By James Gallagher, Fall 2013 Student Intern
Susan Fox, a 63-year old investor, lost 72% of her principal in a real estate investment. When she tried to sell the investment to recoup what little she had left, to her shock and dismay, she couldn’t because there was no one to buy. How did Ms. Fox find herself in this position and what type of real estate did she invest in? Ms. Fox was invested in non-traded REITs.
What is a REIT?
A REIT (“Real Estate Investment Trust”) is a trust or association that owns income producing real estate. REITs bring together multiple investments to create a larger fund that can invest in bigger real estate projects than most individuals can do on their own. For example, if REIT 123 has 1,000 investors each investing $1,000 then it has a $1 million fund ($1,000 *$1,000= $ 1,000,000) that can be used for investments. However, if one of these individuals wanted to invest in real estate on their own they would only have $1,000 to invest.
Once the REIT fund is established, it must decide what type of real estate to invest in. Normally, because REITs have a lot more money than any single investor, they are able to invest in multiple large buildings, thereby diversifying the risk of a single investment. REITs often invest in larger projects such as office buildings, shopping malls, and apartment complexes. Some REITs specialize in certain types of real estate, such as shopping centers, while others invest in a wide variety of real estate.
Different Types of REITS
Once the REIT fund is established, the managers must choose how they will invest in real estate. Managers can invest either directly in real estate or they can invest in mortgages. When a fund invests directly in real estate it is labeled an equity fund. This fund receives its returns through rent payments from the tenants of buildings. Continuing from our example above, if REIT 123 is an equity REIT, it will purchase a small office building which it rents out to Company Y as their headquarters. As part of the lease agreement, Company Y pays the REIT $10,000 a month in rent. This money is then returned to investors through dividends.
The second type of REIT is a mortgage REIT. Instead of investing directly in real estate, mortgage REITs purchase mortgages and their investors get repaid through mortgage payments. If REIT 123 is instead a mortgage REIT it will purchase mortgages instead of buildings. So changing the above example a little, Company Y purchases the building for $1 million but takes out an $800,000 mortgage in order to do so. REIT 123 will then purchase this mortgage and pay investors from the payments Company Y makes on the mortgage.
Why Invest in a REIT?
Some of the advantages to investing in REITS are that they can diversify your portfolio and you can invest in a REIT even if you are not an expert in real estate investment. The REIT, like a mutual fund, has professionals that manage the account for you by researching properties and actually making the purchases and sales of real estate. In addition, the REIT will maintain the property and collect payments. Because REITs must return at least 90% of their taxable income to investors, investors can receive income from their investments.
Additionally, because of tax purposes, REITs are required to return at least 90% of their taxable income to investors. For example, if REIT 123, an equity REIT, makes $10,000 a month through rent, it must distribute at least $9,000 to its investors. If there are 1,000 investors each holding one share, each investor receives $9 a month from their investment share.
All of this sounds really good right? You are diversifying your portfolio while receiving periodic dividends. So why was Ms. Fox not able to sell her investment?
Traded v. Non-Traded REITS
REITs are often traded on exchanges, which are places where people can buy and sell investments such as stocks and bonds. Additionally, when traded on exchanges, companies are required to produce certain financial information about the company. Exchanges create a place where all investors have access to the same information and where investors can purchase or sell investments based on their own interpretations of that information. Because many REITs are traded on exchanges, a market is created where REIT investors can sell their shares if they want to get out of the investment or buy more shares if they believe the investment is going to increase. For example, if You think REIT 123’s value is going to go up you may buy 4 extra shares in which case you would then hold 5 shares of the REIT.
Not all REITs, however, are part of an exchange. REITs that are not traded on an exchange are called “non-traded” REITS. When REITs are not traded on an exchange, they are not required to provide financial information to the public and so it is difficult for potential investors to gage how well the REIT is doing. Therefore, potential investors are less likely buy shares of the REIT and so people already invested in the REIT have a difficult time selling their shares. Sometimes investors have to wait until the underlying property is sold, which can be years, to get out of the investment. This is what happened to Ms. Fox. She was invested in a non-traded REIT and was not able to sell her shares when she wanted to. Additionally, because non-traded REITs are illiquid they usually charge greater fees that can reach 15% higher than exchange traded REITs. These fees chop into the return investors receive on their investments.
Just like any other security, you should research REITs carefully before investing. Learn what underlying properties the REIT invests in and determine whether a REIT is traded or non-traded. Being an informed investor may protect you from unwanted surprises. Additional resources to consult when researching REITS are: REIT.org, Investor.gov and FINRA.org’s Investor Alert on REITs.