How do REITs work, and how to make money investing in REITs, Real Estate Investment Trusts?

REITs own or finance income-generating real estate. Investors pool capital to purchase a portfolio of buildings. REIT collects rent and distributes income to investors through dividends. It's a low-risk way to generate returns.

last updated Friday, August 30, 2024
#how do reits work #how to make money investing in reits

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John Burson

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A Real Estate Investment Trust (REIT) is a company that owns or finances income-generating real estate. Investors pool their capital to purchase and manage a portfolio of commercial and residential buildings, while the REIT collects rent from tenants and distributes the income to investors through high dividends. Investing in REITs can be lucrative in generating attractive returns with relatively low risk. In this article, we will explore how investors can make money by investing in REITs.

How do REITs work?

The legal framework qualifies as REIT needs to meet specific guidelines by Congress. Here are some guidelines to follow:

• A company should be a corporation under the IRS Revenue code
• A company must be managed by a board of directors
• A company should invest at least 75% of the assets
• 90% of the company's taxable income should be paid out  to shareholders through dividends
• At least 100 shareholders must hold a company

Unlike a typical corporation that pays taxes on earnings, a REIT's income is not taxed, which means more money is passed on to the shareholders. Investors can access REITs by utilizing an ETF or mutual fund. The fund merges the investors' money to purchase REIT stocks. It is necessary to keep in mind that not all real estate funds invest in REITs exclusively. Hence, researching the fund's holdings and investment strategy is essential before you purchase.

Type of REITs

There are mainly two categories of REITs: Equity and Mortgage REITs. Mortgage REITs are also known as mREITs.

Equity REITs

Most REITs have equity rates, which means they own or operate income-producing properties or real estate, for example, apartment buildings, offices, etc. This type of REIT invests in those income-producing real estate. Equity REITs can be split into more types:

• Lodging and resort REITs
• Self-storage REITs
• Data Center REITs
• Infrastructure REITs
• Industrial REITs
• Timberland REITs

Mortgage REITs

How do mortgage REITs make money?

Mortgage REITs finance commercial and residential real estate by investing in mortgage and mortgage-backed bonds. These can be agency mortgages, non-agency mortgages, or commercial mortgages. These Mortgage REITs mainly deal with commercial or residential mortgages, but some can invest in both. REITs like this borrowed money to buy mortgages and pay a higher interest rate.

Making money investing in REITs

Making money involves combining two things: dividends and share price appreciation. These combine to produce higher-than-average dividends because investors need to be paid a minimum of 90% of taxable income to make the yield averages greater than returns. According to LaForge, the total return can create problems for some investors, as they tend to choose REITs with the highest dividend yield because that would seem like a good income. "Usually, the higher the yield, the worse the company's financial situation," he says.

Dividend yields differ across the REIT sector, so those who want an income from REITs need to look for safe dividends that have the potential to exceed market averages. REITs that have consistently maintained or increased dividends still have more stable market demands than the others.

Choosing a REIT for Investment

When choosing a REIT, you should identify REITs with a growing cash flow profile and a reasonable price. To determine the price of a REIT, look at its cost and subtract the net asset value or per-share value of each of the holdings, called the P-NAV. A positive P-Nav means you could purchase all the REIT's properties at a low price outside the REIT (this suggests it's overvalued). If the P-NAV is negative, the properties are worth more outside than the REIT and hence could be called undervalued.

A more straightforward method of valuing REITs is comparing their dividend yields to corporate bonds or other asset classes. By comparing them, you can calculate the market values for the yields. A higher yield means a special dividend is streamed for a lower price. Other factors to consider while evaluating a REIT are supply and demand, geographical location, and other causes that might impact rent and occupy levels.

So, how much of a portfolio should be invested in REITs? There are no strict rules, but starting with 5% to 10% is considered good. Some studies show that the optimal exposures fall between 5-10 %, and some research indicates that optimal exposures can even fall between 20%.

Related FAQ

Is investing in REITs profitable?

REITs typically provide high dividends plus moderate, long-term capital appreciation.
The total long-term returns of REITs tend to be similar to those of value stocks but higher than the returns of bonds.

 
 
 

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