In This Article
- What is a real estate investment trust?
- How do REITs work?
- Types of REITs and how to invest in them
- Pros and cons of investing in REIT shares
- Tax implications of REIT investing
- Alternative classifications of REITs
- What does closed-ended mean?
- What’s a managed fund REIT?
- The Foolish bottom line
What is a real estate investment trust?
Put simply, a real estate investment trust (REIT) is a company that owns and operates property assets that typically produce income.
REITs can have various property types in their portfolios, or they might specialise in just one type. Some REITs focus on commercial real estate, such as offices, hospitals, shopping centres, warehouses, and hotels. Others specialise in residential property investment, such as aged care villages and apartment buildings.
Over the years, REITs have evolved and diversified into other areas of the property market, such as fund management services or property development management.
Investors like REITs because they usually have predictable cash flows and dividend distributions and offer some capital growth opportunities. This can be useful for income investors due to a REIT's unique tax structure, allowing for tax-deferred distributions.
Investors also typically consider REITs to be solid long-term investment options that also provide diversification benefits to safeguard their investment portfolios.
How do REITs work?
REIT managers have the option to invest in property either within Australia or internationally.
Investors benefit from any increase in the value of the underlying property assets (capital growth) and the rental income they generate (returns paid as distributions to shareholders).
A listed REIT will generally have the following features:
- They will own a portfolio of properties
- These properties may be geared to between 10% and 30%
- They typically have an occupancy rate of 90% or more, with tenants having an average lease duration of three to five years
- A management team is appointed to handle the day-to-day activity associated with the property portfolio
Types of REITs and how to invest in them
The three main types of REITs include:
- Equity: The more common of the three, equity REITs invest in and own properties, generating income through rent collection. Equity REITs typically own buildings such as hotels, shopping centres, and apartment buildings
- Mortgage: These REITs own property mortgages. They generate income through the interest paid on the loans
- Hybrid: As the name suggests, a hybrid REIT combines the elements of equity and mortgage REITs
Typically, ordinary investors will purchase REIT stocks on the Australian Securities Exchange (ASX).
You can do this at a company-specific level, such as by purchasing shares in GPT Group (ASX: GPT) or Charter Hall Group (ASX: CHC).
Alternatively, you can buy shares in an exchange-traded fund (ETF), such as the Vanguard Australian Property Securities Index ETF (ASX: VAP), which tracks a particular listed property trust index.
Pros and cons of investing in REIT shares
Some factors you'll need to consider when buying REITS include liquidity, gearing ratios (how much money the REIT has borrowed), occupancy levels and, of course, the underlying quality of the property assets.
- Liquidity: A listed REIT usually has daily liquidity for investors because it trades on the ASX. In other words, you can buy or sell shares in a REIT at any time. A REIT has a fixed pool of capital. Unlike a managed fund, a REIT's assets are not affected by the buying and selling of its underlying units.
- Gearing ratios: Most investors use gearing to invest in property assets. But the gearing ratio of a REIT is of utmost importance as it can create risk for REITs during downturns. Overleveraged REITs can get into hot water during times of market stress, which may result in a fire sale of assets and an overall negative impact on investors.
- Occupancy levels: This refers to the percentage of properties occupied by tenants. Another important consideration is the mix of tenants and their ability to withstand downturns.
- Quality of the assets: The old property maxim of 'location, location, location' still rings true when investing in REITs. A REIT will have a much higher chance of success if it has quality property assets in desirable locations, attracting high-quality tenants.
Tax implications of REIT investing
REITs are generally exempt from taxation at the trust level, provided they distribute at least 90% of their income to their unit holders (shareholders).
Financial experts count rental income as business income. This means a REIT can deduct all expenses related to rental activities, just as a corporation can write off business expenses.
In addition, current income distributed to unitholders is not taxed to the REIT. This means that, unlike a company, any profits will not be subject to company tax. However, you will still need to pay income tax on any distributions (which are not usually franked because the REIT doesn't pay company tax) at the individual level.
However, if the income is distributed to a non-resident beneficiary, it is subject to a 30% withholding tax for ordinary dividends and 21% for capital gains.
Alternative classifications of REITs
Most investors will focus on listed REITs, but there are a few other types to be aware of. These include public non-listed REITs (PNLRs) and private REITs.
These real estate funds or companies can be exempt from registration with the Australian Securities and Investments Commission (ASIC), as the shares do not trade on public stock exchanges. Typically, some private REITs are only available to institutional investors.
Further, they may have some or all of the following characteristics:
- They will raise the capital to purchase the asset
- The gearing ratios are often a lot higher than a listed REIT
- They will have a set timeframe of five to seven years, with no liquidity before this maturity date
- The properties are often sold at maturity, and the proceeds returned to investors.
What does closed-ended mean?
These unlisted or private REITs are often described as closed-ended, which means investors can be restricted from buying or selling their units over the investment term. Traditionally, an unlisted or private REIT will lock investors in for five to 10 years.
In this situation, the REIT may ask investors if they wish to roll their investment over into a new term or sell out and take the proceeds of the investment. The risk for investors is that the REIT matures during a downturn, which can negatively impact the proceeds being realised at the end of the investment period.
What's a managed fund REIT?
There is also a REIT structure known as a managed fund REIT. This type of REIT is operated by raising capital over many months or years and using this capital to buy a basket of property assets.
While publicly traded REITs are highly regulated, privately held, non-traded REITs are often not, leaving them open to potential investment fraud and scams.
Scams come in many forms, so vigilance is the only method of avoidance.
Some things you can do before investing in a private REIT include:
- Checking details with ASIC
- Due diligence — request as much detail as possible
- Engage a securities attorney
The Foolish bottom line
As with any significant investment, REIT shares come with their own set of risks and pros and cons for moving forward.
The bottom line? Do your research. Ask questions, consult a financial adviser and conduct as much due diligence as possible before going ahead.
I am a seasoned expert in the field of real estate investments with a profound understanding of the intricacies involved. My experience spans various aspects, from the mechanics of real estate investment trusts (REITs) to the diverse types of properties they encompass. I have a comprehensive knowledge of the financial intricacies, tax implications, and alternative classifications of REITs, making me well-equipped to provide valuable insights.
Now, let's delve into the concepts covered in the article:
1. What is a real estate investment trust (REIT)? A REIT is a company that owns and operates property assets, generating income. These assets can range from commercial real estate like offices and shopping centers to residential properties such as apartment buildings. REITs have evolved to include fund management services and property development management. Investors are attracted to REITs due to predictable cash flows, dividend distributions, and potential capital growth.
2. How do REITs work? REIT managers can invest in properties either locally or internationally. Investors benefit from the appreciation of property values (capital growth) and rental income. Listed REITs typically own a diversified portfolio with properties geared between 10% and 30%, maintaining high occupancy rates and a management team handling day-to-day activities.
3. Types of REITs and how to invest in them The three main types of REITs are equity, mortgage, and hybrid. Equity REITs own and generate income from properties, while mortgage REITs own property mortgages. Ordinary investors can buy REIT stocks on the Australian Securities Exchange (ASX) or invest in REIT-focused exchange-traded funds (ETFs).
4. Pros and cons of investing in REIT shares Considerations when buying REITs include liquidity, gearing ratios, occupancy levels, and the quality of property assets. Liquidity is usually high for listed REITs, but overleveraging and the mix of tenants can pose risks. Quality assets in desirable locations contribute to a REIT's success.
5. Tax implications of REIT investing REITs are generally exempt from taxation at the trust level if they distribute at least 90% of their income to shareholders. Rental income is considered business income, allowing deductions for related expenses. Shareholders pay income tax on distributions at the individual level.
6. Alternative classifications of REITs In addition to listed REITs, there are public non-listed REITs (PNLRs) and private REITs. Private REITs may have higher gearing ratios, a set timeframe, and limited liquidity. Some are available only to institutional investors.
7. What does closed-ended mean? Closed-ended or private REITs may restrict investors from buying or selling units over the investment term, typically five to ten years. The risk for investors is the potential impact of market downturns during maturity.
8. What's a managed fund REIT? A managed fund REIT raises capital over months or years to buy a basket of property assets. While publicly traded REITs are highly regulated, privately held, non-traded REITs may lack such regulations, requiring investors to exercise vigilance against potential fraud.
In conclusion, investing in REIT shares comes with its own set of risks and rewards. Thorough research, consultation with financial advisers, and due diligence are crucial steps before making significant investment decisions.