While we termed REITs as funds, technically they do not have the term “fund” in the name. Either way, they are still pools of assets to help investors gain exposure to otherwise inaccessible assets. In this case, the asset class is real estate.
Conditions of Becoming a REIT
In the first part of this series An Introduction to Mutual Funds, ETFs, REITs, ETNs, we linked a London Stock Exchange guide on becoming a REIT. One of the most important differentiators to MFs and ETFs is the open/closed-ended fund requirement. MFs have dynamic share structures, and ETFs, while they appear closed-ended from the perspective of the retail investor, they are in fact open-ended and shares can be bought and sold by authorized participants. For REITs, there is no such share creation or destruction.
Two other important requirements are not being a close company, which means there must be at least 6 shareholders, and they cannot all be directors, too. There must also be a single class of shares, whereas MFs have various classes of shares (normally Class A, Class B, and Class C shares). A final important aspect of REITs is that they are listed on a recognized exchange. This aspect makes them closer to ETFs than MFs.
For newly-started REITs, there is a three-year waiver period (in the UK), during which the REIT is exempt from the conditions. This period is useful for raising capital and growing the REIT, after which shares can be sold to others and a better portfolio developed.
Types of REITs
In the United States, there are two types of REITs, with three regimes for registration. The two types are equity and mortgage REITs, where the former is directly involved in owning properties, while the second is more of a financing company that underwrites mortgages for properties, generating revenue from the mortgage payments. The three regimes are public, public non-listed, and private. Public non-listed REITs are registered with the SEC as REITs, and they have to report, but they are not listed on any exchange. Private REITs are held privately, exempt from SEC registration, and do not trade on exchanges.
In the United Kingdom, however, all REITs must be listed, so there are no private or public non-listed REITs. Moreover, the mortgage REIT has not made its debut in the UK, though there was a push in the early 2010s to introduce it. So while many types of REITs do exist around the world, at least in the UK at this time, there are only public equity REITs.
Investor Profits from REITs and Dilution
Since REITs in the UK must operate rental properties, the income for REITs is based on such generated income. Dividends are paid to shareholders, and REITs are tax-exempt on their property investment gains in several countries. That means the profits are only taxed once, just like a direct investment in property. Therefore, rental income is an attractive feature for income investors.
Of course, since REITs are tradable on exchanges, the value of the shares may rise if the value of the property rises or it seems significantly more lucrative rental agreements will be finalized. Capital gains on shares may then be taken by investors.
On the other hand, since 90% of profits must be paid out to shareholders, it can be difficult for REITs to amass enough cash to purchase new properties. In that case, a REIT may make further equity offerings, receiving cash and issuing more shares. Normally, different classes of shares might be used to avoid share dilution; but since REITs may only have a single class of shares, dilution of ownership by the current shareholders is a problem.
How ETNs Differ
The first and most obvious way that ETNs differ from the funds is that ETNs are debt securities. The other three securities in this series own some underlying and investors own a proportional share of the underlying (through the fund), whereas ETNs only own the promise of payment in the future.
Stemming from this promise-ownership difference, a lack of collateral is another important way ETNs and the funds differ. For funds, the entity owns something as the underlying (even if they’re synthetic funds, which are derivative-based). For MFs, REITs, and physical ETFs, the entity owns the underlying outright. This provides a degree of collateralization. For ETNs, the payout is entirely dependent on the issuer’s credit. Since most ETNs are issued by big banks, the credit risk is low. But a low risk and zero-risk are not identical. Lehman Brothers, which issued ETNs, was also thought to be low-risk too. And it was, but again, low-risk does not mean zero-risk. However, if the ETN is tracking an index (or even a cryptocurrency, which is popular these days), it may be collateralized, so not all ETNs are credit-risk ridden uncollateralized debt securities.
Also mentioned in the first instalment, ETNs have zero tracking error, in opposition to ETFs. However, the price differential can be problematic due to liquidity squeezes. ETNs are redeemable by authorized participants for the current principal, but the issuer has the right to stop issuing new notes. If demand increases after an announcement of no new issues, the price will likely diverge dramatically. The Credit Suisse TVIX divergence in 2012 is one example of this supply-demand imbalance issue.
Profits from ETN investments
ETNs are debt securities, but they are more similar to zero-coupon bonds than to common interest-bearing bonds. That does not, however, mean the ETN will pay out more than what was paid, which is how profits are received on zero-coupon bonds. Since ETNs track an underlying, the principal will change along with the market; in contrast, zero-coupon bonds simply gain value until maturity, when they reach their face value. In contrast to interest-bearing bonds, though, ETNs make no interest payments.
Therefore, the main way for ETN investors to profit is from capital gains. Investors using ETNs can look for market trends and buy the ETN before they expect the underlying to increase. Once the underlying has increased, the holder can sell into the open market to capture the capital gains.
Tax Efficiency of ETNs
One reason to use ETNs over the funds is tax efficiency. Since ETNs are considered prepaid contracts and there are no dividends or disbursements, as with ETFs, MFs, and REITs, the only taxable event is the realisation of capital gains following the sale of the ETN (or maturity). This means ETNs are a good vehicle to gain exposure to inaccessible markets or indices without having to worry about the tax implications of MFs and ETFs, even though the latter are already tax efficient.
Our next instalment will focus on how to evaluate exchange-traded products, and decide which one will work best for you. We will largely focus on ETFs, as they are more popular than ETNs and REITs. MFs are not ETPs (they must be bought and sold through a broker), but we will touch on them as well.