What Are Non-Traded REITs and How Do They Work?
Explore the fundamentals of non-traded REITs, including their structure, funding, distribution, and regulatory aspects, to understand their investment potential.
Investors seeking opportunities in real estate often encounter various investment vehicles, one of which is the non-traded Real Estate Investment Trust (REIT). These REITs offer access to real estate investments without being subject to stock market volatility. Understanding their function and potential benefits or drawbacks is key for informed investment decisions.
Non-traded REITs provide diversification and income generation but possess characteristics that set them apart from other investment forms. Examining these features offers a clearer picture of what to expect when considering this type of investment.
Basic Structure
Non-traded REITs are corporations or trusts that pool investor capital to purchase and manage income-generating real estate. Unlike publicly traded REITs, these are not listed on stock exchanges, shielding them from daily market fluctuations. This structure emphasizes long-term real estate investments, often in commercial properties such as office buildings, shopping centers, or apartment complexes.
The REIT sponsor forms the entity and manages operations, including property acquisition and management. An external advisor is often employed to optimize asset performance. A defining characteristic of non-traded REITs is their limited liquidity. These are typically long-term commitments with holding periods of five to seven years or more. The absence of a secondary market means investors may face challenges in selling holdings before the REIT’s liquidation or listing.
Funding Sources
Non-traded REITs raise capital primarily through private placements targeting accredited investors who meet income and net worth criteria set by the Securities and Exchange Commission (SEC). This allows for substantial funding from a smaller investor pool.
Funding combines equity and debt financing. Equity financing involves selling shares to form the capital base, while debt financing leverages this capital for acquiring larger or additional properties. While this strategy can amplify returns, it introduces risks tied to managing debt obligations and interest payments.
Some non-traded REITs also attract institutional funding from entities like pension funds or insurance companies, drawn by the potential for stable long-term returns. Institutional involvement, however, can heighten scrutiny and governance expectations.
Distribution Methods
Non-traded REITs provide regular income to investors, typically through dividends derived from rental income and capital gains. Many REITs pay distributions quarterly, though some opt for monthly or semi-annual schedules. These payouts appeal to investors seeking steady income streams.
By law, REITs must distribute at least 90% of taxable income to maintain tax-advantaged status. While they aim for consistent dividends, payouts may fluctuate based on performance and economic conditions. Dividends are often classified as ordinary income, though part may qualify as a return of capital, reducing the investor’s cost basis in the shares.
Redemption Guidelines
Redeeming shares in non-traded REITs requires careful consideration due to their illiquidity. Unlike publicly traded REITs, these lack a secondary market, so investors cannot sell holdings freely. Redemption is managed through share repurchase programs with strict limits, typically allowing 5-10% of total shares to be redeemed annually.
Redemption requests are generally processed on a first-come, first-served basis, and investors may face delays or restrictions. Understanding the terms outlined in the REIT’s offering documents is essential.
Regulatory Requirements
Non-traded REITs are governed by regulations aimed at protecting investors and ensuring transparency. They must register offerings with the SEC unless exempt, such as under Regulation D for private placements. Registration requires detailed disclosures about operations, financial condition, and risks, typically presented in the prospectus or offering memorandum.
To maintain REIT status under the Internal Revenue Code, these entities must derive at least 75% of gross income from real estate-related activities, ensure 75% of total assets consist of real estate or related holdings, and distribute at least 90% of taxable income to shareholders annually. Failure to meet these requirements results in losing REIT status and incurring corporate-level taxes, which could impact returns.
State-level regulations, including blue sky laws, may impose additional investor protections, such as suitability standards restricting sales to individuals meeting financial thresholds.
Tax Implications
The tax treatment of non-traded REITs significantly affects their appeal. They benefit from pass-through taxation under the Internal Revenue Code, meaning they avoid federal income taxes on earnings distributed to shareholders.
Distributions are categorized as ordinary income, capital gains, or return of capital. Ordinary income distributions are taxed at the investor’s marginal rate, while capital gains distributions are taxed at lower long-term rates. Return of capital distributions are not immediately taxable but reduce the investor’s cost basis in REIT shares.
State and local taxes may also apply to distributions. Additionally, the Tax Cuts and Jobs Act of 2017 introduced a 20% deduction for qualified REIT dividends, reducing the taxable portion of these dividends. Consulting a tax advisor is recommended for optimizing after-tax returns.