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Investing in REITs? Here’s what I think you need to know

Ever wondered what a REIT is or why you might want to buy shares in one? Read on to find out.

Why do REITs exist?

Real estate is a very popular sector to invest in for a number of reasons. For one thing, it is easy to understand. While not everyone can accurately model out the demand for a new computer or insurance product, most people intuitively understand demand for housing. The factors affecting supply, demand and price are quite obvious, and a lot of investors will have first-hand experience with the market, either as buyers or renters. Another reason why real estate is popular is that it delivers a steady stream of cash when let out — and investors love regular payouts.

However, the problem with real estate is that it tends to be very expensive. Most people can see the value in owning a rental property, but far fewer are in a position to buy an entire property. Even those who can are usually limited by a single asset, making their portfolio highly concentrated.

Real estate investment trusts (REITs) were created to solve these problems. REITs are companies that own and operate real estate portfolios. Investors buy shares in a REIT, much like any other company, and the income generated by the properties is paid out as dividends. They lower the barrier for entry such that all investors can gain exposure to the property market in a diversified manner. Many REITs are traded on public stock exchanges and are therefore highly liquid, another benefit they have compared with owning property outright.

How are they different?

REITs differ from other businesses in a number of ways. They are required by law to distribute 90% of their income to shareholders. They are taxed in a different way to most other companies — they do not pay corporation tax, but withhold the basic 20% rate from dividend payouts. Most importantly, by virtue of the fact that they are property companies, they must be valued differently. 

Most businesses own assets and charge depreciation expenses from their income to account for the wear and tear on those assets. In the case of a REIT however, their main assets are the properties that they own, and property typically does not lose value over time (if properly taken care of). As a result, earnings are not an accurate representation of how much money a REIT is making. Investors will sometimes use a metric called ‘free funds from operations’, which adds back depreciation and amortisation to earnings (but subtracts gains from property sales). This allows apples-to-apples comparisons between REITs. 

Not everyone has the capital to become a landlord. But almost anyone can become a REIT investor and access the property market. Consider REITs as a supplement to your income portfolio — you may be glad that you did.

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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.