REITs vs. Real Estate Funds | Cresset Partners (2024)

FAQs

REITs vs. Real Estate Funds | Cresset Partners? ›

Whereas REITs pay dividends to investors, real estate funds aim to generate value through the appreciation of the securities they own. REITs are fundamentally a current-income strategy, as they are required to pay out at least 90% of taxable income each year as dividends to shareholders.

By law, REITs must distribute at least 90% of their taxable income to shareholders. This means most dividends investors receive are taxed as ordinary income at their marginal tax rates rather than lower qualified dividend rates. Any profit is subject to capital gains tax when investors sell REIT shares.

Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making. Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 shareholders (the 100 Shareholder Test) and five or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (the 5/50 Test).

The lack of government regulation makes it difficult for investors to evaluate them since little to no information is available publicly. Also, they are not required to prepare audited financial statements.

For Group REITs, the consequences of leaving early apply when the principal company of the group gives notice for the group as a whole to leave the regime within ten years of joining or where an exiting company has been a member of the Group REIT for less than ten years.

General requirements

A REIT cannot be closely held. A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year, (this is commonly referred to as the 5/50 test).

Investors should be aware that non-traded REITs may have high up-front fees or sales commissions. These REITS may also have annual management fees, and the management team may take a percentage of profits in the form of “promoted interest”. Together these fees can put a dent in the ultimate return that investors see.

Limited Liability. When you own a REIT share, you never have to worry about lawsuits or bankruptcy proceedings against you. In contrast, if you own rental properties, you can potentially be sued by your tenants and may have to personally guarantee loans.

Congress created real estate investment trusts (REITs) in 1960 to level the playing field. REITs empower anyone to invest in wealth-creating, income-producing real estate. They've certainly done that over the years. Over the long term, our research found that REITs have outperformed stocks.

What is the 80 20 rule for REITs? ›

80-20 Rule: At least 80% of a REIT's asset value must be in completed and income-generating real estate, with the remaining 20% able to be invested in riskier assets such as under construction buildings, equity shares, bonds, cash, or under-construction commercial property.

It's prudent to begin with a modest allocation and gradually increase your exposure over time. You might begin by investing a small percentage of your portfolio—perhaps 2% to 5%—in a broadly diversified REIT or REIT fund.

Taxes & REIT Investment

REIT dividends can be taxed at different rates because they can be allocated to ordinary income, capital gains and return of capital. The maximum capital gains tax rate of 20% (plus the 3.8% Medicare Surtax) applies generally to the sale of REIT stock.

Summary. Blackstone has been on a REIT buying spree. Its leaders are self-made billionaires, and they talk highly about REITs.

A lot of REIT investors will select their investments based on the dividend yield and think that a higher yield will likely lead to higher total returns. But in reality, it is often the opposite. More often than not, the lowest-yielding REITs have actually outperformed the highest-yielding REITs over the long run.

What happened? These stocks, which invest in real estate and pass the rent through to investors, were supposed to be a big beneficiary of the interest-rate cuts that were expected this year but have yet to occur. High interest rates make it more expensive for REITs to invest in new properties.

Derive at least 75% of gross income from rent, interest on mortgages that finance real estate, or real estate sales. Pay a minimum of 90% of their taxable income to their shareholders through dividends. Be a taxable corporation. Be managed by a board of directors or trustees.

To qualify as securities, REITs must payout at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they payout.

30% Rule. This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income. REITs use debt financing, where the business interest expense comes in.