Stock REIT Basics – An Alternative Income Investment

REIT Funds - REIT Investing Guide

Stock REITs are a relatively new financial innovation that was created to make it easier for individuals to gain exposure to real estate investments. Before REITs, investors typically needed a lot of money to invest in real estate, particularly commercial real estate. Often, real estate was owned by partnerships. Only certain types of investors could participate, typically those with a lot of capital. As a result, accessing the real estate markets was difficult for most investors.

This all changed in 1960 when President Eisenhower signed a law creating real estate investment trusts (REIT)s. REITs were a new type of corporation that democratized real estate investing and made it easier for individuals to gain exposure to investments in real estate.

A REIT is a type of company, or more accurately a trust, that invests in a real estate portfolio. Investors can participate in the gains and losses of the portfolio by buying shares of a REIT. Because equity REITs are publicly traded and listed on the same exchanges as other companies, buying a REIT is similar to buying a stock.

There are non-traded REITs which means they are not on the exchanges and considered riskier. Investors need to take extra caution when looking at an investment that is not on the exchanges because the values are not publically known.

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Let’s examine what a REIT looks like. This is the XYZ Strip Mall’s REIT. This REIT invest in commercial real estate, particularly strip malls. This trust-owned strip malls across the United States. By purchasing a share in the XYZ Strip Mall’s REIT, an investor is able to participate in the profits or losses generated from this portfolio of strip malls. REITs typically purchase and maintain real estate. Therefore, part of the business is making sure the strip malls are maintained, managed and occupied.

For XYZ Strip Malls, longterm leases are the primary source of cash. The stores that occupies space pay rent, which is this REITs main source of revenue. This revenue may be reinvested to purchase existing strip malls or raw land to develop into new strip malls. XYZ Strip Malls can also expand by borrowing money. Doing this introduces leverage to a REIT. Leverage means controlling a large amount of real estate with a small amount of money. Too much leverage is risky because it could expose XYZ Strip Malls to interest rate risk. That means if interest payments move higher, the trust may have to spend more paying back its borrowed money.

Payments on borrowed money, capital expenditures and other costs are subtracted from a REITs revenue. What’s left over is net income, also known as earnings. As a REIT, XYZ Strip Malls is required to pay 90% of earnings to investors in the form of dividends. However, not all REITs are guaranteed to perform well and provide steady dividends. REIT management faces several challenges. One such challenge is building and expanding a portfolio of investments.

For example, if XYZ Strip Malls expands too far and buys too many strip malls too fast, the trust could have low or even negative earnings. This could make it difficult for the trust to provide a dividend to investors. If the dividend is reduced or a payment is missed, its shareholders would likely sell their shares, possibly at a loss, and look for a better managed REIT. However, if a REIT performs performs well, it’s good for the trust and its shareholder.

Now that you know more about REITs and how they can provide a way to invest in the real estate market, you can see why some investors might consider including them in a diversified income portfolio.

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