What is a real estate investment trust (REIT)?

Here we explore how to invest in property on the ASX share market through real estate investment trusts (REITs).

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What is a real estate investment trust?

Put simply, a real estate investment trust (REIT) is a company that owns and operates property assets that typically produce income.

REITs can have various property types in their portfolios, or they might specialise in just one type. Some REITs focus on commercial real estate, such as offices, hospitals, shopping centres, warehouses, and hotels. Others specialise in residential property investment, such as aged care villages and apartment buildings.

Over the years, REITs have evolved and diversified into other areas of the property market, such as fund management services or property development management.

Investors like REITs because they usually have predictable cash flows and dividend distributions and offer some capital growth opportunities. This can be useful for income investors due to a REIT's unique tax structure, allowing for tax-deferred distributions.

Investors also typically consider REITs to be solid long-term investment options that also provide diversification benefits to safeguard their investment portfolios.

How do REITs work?

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

Investors benefit from any increase in the value of the underlying property assets (capital growth) and the rental income they generate (returns paid as distributions to shareholders).

A listed REIT will generally have the following features:

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

Types of REITs and how to invest in them

The three main types of REITs include:

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

Typically, ordinary investors will purchase REIT stocks on the Australian Securities Exchange (ASX).

You can do this at a company-specific level, such as by purchasing shares in GPT Group (ASX: GPT) or Charter Hall Group (ASX: CHC).

Alternatively, you can buy shares in an exchange-traded fund (ETF), such as the Vanguard Australian Property Securities Index ETF (ASX: VAP), which tracks a particular listed property trust index.

Pros and cons of investing in REIT shares

Some factors you'll need to consider when buying REITS include liquidity, gearing ratios (how much money the REIT has borrowed), occupancy levels and, of course, the underlying quality of the property assets.

  • Liquidity: A listed REIT usually has daily liquidity for investors because it trades on the ASX. In other words, you can buy or sell shares in a REIT at any time. A REIT has a fixed pool of capital. Unlike a managed fund, a REIT's assets are not affected by the buying and selling of its underlying units.
  • Gearing ratios: Most investors use gearing to invest in property assets. But the gearing ratio of a REIT is of utmost importance as it can create risk for REITs during downturns. Overleveraged REITs can get into hot water during times of market stress, which may result in a fire sale of assets and an overall negative impact on investors.
  • Occupancy levels: This refers to the percentage of properties occupied by tenants. Another important consideration is the mix of tenants and their ability to withstand downturns.
  • Quality of the assets: The old property maxim of 'location, location, location' still rings true when investing in REITs. A REIT will have a much higher chance of success if it has quality property assets in desirable locations, attracting high-quality tenants.

Tax implications of REIT investing

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

Financial experts count rental income as business income. This means a REIT can deduct all expenses related to rental activities, just as a corporation can write off business expenses.

In addition, current income distributed to unitholders is not taxed to the REIT. This means that, unlike a company, any profits will not be subject to company tax. However, you will still need to pay income tax on any distributions (which are not usually franked because the REIT doesn't pay company tax) at the individual level.

However, if the income is distributed to a non-resident beneficiary, it is subject to a 30% withholding tax for ordinary dividends and 21% for capital gains.

Alternative classifications of REITs

Most investors will focus on listed REITs, but there are a few other types to be aware of. These include public non-listed REITs (PNLRs) and private REITs.

These real estate funds or companies can be exempt from registration with the Australian Securities and Investments Commission (ASIC), as the shares do not trade on public stock exchanges. Typically, some private REITs are only available to institutional investors.

Further, they may have some or all of the following characteristics:

  • 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 timeframe of five to seven years, with no liquidity before this maturity date
  • The properties are often sold at maturity, and the proceeds returned to investors.

What does closed-ended mean?

These unlisted or private REITs are often described as closed-ended, which means investors can be restricted from buying or selling their units over the investment term. Traditionally, an unlisted or private REIT will lock investors in for five to 10 years.

In this situation, the REIT may ask investors if they wish to roll their investment over into a new term or sell out and take the proceeds of the investment. The risk for investors is that the REIT matures during a downturn, which can negatively impact the proceeds being realised at the end of the investment period.

What's a managed fund REIT?

There is also a REIT structure known as a managed fund REIT. This type of REIT is operated by raising capital over many months or years and using this capital to buy a basket of property assets.

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

Scams come in many forms, so vigilance is the only method of avoidance.

Some things you can do before investing in a private REIT include:

  • Checking details with ASIC
  • Due diligence — request as much detail as possible
  • Engage a securities attorney

The Foolish bottom line

As with any significant investment, REIT shares come with their own set of risks and pros and cons for moving forward.

The bottom line? Do your research. Ask questions, consult a financial adviser and conduct as much due diligence as possible before going ahead.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. 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 Scott Phillips.