Outside of investing a small percentage of my bi-weekly 401(k) contributions into a Real Estate Investment Trust (REIT) Fund, I have very little personal experience investing in these interesting vehicles, however, when I saw a FINRA Investor Alert I was curious what it had to say. The FINRA Investor Alert was titled, “Public Non-Traded REITs – Preform a Careful Review Before Investing,” and provides some fantastic risks that may not be explained before they are sold. I should mention that while there are obviously risks it does not mean they are bad investments, actually, I see myself using this type of investment vehicle in the future as one of my multiple streams of income.
What is a Real Estate Investment Trust?
The same FINRA note provides a pretty good definition for a REIT,
A real estate investment trust, or REIT, is a corporation, trust or association that owns (and might also manage) income-producing real estate. REITs pool the capital of numerous investors to purchase a portfolio of properties—from office buildings and shopping centers to hotels and apartments, even timber-producing land—which the typical investor might not otherwise be able to purchase individually.
REITs can offer tax advantages. For instance, qualified REITs that meet Internal Revenue Service requirements can deduct distributions paid to shareholders from corporate taxable income, avoiding double taxation. The REIT must also distribute at least 90 percent of its taxable income to shareholders annually. These distributions are taxable to the extent of any ordinary income and capital gains included in the distribution.
I think it is easy to make the leap from a mutual fund to REIT pretty easily. A mutual fund pools money together to often purchase stocks, bonds, etc.; REITS pool investor money to purchase a different asset class – Real Estate. If one can make the leap between the asset classes, it is easy to understand the two types of REITs often referred to:
- Publically traded
- Non-Publically traded
As you could probably guess publically traded means that you can buy and sell shares freely on an exchange. Alternatively, a non-publically traded has a lot more restrictions when it comes to selling shares. There is a third type we won’t be discussing which is often referred by different names but has the common attribute that it is for accredited investors (i.e. those with a net worth of a $1,000,000 not including his or her primary residence or certain income requirements are met).
Comparing Non-Traded REITs and Exchange Traded REITs
When I was thinking about how to structure this post it was funny how many pros/cons are shared by both types of REITs. For example both have the following pros:
- Both tend to provide a steady form of income since both usually distribute 90% of their rental income
- Both allow an investor to get involved in real estate without all the headaches of a tenant calling you
- Both allow an investor to rely on a real estate expert
- Both allow an investor to diversify or not diversify
and they both of the following cons:
- Both do not allow the owner to take advantage of certain tax breaks associated with owning investment property
- There are no guarantees
- Rental income is usually taxed higher than qualified dividends
Pros of Non-Traded REITs Compared to Exchanged Traded REITs
When a non-traded REIT is created the exit strategy may be known or it may not be known but often there is one in the minds of the creators/managers. At some point the property is either sold to another company and/or it is taken public. When this occurs there may be a windfall for the investor if the property appreciated during the course of the non-traded REIT.
I think one of the biggest value propositions associated with a non-traded REIT is that the value of the underlying asset (while illiquid discussed below) is not subject to the stock market whims. Since there is no ticker symbol a terrible day in the market doesn’t bring down the value of your holding. Rather the value of the building/property is based solely on just that..itself.
Cons of Non-Traded REITs Compared to Exchanged Traded REITs
They are very illiquid. Once involved in a non-traded REIT for the most part you can not call your broker or financial planner and ask them to sell your shares. Some REITs provide an out, but other do not; those that do allow you to sell your shares will charge you a lot to do so. As such, one con is that this is a very long term investment (I guess one could argue that this is a pro too).
Another con, and again this is REIT to REIT, is that there may be no disclosure as to what you are actually investing in. For example a Non-Traded REITs’ prospectus may just say “commercial property in downtown NYC” but what does that even mean? Publically traded REITs are much more transparent in what they own, although they can easily change what they own moments after you buy your first share.
I absolutely see myself getting more into REITs one day, but that would be in the very distant future. But what about you? Do you own any REITs? Are they traded or non-traded?