Published Wednesday, August 8, 2012 at: 7:00 AM EDT
Suppose you want to diversify your holdings by investing in real estate. Or maybe you believe that the real estate market, in the doldrums for years, is ready to bounce back. Even with depressed prices throughout most of the country, you’ll still have to pay a pretty penny to acquire a building or a parcel of land in a prime location.
But you don’t necessarily have to go whole hog. Instead of buying a property outright, you might acquire shares in a real estate investment trust (REIT). It’s akin to buying shares of a mutual fund, so this type of investment hedge doesn’t have to cost you a small fortune.
Although past performance is no guarantee of future results, REITs have performed favorably in comparisons to notable benchmarks the last few years, including the S&P 500 stock index and 10-year Treasury bonds, according to the National Association of Real Estate Investment Trusts (NAREIT).
A REIT is a corporate entity that invests in real estate properties in much the way a mutual fund invests in stocks. Professional managers handle the portfolio, and if the REIT meets certain requirements, it gets favorable tax treatment. Due to income and tax reporting rules for REITs, such investments are often held in retirement accounts.
There are three basic types of REITs:
1. Equity REITs. These are by far the most common type. An equity REIT holds physical real estate properties—typically, shopping malls, hotels, hospitals, offices, or timberland—that generate rental income. Some equity REITs focus on properties in a particular geographic area. A REIT’s properties usually are purchased to be part of a portfolio of investments instead of being developed for resale.
2. Mortgage REITs. A mortgage REIT originates and buys or sells mortgages for property owners. The loans are secured by real estate, mortgage-backed securities, or existing mortgages. Essentially, this type of REIT is a finance company. The main revenue source is interest from the mortgages.
3. Hybrid REITs. These combine elements of equity and mortgage REITS, including direct property ownership and mortgage lending. They earn both rental and interest income, and can provide diversification within a single investment.
A REIT doesn’t have to pay corporate income tax if it distributes at least 95% of its net annual earnings as dividends. But note that REIT income generally doesn’t qualify for the favorable 15% maximum tax rate that applies to “qualified” dividends (A 20% rate on qualified dividends applies to certain upper-income investors).
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