REIT 101 – The basics of investing in REIT

Back in 90s, Pakistan was considered one of the rising stars in the developing world. Its strategic location, deep sea ports, rich agricultural land and natural beauty, among others, made it an ideal place for investors to put their money on the line. However, political uncertainty and lawlessness swung investors towards other countries.

But as the saying goes, “what goes around, comes around,” Pakistan is back on global investors’ list with construction in the real estate sector one of the biggest beneficiaries. High rises and large cities are being built at an exponential pace, along with an inflow of funds from overseas and a rise in the market value of property. One question that often pops up in our minds is how can a common person earning a nominal level of income, own a decent property in these times? This is where Real-Estate Investment Trust (REIT) comes in, making it affordable for a low-income investor to take advantage of the inflationary pressures in the property sector.

What is a REIT?

REIT is basically a fund managed by a professional firm specializing in investing in the real estate market. The management firm raises money required by offering shares, called “units”, to common public and invests the funds in a particular real estate segment(s). The units of the REIT are then traded on the stock exchange and can be bought from and sold to other investors. For example, our old friend Wafa wants to invest in a house but does not have the required funds to buy it. She can instead buy units of a REIT operated by a professional firm and get a return in the form of capital appreciation or dividends (discussed in the sections below). To qualify as a REIT, 90% of the proceeds should distributed to the holders of the unit after accounting for the management fee.

Note – REITs can also be held privately without floating on the stock exchange. However, larger REITs are generally floated on an exchange.

How many types of REITs are there?

REITs are mainly of three types:

  1. Equity REIT – the management firm raises money by offering units of REIT. It uses the funds to buy a property, manages it and gives it out on rent. The rent generated from this scheme is then paid out to the holders of the units. The unit holders will also be paid once the property is sold at a higher price by the managing firm.
  2. Mortgage REIT – management firm raises money and loans it out to investors looking to buy real estate. For instance, the managing firm can raise funds from Wafa and loan it out to John, who wants to buy a house. A portion of the interest paid on the loan will be provided to Wafa
  3. Hybrid REIT – this type of REIT combines the features of the equity and mortgage REITs

How can we earn from REIT?

We can earn a decent income from REIT in the following two ways:

  1. Dividends – the money earned from rent and sale of the land is paid to the unit holder, net of operating expenses of the management firm. In the case of mortgage REITs, the interest payments from our borrower John are paid to Wafa after accounting for the management fee
  2. Capital appreciation – Just like stocks, REIT units can appreciate or depreciate in value. For example, suppose investors are optimistic about the real estate market in Pakistan and are willing to pay a higher price for each unit of REIT that they were when REITs were initially floated. Also imagine that Wafa initially bought a unit for Rs. 10 and due to a growth in real estate market she can sell her unit for Rs. 20. Thus, she makes a profit of Rs. 10, not accounting for transaction costs.

Benefit of investing in REIT

  1. Avoid the costs of buying and maintaining a property – Imagine buying a house from a broker, getting all the necessary paperwork done, paying the broker’s fee, paying the loan along with interest and maintaining the house! The intrinsic and the extrinsic costs just keep coming. Instead you can just invest your savings in a REIT, earn a nominal return and let the management do the dirty work for you!
  2. Management expertise in real estate investing – management firms operating a REIT usually have a vast level of experience and expertise in real estate investments. They have experts who survey a particular piece of property or a location, do all sorts of cost benefit analysis and then make a decision whether they should go ahead with the investment
  3. Transparency – Unit prices can be easily viewed on the website of the exchange. Moreover, the website of the management firm has to put up a full-fledged business plan along with the upcoming projects, which can be viewed by anyone looking to invest in the fund
  4. Units can be sold on the exchange – if you are in urgent need of cash, units of REIT can easily be sold on the exchange. However, selling a physical property can be a long and a painful process and it might take a long time before the entire payment is made. Moreover, by investing in REIT, few units can be sold and the rest can be retained; whereas, you need to sell the entire house if you were to raise money from the sale of physical property

Drawbacks of investing in REIT

  1. Management fee – By far the most important drawback of this investment vehicle. Management fee takes up a large portion of the revenues (in some cases up to 90%), passing down very little to the investors. It is for this reason that many professional investors recommend owning a piece of real estate on you own
  2. Lack of control – you have absolutely no control over where your funds are invested. Imagine Wafa believes that her money can earn better returns by investing in Clifton rather than Nazimabad, which is where the management firm wants to invest. In this case, she cannot do anything, since it is entirely up to the management to decide where the funds will be used
  3. Dividends are taxed – the dividends received by the investor are taxed. If you couple this with the fact that the management will take in a significant amount of fee, your return after taxes will be quite low
  4. Low growth opportunities – as mentioned before, REITs have to pay 90% of the income to the investors. This means they will only have 10% of the remaining income that they can invest in other projects.
  5. Lack of diversification – REITs only focus on investing in real estate. If the real estate market suffers due to micro level shocks, there is no other asset in the fund that can cover for the losses. Therefore, astute investors often combine REITs with other assets in their portfolios

Investing in REITs in Pakistan

If you are interested in investing in Pakistan’s local REITs, look nowhere else. Local brokerages provide you with an easy way to invest your funds in some of the nation’s top REITs. Most of the brokerages, such as IGI, Zafarstocks and Standard Capital, have a similar subscription process. All you have to do is:

  1. Enter your details on a broker’s website, including your name, email address, phone no., NIC number etc.
  2. Submit this e-form on the website
  3. You will be contacted by a customer service representative in the next few days to gather some more information including your bank details
  4. Their representative will also ask you to deposit some cash in your newly opened account with the broker and will guide you through the next stages of the process
  5. Once all the formalities are completed, you will be able to buy and sell the required quantity of REIT through their online trading platform

Conclusion

To conclude, REITs are an easy and a cost-effective way to invest in real-estate. Investors interested in earning a nominal level of income through real-estate should find this investment quite appealing. On the contrary, drawbacks such as lack of diversification and high management fee should be taken into account before making a decision about investing large sums. However, every investment comes with its costs, thus making these kinds of decisions a subjective matter.