What is a REIT?
A REIT or Real Estate Investment Trust is a company that owns or finances income-producing real estate. Created by the Real Estate Investment Trust Act of 1960, REITs allow a broad range of investors to enjoy rental income from commercial property.
To qualify as a legitimate REIT in the eyes of the law, 75 percent of the Trust’s income must be derived from rents on real property, tenant’s reimbursements for property tax abatements and refunds, interest on real estate mortgages, distributions from other REITs (yes, a REIT can invest in another REIT), gains on the sale of real estate and mortgages not held primarily for sale to customers, income from shared appreciation mortgages, commitment fees and qualified temporary investment income.
Some of the advantages of REIT investments include:
Chief among the benefits of REITs are remarkably high yields. According to Morningstar, in September of 2012 the average yield for REITs was 4.3 percent. This well outpaced the S&P 500 Index, even though yields were down from their longer-term average, which is typically in the seven to eight percent range.
Tax issues are pretty straightforward. In a nutshell, dividends are allocated to ordinary income, capital gains and return of capital. REITs are not taxed directly, which avoids double taxation. Investors are taxed at their individual rate for the ordinary income portion of the dividend. Capital gains only come into play if the Trust sells assets at a profit. Return of capital is applied to reduce the shareholders cost basis in the stock. When shares are sold, the difference between the share price and reduced tax basis is taxed as a capital gain.
REIT shares are bought and sold on a stock exchange. This makes shares considerably more liquid than actually owning property. Additionally, buying and selling property involves considerably higher expenses and requires a lot more effort than simply buying and selling shares of a trust.
On the other hand, there are some drawbacks to consider:
Rising interest rates tend to make other investments more attractive, which draws investors out of REITs into instruments like Treasury Securities. When investors sell to move into more attractive investments, share prices take a hit.
REITs, as holders of real estate, must pay property taxes. In some cases, this can amount to as much as 25 percent of total operating expenses. And these are not fixed costs; states and municipalities can raise taxes at will to soften their own shortfalls. This siphons cash flow away from investors.
Those high yields can result in high tax liability. Because REIT dividends are considered ordinary income, they are subject to a much higher tax rate than the typical 15 percent attached to standard dividends.
As is true for most investments, whether the advantages outweigh the downsides varies according to individual situations. It’s always best to stick to your business plan.