Real Estate Investment Trusts (REITs): A jargon-free guide

Real Estate Investment Trusts or REITs are companies that own and manage a portfolio of real estate properties and/or mortgages. They provide investors with exposure to real estate by allowing them to buy units in their stock portfolio. 

REITs are somewhat similar to managed funds. They pool investors’ money to invest in commercial real estate, such as office spaces, shopping centres and hotels, as well as apartment buildings. The overall purpose is to own and manage a real estate portfolio for the benefit of shareholders by investing in properties with strong rental yield and potential for capital gain. 

Most of the taxable income from the portfolio, such as rental income, is passed on to shareholders as dividends. REITs are traded on the Australian Securities Exchange (ASX), and you can buy and sell them like stocks during trading hours. While it’s not possible to sell a portion of your investment property if you urgently need cash, REITs are highly liquid in comparison, which may add to their appeal for some investors.

In Australia, REITs are usually known as A-REITs. They are traded on the ASX, and you will generally encounter two common types of REITs – Equity and Mortgage REITs. 

Equity REITs are the most common type of REITs. They invest in properties and own them to generate income through rent. So, if you purchase units in an Equity REIT, you will become a part-owner of the income-producing assets held in the portfolio. 

Mortgage REITs, on the other hand, own property mortgages. They lend money to real estate owners and generate income through the interest paid. These loans are generally secured by real estate assets. So, if the borrower defaults on the loan, the lender (which is a REIT in this case) can take possession of the security property and sell it to recoup the outstanding loan amount.

Broadly speaking, there are two main differences between Equity and Mortgage REITs. The first is ownership. While an Equity REIT invests in and owns real estate, mortgage REITs don’t own real estate but lend money to real estate owners who mortgage their properties to secure the loans. The second difference is the source of income. While Equity REITs generate their income from rent, Mortgage REITs generate income through the interest paid on the issued mortgages.

If you want to invest in REITs, you could purchase listed REIT stock on the ASX.  You may either buy stocks of the company itself or purchase an exchange-traded fund (ETF) that tracks a basket of REIT companies.

The minimum investment you need to make in a REIT is generally $500. Thus, it provides an affordable way of diversifying your portfolio by investing in real estate without actually owning or managing a property. 

Some investors believe that REITs can also offer more diversification. As REITs tend to invest in multiple property assets, they can provide exposure to different parts of the property market, which may help minimise investor risk to some extent. 

However,  the portfolio is run and managed by a single team. The overall performance of the portfolio depends on this team’s astuteness, vision and goals. It’s also worth noting that even though the property market has delivered consistent returns over time, there is no guarantee that a property will always appreciate in value. 

It’s also not necessarily the case that all properties in a portfolio will always have tenants, and the rental income generated by the REIT may not be steady. It’s true that commercial properties generally have longer leases (up to 10 years in some cases). However, once a lease expires and a tenant doesn’t renew, there will be no income from that property unless another tenant fills up the vacancy. 

If multiple properties fall vacant at once, you can imagine how it will reduce the REIT’s income and your dividend as well. If you’re considering investing in an Equity REIT, spend some time reading all the details about the portfolio and its historical performance. Also search for the ‘weighted average lease expiry’ in the REIT documentation, which will tell you the lock-in period for the current portfolio’s leases or rental streams. In general, the longer the lock-in period, the better it is, as you can expect steady rental income during the period. 

As an investor, you also need to know that REITs usually take on some level of debt to grow their portfolio. Lower interest costs in the past couple of years have thus contributed to the strong performance of some REITs. However, before being tempted by the higher dividends, it’s also worth considering the reverse scenario. If interest rates rise in the future, it could impact the performance of various REITs, especially those with a higher percentage of debt.

Conversely, in the case of Mortgage REITs, lower mortgage interest rates translate into lower earnings for unitholders. Unitholders may earn higher dividends once the interest rates rise as the individual REITs will earn more in interest costs. But if several borrowers are unable to service their loans at a higher rate, it could lead to a string of defaults that may adversely impact the returns.

You may also invest in Hybrid REITs that combine the benefits (and risks) of Equity and Mortgage REITs.

Overall, investing in REITs may be considered just as risky or safe as investing directly in property. Whether it’s a suitable investment for you depends on your risk appetite and investment goals. As always, it’s important to learn more about the product and be aware of the associated risks before investing your money. You could also read about other investment options available to you before deciding on where to invest your hard earned money.