining an REIT, you can either choose to purchase private, publicly-traded or non-exchange traded.

A publicly-traded REIT will be registered with the SEC and traded on major stock exchanges. These types of REITs are the easiest to join because they're easily accessible. And because they're traded on the exchanges every day, shares can be bought or sold quickly.

Private REITs are not registered with the SEC. Equity is raised from trusts, individuals and entities accredited under securities laws. Regulation is sparse.

A non-exchange traded REIT is registered with the SEC, but isn't traded on a public exchange. Private sponsors market these REITs to investors.

As an investor, you earn from an REIT through dividend income and in some cases, share value appreciation. Depending on the annual earnings and distribution policy, some of the income you receive may be considered a nontaxable return of capital.

How Do You Analyze an REIT's Performance?

Let's say you've decided to invest in an REIT. How can you analyze its performance to determine whether it's a good investment?

When evaluating each REIT, take a look at the potential for revenue growth, like related service income, rent and FFO (funds from operations).

FFO is calculated by adding or deducting from net income losses or gains from: the sale property, depreciation, joint ventures and unconsolidated partnerships. Simply put, FFO measures the operating cash flow produced by its properties minus the financing and administrative costs.

To get a true FFO, you'll need to read the company's quarterly report and any additional disclosures.

Ideally, you want an REIT that has a unique strategy for raising rent and improving its occupancy rates. Acquisitions are another way to spur growth if the REIT has difficulty improving occupancy rates or increasing rent.

Also, take a look at the balance sheet. Consider leverage and the ratio of fixed to floating-rate debt. REITs that use floating-rate debt are more vulnerable to interest rate changes.

REITs are a great way to diversify your portfolio and dabble in real estate without having to own or manage any property. But it's important to note that because these companies are pass-through entities, you won't be able to take advantage of the 15% dividend tax rate established in 2003. In other words, you will need to pay taxes at individual income rates – as high as 35%. When shares are sold, nontaxable distributions are then taxed as capital gains.

When choosing an REIT, it's better to aim for diversity to minimize vulnerability. If the REIT focuses on one geographic area or one type of commercial development, it may be more vulnerable to downturns. Do your research and start investing slowly to get first-hand experience with this investment vehicle. It's one thing to read about it, and another to take the dive and start investing. But if you're looking to take advantage of real estate investing without having to make a huge investment or manage properties. REITs may be a good fit for you.