Upbeat music plays throughout.
Narrator: Real estate investment trusts, most commonly known as REITs, were created to make it easier for individuals to gain exposure to real estate investments.
Before REITs, investors typically needed a lot of money to invest in real estate, particularly commercial real estate.
Often, real estate was owned by partnerships. Only certain types of investors could participate.
Typically, those with a lot of capital. As a result, accessing the real estate markets was difficult for most investors.
This all changed in 1960, when President Eisenhower signed a law creating REITs.
REITs were a new type of corporation that democratized real estate investing and made it easier for individuals to gain exposure to investments in real estate.
A REIT is a type of company, or more accurately, a trust, that invests in a portfolio of real estate like apartment buildings, shopping centers, hospitals, and hotels.
Investors can participate in the gains and losses of the portfolio by buying shares of a REIT.
Because equity REITs are publicly traded, and listed on the same exchanges as other companies, buying a REIT is similar to buying a stock.
Let's examine what a REIT looks like. This is the XYZ Strip Malls REIT.
This REIT invests in commercial real estate, particularly strip malls.
This trust owns strip malls across the United States.
By purchasing a share in the XYZ Strip Malls REIT, an investor is able to participate in the profits or losses generated from this portfolio of strip malls.
REITs typically purchase and maintain real estate. Therefore, part of the business is making sure the strip malls are maintained, managed, and occupied.
For XYZ Strip Malls, long-term leases are the primary source of cash. The stores that occupy space pay rent, which is this REIT's main source of revenue.
This revenue may be reinvested to purchase existing strip malls or raw land to develop into new strip malls.
As you might imagine, the performance of the underlying businesses, in this case, shops and restaurants, can affect the REIT's performance.
XYZ Strip Malls can also expand by borrowing money. Doing this introduces leverage, which is controlling a large amount of real estate with a small amount of money.
Too much leverage is risky because it could expose XYZ Strip Malls to interest rate risk. That means if interest payments move higher, the trust may have to spend more paying back its borrowed money.
Payments on borrowed money, capital expenditures, and other costs are subtracted from a REIT's revenue. What's left over, if anything, is typically net income, also known as "earnings".
REITs in the United States are required to pay 90% of their taxable income as dividends.
REITs don't always generate earnings, so dividends are not guaranteed.
REIT management may face several challenges like building and expanding a portfolio of investments.
For example, if XYZ Strip Malls expands too far and buys too many strip malls too fast, the trust could have low or even negative earnings.
This could make it difficult for the trust to provide a dividend to investors.
If a dividend is reduced or a payment is missed, its shareholders would likely sell their shares, possibly at a loss, and look for a better-managed REIT.
However, if a REIT performs well, it's good for the trust and its shareholders.
Now that you know more about REITs—and how they can provide a way to invest in the real estate market—you can see why some investors might consider including them in a diversified income portfolio.
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