Investing in real estate investment trusts

In his novel Great Expectations Charles Dickens poked fun at the British obsession with housing when he made the home of one character an actual castle, complete with a functioning cannon. Over 150 years later, the idea that every Englishman’s home is his castle still runs deep. For good or for ill, we are a country that loves to own property.

One difference between the Victorian era and now, however, is that many more people today don’t just buy a home to live in. Lots of us also want to buy properties as a form of investment, whether that’s to buy low and sell high or live off a stream of rental income.

The problem for regular investors is that this is a very expensive thing to do. It’s hard enough to buy a property for yourself, let alone to put down the cash for another one. And even if someone does have a lot of money, the odds are most of the property market will still be out of their reach.

That’s because the sector is far broader than the houses or flats most people look to invest in. Commercial real estate, like car parks, warehouses, offices, or shopping centres are all types of property that see lots of investment. Of course, if buying a house is expensive for most people, then taking over an office block is going to be impossible for all but a tiny part of the population.

Why REITs are a good way to invest in real estate

This does not mean that all is lost and you can’t invest in these types of property. True, you aren’t likely to own a warehouse or huge portfolio of apartment buildings but you can take a small stake in these sorts of properties by investing in a real estate investment trust.

Real estate investment trusts (REITs) are closed-ended funds that have publicly traded shares. At the time of writing, there are more than 50 such trusts listed on the London Stock Exchange. They manage over £50bn in assets, although they vary substantially in size.

London-listed REITs invest in a range of properties. Retail stores, warehouses, car parks, office buildings, and apartment blocks, are all accessible through them.

REITs may also have a very narrow focus or a relatively wide one. For instance, a trust may only invest in warehouses or hotels, whereas others may mix together commercial and residential properties in a single portfolio.

REIT liquidity benefits

Beyond being one of the only ways investors can access certain parts of the real estate market or indeed the real estate market in general, REITs have structural benefits which provide several benefits to investors.

To understand why this is, you need to know a little bit about closed-ended funds, of which REITs are an example. These are essentially investment funds that are set up as a company. That company raises money from investors, who receive shares in return for providing the fund with cash to invest.

Once issued, the shares in an investment trust or REIT are listed on the stock exchange and can be bought and sold there just like shares in any other company – with no impact on the underlying portfolio.

This may sound like mundane financial technicalities but it has a big impact for investors. It means that a REIT’s shares can be bought or sold very easily. In turn, that means investors can get exposure to real estate, or dispose of their exposure to real estate, much more easily than if they owned physical property.

It also means the REIT’s manager does not need to worry about selling underlying assets when shareholders in the REIT want to sell their shares – which they must do via the stock market in the same way they’d sell any other share, rather than by asking the manager to redeem them as would be the case for an OEIC.

When you then factor in the price of those shares, which are likely to be in the reach of most investors, it means that REITs provide a much simpler and more affordable route to the real estate market than physical property does, with the added ability to dispose of that exposure more quickly too.

They are also protected from the threat of ‘gating’ – whereby shareholders in OEICS have seen themselves locked into property funds during various market crises because the managers refuse to allow redemptions while the underlying portfolio is in freefall.

REIT structural benefits

Aside from these liquidity benefits, REITs also have several traits that can help boost returns for shareholders. As we have discussed, unlike open-ended funds, REITs do not have to return cash to shareholders every time they want to sell their shares.

The result of this is that REITs can typically invest a larger proportion of the cash they receive from investors. If their investments are successful, this means they can generate greater returns for shareholders as they don’t suffer from the same level of ‘cash drag’ that an open-ended fund will.

REITs can also use gearing – borrowed money – to boost returns. If the REIT makes good investments then this will boost its total return. Obviously the reverse is also true and this is something investors should keep in mind.

REIT dividend policy

REITs are also exempt from paying corporation tax in the UK on any profits derived from renting property. However, they are also required to distribute 90% of that income as dividends to shareholders.

These are not ‘normal’ dividends per se. They are what are known as a ‘property income distribution’ (PID). A PID is classed as property income by UK tax authorities, which means they are treated differently to other dividend payments.

When a REIT pays out a PID dividend, it will withhold 20% of the total amount to be paid as tax. Depending on your tax band, you may have to pay more than this after you’ve received the dividend.

The reason REITs are set up like this is to prevent double taxation. If a REIT had to pay corporation tax on its property income and shareholders then had to pay income tax on their dividends, it would mean paying tax twice over.

This may sound like bad news but investors that hold REIT shares in a tax efficient account, like an individual savings account (ISA) or self-invested personal pension (SIPP), do not have to pay any tax on REIT dividends. You can claim back the 20% withholding tax as a result. Your stockbroker may do this for you, but be sure to check if they do.

UK REITs historical performance

UK REITs have historically provided investors with respectable returns. Research by asset management group Schroders found that REITs outperformed a benchmark of returns produced by private property investors over several prolonged periods of time.

In the 20 years up until October 2020, REITs produced an annualized total return of 7.4%. Over 30 years and 50 years, the figures were 7.0% and 10.4%. There was no benchmark data for the 50-year period but in the 20 and 30 year periods, private investment returned 6.5% and 6.4% annualized returns respectively.

What’s remarkable about this is, over relatively long periods of time like these, you’d expect the private property investors to outperform. The reason for this is that private property investors hold the physical real estate. As a result they’d typically charge more when making sales in response to taking on a more illiquid asset. But this appears not to have been the case.

When gauging performance, however, investors should keep in mind that the REIT market in the UK is a diverse one. Individual REITs will have their own risk profile and investment process. So even if they have produced respectable returns as a collective, that’s not to say the same will continue into the future or that an individual REIT is likely to match that performance.

Past performance is not a reliable indicator of future results