- REITs own, operate, or finance income-producing real estate ventures.
- REITs offer investors a liquid way to invest in real estate without buying the property themselves.
- They provide portfolio diversification but come with tax consequences and interest rate-related risks.
A real estate investment trust (REIT) allows people to invest in real estate without the hassle of directly buying or managing a physical property. REITs are often the real estate investment of choice for individual investors.
According to the National Association of Real Estate Investment Trusts (NAREIT), as of January 2024, an estimated 168 million Americans, or roughly 50% of U.S. households, own REIT shares, most of which trade on major stock exchanges.
With the best real estate investing apps, you can invest in REITs and generate passive income streams. But, ensure you understand the fees, time horizon, and liquidity risks of investing in real estate.
Introduction to REITs
REITs were established in 1960 due to a Congressional amendment, making it possible for investors to invest in commercial real estate portfolios. Today, REITs remain a popular investment option for those looking to participate in the real estate market without the significant upfront costs of direct property ownership.
While most stock dividends are taxed twice — first when the company pays its corporate taxes, then when the investor pays their income tax — REIT payouts are only taxed through investors. The result is higher returns for investors.
REIT rules
Certain Internal Revenue Code (IRC) rules must be met for a company to qualify as a REIT (and avoid corporate taxes). The company must be registered as a corporation and managed by a board of trustees or directors.
A REIT must also:
- Distribute at least 90% of its annual taxable income in dividends
- Rent at least 90% of the property to people who are not subsidiaries of the REIT
- Derive at least 75% of its gross income from real estate
- Invest at least 75% of its total assets in real estate ventures, cash vehicles (bonds, etc.), or government securities
- Have at least 100 shareholders
- Have no more than 50% of its shares held by less than five individuals
How REITs work
Let's examine REITs' workings, including their structure, investment focus, and potential for generating income.
Structure of REITs
REITs, or real estate investment trusts, are investment funds that specialize in owning, operating, or financing income-producing real estate. They are usually structured as corporations, trusts, or associations.
Like mutual funds and ETFs, REITs offer instant diversification by investing in a portfolio of properties. Investors purchase shares of a REIT and receive a portion of the income generated by these properties.
Investment focus of REITs
REITs generally focus on one type of real estate sector, but some hold multiple types of properties in their portfolios. Here are real estate sectors and their associated property types:
A REIT can invest in any real estate property if it complies with the IRC rules.
Generating income and dividend distributions
Many investors add REITs to their portfolios because these products combine the ease and liquidity of investing in stocks with the opportunity to own and profit from real estate. REITs offer regular returns and outsized dividends to generate income.
REITs generate primary income from rent or mortgages, depending on the properties invested. REITs must also distribute at least 90% of their taxable income to shareholders as dividends.
Types of REITs
All REITs are oriented to producing income, but they do so in different ways. In total, there are three types.
Equity REITs
Most REITs fall into this category (and are what most people mean when they discuss REITs). Equity REITs own and operate real estate properties. Revenue comes from rent, but it also offers the potential for capital appreciation from building sales.
Mortgage REITs
Mortgage REITs (mREITs) are investment vehicles primarily focusing on income generation from mortgages and mortgage-backed securities. Unlike equity REITs, they do not own properties directly. Mortgage REITs tend to be more leveraged, which can increase their risk but also potentially boost returns.
Hybrid REITs
As the name suggests, hybrid REITs use a mix of owning actual properties and mortgages. These appeal to generalist investors who can't decide between equity and mortgage REITs, though hybrid REITs tend to lean one way or another.
Benefits of investing in REITs
Before you can decide whether investing in REITs is right for you, it's crucial to understand their advantages and disadvantages.
Diversification
REITs are a good risk-offsetting strategy for diversifying your portfolio beyond traditional stocks and bonds. Investing in the real estate sector exposes you to multiple market sectors, mitigating risk and volatility without significantly diminishing long-term returns.
Dividend income
Since REITs must pay 90% of their taxable income to shareholders, they tend to have higher-than-average dividend yields. In addition, they have the potential for capital appreciation as the value of their underlying assets grows over time.
Liquidity
Real estate is a notoriously illiquid investment. Buying and selling buildings takes a while. But if you need to unload a REIT, doing so is often as easy as clicking a button or calling your broker. And since they're publicly traded, you can measure your investment's worth daily.
Inflation hedge
REITs can serve as a hedge against inflation by regularly generating income through property appreciation or rental payments. This provides a built-in hedge against the rising cost of living.
Transparency
Most REITs are subject to SEC regulations and reporting requirements, offering investors enhanced transparency. This transparency, not always available with private REITs, allows investors to make informed decisions based on detailed information about the properties being invested in, historical performance, investment strategy, and potential risks.
Risks of investing in REITs
While REITs offer portfolio diversification, high yields, and a hedge against inflation, there are also notable risks to consider.
Market risk
Like any investment, REITs are subject to market fluctuations and economic cycles. Overall, market trends and changes in the real estate market can influence the price of REITs, impacting their performance and potential for appreciation.
While REITs offer a valuable way to diversify your portfolio, it's important to note that individual REITs may not be well-diversified. If a specific type of commercial real estate is struggling, it can negatively impact the performance of REITs focusing on that sector. To mitigate this risk, consider investing in REITs with properties in multiple real estate sectors.
Interest rate sensitivity
REITs, especially mortgage REITs, are significantly impacted by interest rate changes. As interest rates rise, Treasury securities become more appealing investments, drawing funds away from REITs and causing their share prices to decline.
Property-specific risks
In addition to market risk, REITs are exposed to property-specific risks, such as property damage, vacancies, and economic downturns. Real estate properties are also susceptible to natural disasters, such as hurricanes, earthquakes, or floods, which can cause substantial damage or destruction.
The best way to mitigate property-specific risks in your REITs is to invest in multiple property types and locations.
Income is taxed
The REIT itself gets a break from paying taxes, but the investor doesn't. Since REIT payouts typically don't meet the IRS definition for qualified dividends, your returns are taxed as ordinary income, a higher rate than other types of investments.
How to invest in REITs
Here's how to invest in REITs.
Individual REITs
You can buy shares of specific REITs through a brokerage account. There are several ways to invest in REITs, including:
- Publicly traded REITs: These are the most common REITs and the ones most individuals should consider. They are regulated by the Securities Exchange Commission (SEC) and typically have a low minimum investment.
- Public non-traded REITs: Public non-traded REITs, or non-listed REITs, are subject to SEC regulation and reporting requirements but not traded on public exchanges. This makes them less liquid than regular public REITs and requires investors to purchase shares directly from the REIT or a third-party dealer. Non-listed REITs often have longer holding periods and may involve higher upfront transaction fees.
- Private REITs: Private REITs are not subject to SEC registration requirements, making them suitable for institutional or accredited investors. These REITs typically have a higher minimum investment threshold, often in the five-figure range, and are associated with higher risks than public REITs.
REIT ETFs or mutual funds
There's an ETF or mutual fund for every asset (including cryptocurrencies), and REITs are no exception. Offered by investment companies like Vanguard or Fidelity, these managed funds invest most of their assets into REIT securities and related derivatives.
A REIT fund could be a good option if you want maximum diversification or don't want to research individual REITs.
FAQs about REITs
Are REITs a good investment?
REITs can be a good investment for experienced investors to generate passive income and diversify their holdings. However, REITs involve substantial risks. Before investing, thoroughly evaluate your investment goals, time horizon, and risk tolerance.
How are REIT dividends taxed?
REIT dividends are taxed as regular income, since they don't meet the IRS's definition of a qualified dividend. That said, certain REITs may have different tax implications, so make sure to consult a financial advisor or tax expert regarding your investments.
What are some examples of popular REITs?
Some examples of popular REITs are the iShare Cohen and Steers REIT ETF (ICF), iShares Residental and Multisector Real Estate ETF (REZ), Federal Realty Investment Trust (FRT), and the Goldman Sachs Real Estate Securities (GMJPX).
