What is a REIT?
REIT stands for Real Estate Investment Trust, and it is defined as a company that owns, operates, or finances income-generating real estate. They make money by renting, leasing, or selling properties. Like mutual funds, REITs pool the capital of numerous investors, allowing them to earn dividends from real estate investments without having to buy, manage, or finance any properties themselves. In addition to public REIT stocks and non-traded REITs, investors can also buy REIT mutual funds and REIT exchange-traded funds.
Successful REITs can provide consistent income for investors. That said, there are major potential drawbacks to REIT stocks that every investor should know.
REITs’ Potential Drawbacks:
- Unlike real estate, REIT shares do not appreciate over time.
- REIT companies do not pay taxes on the corporate level. Shareholders bear the tax burden, and the returns may be taxed as income, capital gains, or return of capital. Financial advisors should ensure their investors know what type of tax they can expect.
What Makes a REIT a Risky Investment?
Although REITs may sound appealing because investors don’t have to buy a property directly, there are a plethora of risks associated with investing in REITs.
- Fees. REITs come with upfront fees and may also charge external manager fees.
- Market Dangers. Publicly traded REITs risk losing value when interest rates rise, which typically sends investment capital into bonds.
- Broker Conflicts of Interest. Additionally, several conflict-of-interest issues can arise when investing in a REIT. Regulation Best Interest requires that brokerage firms reveal their brokers’ commissions, but they might not reveal that an investor could make a similar investment without paying as much in commissions.
- Sponsor control: The interests of the management team and residual shareholders may not be aligned. Most REITs do not own property directly but through an operating partnership, which directly owns and operates the properties. The operating partnership may have interests that conflict with the interests of shareholders.
- Resource allocation: Agents for REITs have ownership interests outside the REIT and could allocate a disproportionate amount of time to their outside investments.
- Tax timing: Agents of the REIT may have different objectives from the shareholders and may disagree on the appropriate pricing and timing of any sale due to their federal tax liability.
Non-Traded REITs Are Especially Risky
Non-traded REIT investments can be very difficult to sell. If you did not understand the risks associated with your non-traded REIT, you should contact a REIT investment lawyer. These highly illiquid investment products are often the subject of FINRA arbitration disputes, and a securities lawyer will know how to present your case to an arbitration panel.
Non-traded REITs come with the following risks:
- Investors should not buy a non-traded REIT with money they think they might need in the next few years. The risks associated with private REITs are a lack of liquidity and limited cash flow. If investors want to get their money out of a REIT, they may have to pay fees and wait an extended period. This could result in significant losses for the investor.
- Because non-traded REITs do not trade on a public exchange, they do not have to make the REIT company’s financial information public. Therefore, it can be difficult for investors to determine the true value of their REIT shares.
- Investors might be attracted to a non-traded REIT because of dividends, but those dividends could be paid using borrowed money. This reduces the value of the shares.
- Non-traded REITs have higher up-front fees than publicly traded REITs.
Investors with conservative financial goals should not invest in non-traded REITs, and if your stockbroker persuaded you otherwise, you may have a securities fraud case worth pursuing.
What is the Definition of a REIT?
The SEC has established the following REIT rules. Each of the following must apply to the REIT:
- Pay out at least 90% of its taxable income annually in the form of shareholder dividends.
- An entity that would be a taxable corporation but for its REIT status.
- Managed by a board of directors or trustees.
- Must have fully transferable shares.
- Have a minimum of 100 shareholders after its first year.
- Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year.
There are also rules that dictate how REITs invest their money.
A REIT must:
- Invest at least 75% of its total assets in real estate assets and cash
- Derive at least 75% of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property
- Derive at least 95% of its gross income from such real estate sources and dividends or interest from any source
- Must also have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.
Three Types of REITs: Equity REITs, Mortgage REITs, and Hybrid REITs
There are three types of REITs:
- Most REITs are equity REITs, which own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties). Equity REITs have straightforward business models—they lease space, collect rents on the properties, and then distribute that income as dividends to shareholders.
- Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by the net interest margin, and this model makes them potentially sensitive to interest rate increases.
- Hybrid REITs use both equity and mortgage REITs.
What Type of Property Do REITs Own?
REIT real estate can include apartment buildings, office buildings, retail centers and malls, storage facilities, warehouses, cell and data towers, medical facilities, and hotels.
Before You Buy a REIT
If you are in the market for a REIT, carefully consider its pros and cons. Most importantly, make sure you understand the tax implications of your REIT investment and any potential conflicts of interest.
REITs can be highly complex investments that your stockbroker should understand before recommending them. If you feel your stockbroker did not consider your individual needs before recommending a REIT, get in touch with an investment lawyer. Call 877-600-0098 or email email@example.com to speak with one of the experienced securities attorneys at Kurta Law. Kurta Law provides free case evaluations and works on a contingency basis, which means you only pay for their services if the firm recovers money on your behalf.