REITs: What Is a Real Estate Investment Trust?
Real Estate Investment Trusts (REITs) are a popular method of investing in the property market without buying physical real estate. But what is a real estate investment trust? How do they work? What are their advantages? In this article, we will be answering these questions, highlighting a UK REIT to watch and more!
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What Is a Real Estate Investment Trust?
So, what is a Real Estate Investment Trust? A Real Estate Investment Trust, or REIT, is a company which uses a pool of investor money to acquire, or develop, and usually manage a portfolio of income-generating properties. These properties can include apartment buildings, shopping centres, warehouses and office blocks.
REITs operate similarly to mutual funds or Exchange-Traded Funds (ETFs), in that they permit retail investors to gain exposure to the property market without the high associated costs and headaches which accompany owning and managing real estate.
Although REITs generally tend to specialise in a specific sector of the property market, you can also find REITs whose portfolios are diversified and span several different sectors.
So, what distinguishes a REIT from these other funds and from any other type of company? The exact characteristics of a REIT differ between countries, depending on which financial jurisdiction they fall under. However, the common quality among them is that, as a REIT, a company enjoys preferential tax treatment – usually being required to pay less in both corporation tax and capital gains. But in order to qualify as a REIT, companies must meet certain conditions.
How Does a Company Become a REIT?
As with the characteristics of REITs, the criteria with which a company must comply to become a REIT differs from country to country.
Below, we have highlighted a few of the most important conditions for UK REITs:
- They must distribute a minimum of 90% of their tax-exempt profit to investors as a dividend
- UK REITs must be a close-ended investment trust
- A close-ended trust is essentially the opposite of an open-ended trust, which is how the majority of mutual funds are categorised. An open-ended trust regularly creates new shares to meet investor demand and, when an investor wishes to exit their position, the fund redeems their shares.
- A closed-ended trust, on the other hand, issues shares through an Initial Public Offering (IPO) in order to raise capital for its investment activities. Once the shares have been created, they are exchanged between investors on the secondary market. New shares are not created to meet an increase in investor demand, nor are they redeemed by the fund.
- They must be UK-resident and listed on a recognised stock exchange
- They cannot be a close company – although UK REITs have a three year grace period in which to comply with this condition
- A close company is a company which is controlled by five or fewer investors
There are more conditions which must be adhered to, but these are some of the most important. Qualifying as a REIT entitles the company to privileged tax treatment, but what are the benefits of REITs for investors?
Benefits of REITs For Investors
We have already touched on a couple of the main benefits of investing in REITs for investors, but here, we will expand on these benefits and another.
The property market tends to behave differently to other asset classes, which makes it a good option for diversifying your portfolio. REITs provide investors with this diversification, allowing them to gain exposure to the property market without buying or managing any physical real estate.
A requirement of becoming a REIT is distributing 90% of tax-exempt profit among investors. This means that, by investing in REITs, an investor tends to enjoy a fairly stable source of additional income. This makes REITs particularly attractive for income investors.
One of the major downsides of investing in physical property is the lack of liquidity in the property market. Buying and selling property can take months or even years in some cases. UK REITs, on the other hand, trade on the stock exchange and enjoy a high level of liquidity meaning that they are easy to buy and sell.
This is perhaps not so much an advantage specifically for REITs as it is for the property market in general, but in times of inflationary pressure, property has historically proven to be an effective hedge against inflation.
If we focus specifically on REITs, their revenue is mostly generated through collecting rent on their portfolio of properties. Rent tends to be positively correlated with inflation; in other words, when inflation rises, rent payments usually rise as well. This correlation allows REITs to continue to grow and maintain their dividend payments during periods of inflationary pressure.
Disadvantages of REITs
Naturally, it is not just positives associated with investing in REITs and there are some drawbacks which potential investors will need to consider.
Whilst the requirement to pay out 90% of their tax-exempt profit to investors is great from an income perspective, it only leaves the REIT with 10% to reinvest back into the company. Naturally, this has a negative effect on the company’s ability to grow and acquire new property to add to its portfolio.
Therefore, while many REITs will have a favourable dividend yield, they are not always the best option for people who are looking for an investment with capital appreciation potential.
Another drawback of investing in REITs is the way that dividend payments are taxed. Dividend payments made from the REITs tax-exempt profit is known as a Property Income Distribution (PID) and is taxed differently to non-PID dividends.
As the profit which is distributed as PID dividends has been exempt from tax, once distributed, it is classed as property letting income, which is liable to income tax. Usually, the PID dividends are only paid out after the deduction of tax at the basic income rate (in the UK) has already been made. The REIT then pays directly this tax to HMRC on the shareholder’s behalf.
UK REIT to Watch: Tritax Big Box
Tritax Big Box is a UK REIT which invests in and leases out distribution centres, currently boasting a portfolio of 60 assets with a total value of £4.89 billion.
Amongst the top ten of their 42 customers are Amazon, Morrisons, Tesco and Co-op; in fact, according to their H1 2021 results, as a proportion of their total contracted rent, “63% of the Group’s customers are in defensive and resilient sectors, such as e-commerce and food retail” – which is particularly important as the global economy still faces an uncertain future in the wake of the coronavirus pandemic.
Elsewhere in the H1 results, we learn that operating profit has increased more than 19% compared to 2020, reaching £84.1m. Dividend per share also increased 2.4% giving them a current dividend yield of around 2.9%. Furthermore, the REIT acquired a new asset for their portfolio in April 2021, helping to increase their portfolio value by almost 11% since the end of 2020.
In the face of rising inflation, it is also important to note that 37% of the rent roll is up for review in 2021, with a further 27% in 2022.
Looking at the Tritax Big Box price chart, following the lows caused by the outbreak of Covid-19, the share price took less than three months to recover its pre-pandemic levels and has since increased significantly.
Tritax Big Box owes a lot of its recent success to the growth in popularity of online retail. The e-commerce market has grown considerably over recent years and this growth has been compounded by the pandemic - which saw many forced to shop online. As the market continues to grow, distribution centres will be in higher demand and Tritax Big Box looks well positioned to benefit from this increase.
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