» » Understanding Real Estate Investment Trusts (REITs)

Understanding Real Estate Investment Trusts (REITs)

posted in: Investments | 0

by Arne R. Themmen- May 2014

Today, the interest rate returns available from fixed income investments are at all time historic lows. In the search for increased income returns, more and more people are turning to Real Estate Investment Trusts, commonly known as “REITs” in order to generate a higher current income return on their money. Real estate investment trusts come in many shapes and sizes. Basically they pool money from investors and invest in various types of real estate or real estate related entities such as collateralized mortgage obligations, individual mortgages, and other real estate derivatives. Even the trusts that invest in real estate directly, generally try to limit their investment to specific types of real estate such as commercial properties, shopping malls, health facilities, nursing homes, rental apartments, hotels and even timberland. In fact, today, single-family homes are being acquired for current rental and future sale by some REITs and hedge funds.

Investments in these trusts may be attractive because of their high dividend payout, and because with interest rates so low these trusts can use leverage to increase the number of properties they can purchase for the fund. They were created in order to give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate in the same way they invest in other asset classes, through the purchase and sale of liquid securities. Like other fixed income investments they may suffer loss of principal if/when interest rates increase, but the impact of this reduction is reduced by current returns ranging from 5 to 15%.

One drawback to these funds is the treatment of the distributions as ordinary income to the recipient. Accordingly, the payments do not receive the treatment given to qualified corporate dividends, which are taxed at 15% instead of at ordinary income tax rates. This is due to the fact that the REIT is entitled to deduct dividends paid to its owners or shareholders, reducing or eliminating their corporate income tax liability. REITs are required to distribute at least 90% of their taxable income into the hands of their investors and must derive at least 75% of their gross income from rents or mortgage interest.

This tax structure makes REITs an ideal investment for IRAs and other tax deferred entities. Assets with favorable capital gains and qualified dividend treatment are most appropriate in after tax accounts, where the benefit of a reduced tax can be maximized. REITs should be considered as a fixed income alternative since the taxation is the same as for bond interest. As noted above, this class of investment is also subject to downward price pressure in an increasing rate environment, which will result in increasing borrowing costs and competition for investor dollars from less risky bond investments.

 

Disclaimer: This article is intended as general information, not individually targeted personalized advice. Investors should assess for themselves whether the advice is appropriate to their individual investment objectives, financial situation and particular needs before making any investment decision on the basis of such general advice. Investors can make their own assessment of the advice or seek the assistance of a professional adviser.