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.

REITs can have a variety of property types in their portfolios, or they might specialise in just one type. Some REITs focus on commercial property, such as offices, hospitals, shopping centres, warehouses and hotels, while others specialise in residential property, 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, as well as offering some capital growth opportunities. This can be useful for income investors due to a REIT’s unique tax structure, which can allow for tax-deferred distributions.

How REITs work

REITs 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), as well as from the rental income they generate (returns paid as distributions to shareholders). 

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 3 main types of REITs:

  1. Equity: The more common of the 3, 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: These REITs own property mortgages. They generate income through interest paid on the loans
  3. Hybrid: As the name suggests, a hybrid REIT combines the elements of equity and mortgage REITs.

 

How to invest in REITs

Typically, ordinary investors will purchase REITs on the ASX.

This can be done at a company-specific level, such as purchasing GPT Group (ASX: GPT) or Charter Hall Group (ASX: CHC) shares. Alternatively, you can purchase an exchange-traded fund (ETF), such as the Vanguard Australian Property Securities Index EFT (ASX: VAP), which tracks a particular listed property trust index.

 

Pros and cons of investing in REITs

Some of the 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

Gearing ratios create another risk for REITs during downturns.

Most investors use gearing to invest in property assets. But the gearing ratio of a REIT is of utmost importance. 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 for 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 

When it comes to REITs, the old property maxim of ‘location, location, location’ still rings true. A REIT will have a much higher chance of success if it has quality property assets in desirable locations, thereby 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).

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. 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 at the individual level (which aren’t usually franked, seeing as the REIT doesn’t pay company tax).

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

 

Alternative classifications of REITs

The majority of 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 5-7 years, with no liquidity before this maturity date
  • At maturity, the properties are often sold and the proceeds returned to investors. 

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 term of the investment. Traditionally, an unlisted or private REIT will lock investors in for a duration of 5-10 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 have a negative impact on the proceeds being realised at the end of the investment period.

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, the 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 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 28 October 2021. 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 Bruce Jackson.