What is a Real Estate Investment Trust (REIT)?

Here we take a closer look at what a REIT is, how to invest in REITs, the tax implications and what investors should look out for.

What is a real estate investment trust? 

Put simply, a real estate investment trust, or REIT, is a company that owns, and usually operates, income-producing real estate.

This segment of the market can be a listed or unlisted vehicle, and at a high level, might own a portfolio of commercial properties, such as offices, apartment buildings, hospitals, shopping centres or hotels.

Over the years, this area of the market has developed, with some REITs diversifying into other areas of the property market, such as fund management services or property development management.

“Historically, investors have purchased these assets looking for stable ongoing cash flow streams,” says financial advisor Alex Jamieson.

“The income streams often come with tax-deferred distributions which can be more tax effective than, say, interest from a fixed interest instrument.

“There is also some form of capital growth in some of these assets too.”

How REITs work

REITs have the option to invest in property either within Australia or internationally.

Investors benefit from any increase in value in the underlying asset, as well as from rental income generated from the properties owned.

A listed REIT will often have the following features:

  • They will own a portfolio of properties
  • These properties may be geared to between 10%-30%
  • They typically have an occupancy rate of 90% or more, with tenants having an average lease of 3-5 years duration
  • There is a management team appointed to handle the day-to-day activity associated with the property portfolio.

Types of REITs

There are three main types of REITs:

  1. Equity REITs: The more common of the three, equity REITs invest in and own properties, generating income through the collection of rent. Equity REITs typically own buildings such as hotels, shopping centres, and apartment buildings.
  2. Mortgage REITs: These REITs own property mortgages by loaning money to owners of real estate for mortgages. They generate income through interest paid on the loan.
  3. Hybrid REITs: As the name suggests, a hybrid REIT combines the elements of equity and mortgage REITs.

Classifications of REITs

Public non-listed REITs (PNLRs)

PNLRs do not trade on national stock exchanges. Liquidity options include share repurchase programs or secondary marketplace transactions, but are generally limited.

Private REITs

These real estate funds or companies are exempt from SEC registration, with shares that do not trade on national stock exchanges. Typically, private REITs can be sold to institutional investors only.

Further:

  • 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 time frame of 5-7 years with no liquidity before this maturity date
  • At maturity, the property will often be sold and the proceeds are returned to investors.

“This is regarded as a closed-end REIT, meaning that investors are unable to buy in during the term of the investment or exit,” Jamieson says.

“The other variation on this is a managed-fund REIT. This will raise capital throughout the year and deploy this to either buy a combination of listed and unlisted properties or REITs. They often offer daily or monthly liquidity.”

How to invest in REITs

Typically, you can purchase REITs on the ASX.

They can be done on a company-specific level such as GPT Group (ASX: GPT) or Charter Hall Group (ASX: CHC), or alternatively as an exchange-traded fund (ETF) such as Vanguard Australian Property Securities Index EFT (ASX: VAP) which tracks a particular listed property trust index, says Jamieson.

Pros and cons of investing in REITs

According to Jamieson, the biggest areas of consideration are liquidity, gearing ratios, occupancy levels and quality of the asset.

Liquidity

A listed REIT usually has daily liquidity for investors as it trades on the ASX.

“The REIT has a fixed pool of capital to work on which means that if an investor buys or sells the shares, this does not change the capital pool which the REIT has to work with at any given point in time,” Jamieson said.

An unlisted REIT historically will lock investors in for a duration of 5-10 years.

“At the end of the term, they will ask the investors if they want to continue for a further term, or sell the asset at that time and return the proceeds back to the investors.”

The risk for investors is that the REIT matures during a downturn, which can have a negative impact on the proceeds being realised at the end of the investment.

Gearing ratios

Gearing ratios create another risk for REITs during downturns.

“It is important that you look at the gearing ratio of a REIT as a key valuation metric… if the gearing ratios exceed particular levels, they can breach loan covenant requirements which can have a negative impact for investors, and may require an asset to be sold during a poor timing period in the market.”

Occupancy levels

Another important consideration is the mix of tenants and their ability to withstand downturns.

Quality of the assets 

“Having a desirable property in a strong location should place the asset well for future capital growth, as well as attracting potential tenants,” Jamieson said.

Tax implications of REIT investing

As with unit investment trusts, REITs must be taxed first at the trust level, then to the beneficiaries.

However there are a few other rules when it comes to REITs

Rental income is considered business income, meaning all expenses related to rental activities can be deducted, just as business expenses can be written off by a corporation.

In addition, current income distributed to unit holders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, then it must be subject to a 30% withholding tax for ordinary dividends and a 21% for capital gains.

REITs are generally exempt from taxation at the trust level, provided they distribute at least 90% of their income to their unit holders.

REIT fraud: risks to be aware of

While publicly-traded REITs are highly regulated, privately held, non-traded ones are not, leaving them open to investment fraud and scams.

Scams come in many forms, so vigilance is the only method of avoidance. Some things you can do before diving in include:

  • Checking in with the Securities Investment Commission
  • Due diligence – request as much detail as possible
  • Engage a securities attorney

The bottom line

As with any major investment, REITs come with their own set of risks, and pros and cons for moving forward. 

The bottom line? Do your research. Ask questions and conduct as much due diligence as you can prior to going ahead.

Updated 5th August, 2021. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.