In previous blogs, we’ve touched on the idea of passive income for investors. One way to pursue passive income is the Real Estate Investment Trust, or REIT. Unlike other types of investments that strive to provide passive income, such as the Delaware statutory trust, REITs are positioned as securities. In other words, investors put their capital into the companies that manage portfolios, potentially receiving income in return.
But how exactly does this happen? How do REITs make money, passing it to investors? This can happen in two ways: rental income and property appreciation.
What They Are
But first let's offer a little more detail about the REIT structure.
Real Estate Investment Trusts came into existence in 1960, when legislation was introduced that offered real estate investment options to middle-class Americans. These days, a REIT is a company that buys, sells, manages, and finances real estate assets. The goal here is to generate income for investors.
According to NAREIT, there are four different types of REITs:
- Equity REITs
- Mortgage REITs
- Public Non-Listed REITs
- Private REITs
The most common type of REIT is the equity REIT; this is generally traded on public stock exchanges, but any of the above allows investors access to portfolios. This is done by offering shares to investors, either on public exchanges or privately through registered brokers or representatives. Once capital is pooled, it goes to the investment of certain property types. The main benefit of REITs is that they give investors the opportunity to invest in commercial-sized real estate portfolios.
Whether they operate publicly or privately, REITs must adhere to certain rules:
- At least 75% of its total assets must be in real estate, cash, or US Treasuries
- At least 90% of taxable income needs to be paid to shareholders
- The REIT must have at least 100 shareholders after being in business for a year
- At least 75% of the REIT’s gross income must come from rents, mortgage interest, or real estate sales
This last point answers the question as to how REITs make money.
How They Earn
The REIT business model involves buying real estate, leasing space in those assets, and collecting rents from tenants. These rents generate income which is paid out to shareholders through dividends. This is the case for REITs that manage real estate assets.
The situation is different for mortgage REITs, also known as mREITs. These types of trusts don’t directly own real estate. Rather, they purchase or originate mortgages and mortgage-backed securities; as such, mREIT income comes from interest payments on these investments.
Regardless of the type of REITs, successful ones know how to build their value (and, in turn, potentially increases investor return) by building and buying cash-flowing assets. When they sell these assets, investors may also benefit from the proceeds of that sale.
Investing in REITs
Unlike other types of property investments, publicly-traded REITs can be easier for investors to access either directly online, or with the help of a stock or securities broker or agent. Privately traded REITs are generally directed to accredited investors, and are only available through registered broker-dealers.
Regardless of what REIT you might target, be sure that it fits with your investment objectives, and that you understand the risks of buying shares. While REITs do offer a passive income opportunity, due diligence is important.