Can a REIT take on debt?
A REIT may incur indebtedness for a variety of purposes, including to smooth out cash flow, as a bridge to an additional capital raise, and/or to leverage its assets for the purpose of acquiring additional assets.
Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities.
Because you're smart, you may be asking yourself, What happens if the short-term interest rate goes up? Any increase in the short-term interest rate eats into the profit—so if it doubled in our example above, there'd be no profit left. And if it goes up even higher, the REIT loses money.
What this means is that REITs are ideal borrowers for banks. They are exactly who they want to do business with because they know that the risk of a REIT bankruptcy is extremely low. Just look at the past. There have been very few REIT bankruptcies over the past 50+ years.
Risks of REITs
REITs closely follow the overall real estate market and are subject to much of the same risks, including fluctuations in property value, leasing occupancy, and geographic demand. Real estate is typically very sensitive to changes in interest rates, which can affect property values and occupancy demand.
There are two main types of real estate investment trusts (REITs) that investors can buy: equity REITs and mortgage REITs. Equity REITs own and operate properties, while mortgage REITs invest in mortgages and related assets.
REIT Operating Basic
One of those restrictions is that REITs must distribute (i.e., dividends) 90% of their taxable income to investors. If there are no earnings to distribute, the distribution is considered a return of capital and not taxed. Paying 90% of income disqualifies the REIT from paying corporate taxes.
REITs allow investors to pool their money and purchase real estate properties. By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions.
REITs do not guarantee income or total performance. Diversification in REITs does not guard against loss of income nor loss of principal. REITs are subject to economic volatility.
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
Can a REIT go to zero?
But since REITs are invested in property, there's more protection against the horror show of having shares crash to $0. By law, 75% of a REITs asset must be invested in real estate. The market value of the property owned by the REIT offers a bit of protection, as long as the value of the property doesn't go to zero.
If the REIT fails this ownership test for more than 30 days (31 days if the year has 366 days) in a taxable year of 12 months, it can lose REIT status and cannot elect to be treated as a REIT for five years (IRCазза856(a)-(b)). The test is pro-rated for taxable years shorter than 12 months.
That's because when interest rates rise and yields balloon, their valuations tend to suffer, which is what happened after it became clear in 2021 that the U.S. Federal Reserve would embark on an aggressive, multiyear tightening campaign. Many REITs experienced declines of more than 50% after that point.
The value of a REIT is based on the real estate market, so if interest rates increase and the demand for properties goes down as a result, it could lead to lower property values, negatively impacting the value of your investment.
Investments are influenced by a variety of factors, but REITs can be hypersensitive to changes in interest rates. Rising interest rates can spell trouble for the price of REIT stocks (also known as interest rate risk).
But interest rates have still been rising, so you wouldn't expect REITs to begin rebounding yet. As this chart shows, REITs perform poorly during periods of rising long-term interest rates, such as we are in right now. They perform even more poorly relative to non-REIT equities.
Given the asset-heavy nature of the business's continuous requirement to fund new acquisitions and investments to ensure successful operations of REITs, debt is an important component of the capital structure of a REIT.
Debt REITs own no physical property, but instead invest in property mortgages. These REITs loan money for mortgages to owners of real estate or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans.
REITs and Debt Financing
Debt financing is typically done through fixed rate and variable rate lending. Since REITs require capital for regular dividend payments, there are key restrictions in place to avoid them becoming overleveraged. Debt refinancing also is an important aspect of fundraising for REITs.
Investors can buy and sell shares of public REITs at any time during trading hours. With private REITs, on the other hand, investors may have to wait for a redemption event, which can occur quarterly or annually, before they can cash out their investment. Additionally, private REITs may charge redemption fees.
What is the REIT 10 year rule?
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.
REITs make their money through the mortgages underlying real estate development or on rental incomes once the property is developed. REITs provide shareholders with a steady income and, if held long-term, growth that reflects the appreciation of the property it owns.
Key Points. REITs have outperformed stocks on 20-to-50-year horizons. Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large.
Historically, REITs are one of the better-performing sectors during inflationary periods. We can see this in the following image. You'll notice REITs are in the upper right area, showing they are outperformers during periods of high inflation.
REITs provide natural protection against inflation. Real estate rents and values tend to increase when prices do. This supports REIT dividend growth and provides a reliable stream of income even during inflationary periods.
