REITs are a way to own real estate without becoming a landlord — here's how they work, how to invest, and the different kinds to invest in

Tara Mastroeni

Sep 10, 2020, 01:07 IST

REITs are a way to own real estate without becoming a landlord — here's how they work, how to invest, and the different kinds to invest in

REITs offer investors a liquid way to profit from real estate, without management hassles.NurPhoto / Contributor/Getty Images

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate ventures.
Publicly traded REITs offer investors a liquid way to invest in real estate without having to buy or manage property themselves.
REITs provide a steady, high income stream and portfolio diversification, but they come with tax consequences and certain risks.

A real estate investment trust (REIT) allows people to invest in real estate without having to buy or manage any property themselves. Given that landlord duties are beyond the scope of most folk, REITs are becoming the real estate investment of choice for individual investors. According to the National Association of Real Estate Investment Trusts (NAREIT), an estimated 87 million Americans, or roughly 44% of US households, own REIT shares, most of which trade on major stock exchanges.

Many investors decide to 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. Geared to generating income, REITs offer regular returns and higher-than-usual dividends.

What is a REIT?

REITs are companies that own, operate, or finance income-producing properties and real estate ventures. Like mutual funds or exchange-traded funds (ETFs), they own not just one, but a basket of assets. Investors purchase shares of a REIT and earn a proportionate share of the income produced by those assets.

REITs date back to 1960 when Congress established them as an amendment to the Cigar Excise Tax Extension, which allowed investors to buy shares in commercial real estate portfolios. Since then, REITS have grown to the point where, today, NAREIT estimates that REITs collectively own about $3 trillion in assets across the US.

REITs also appeal to investors because of the unique way that they are taxed. While most stock dividends are in effect taxed twice (first when the company pays its corporate taxes, then when the investor pays their income tax), REIT payouts are only taxed once. A REIT is structured as a pass-through entity — which means, it doesn't pay any corporate tax. This effectively means higher returns for its investors.

The Rules of REITs

There are certain Internal Revenue Code (IRC) rules that a company must comply with in order to qualify as a REIT (and avoid those corporate taxes). They must be registered as corporations, and be managed by a board of trustees or directors.

A REIT must also:

Distribute at least 90% of its annual taxable income in dividends
Derive at least 75% of its gross income from real estate
Invest at least 75% of its total assets in real estate ventures or cash vehicles (bonds, etc.)
Have at least 100 shareholders
Have no more than 50% of its shares held by less than five individuals

Varieties of REITs

All REITs are oriented to producing income, but they do so in different ways. In total, there are three types.

Equity REITs

The vast majority of REITs fall into this category (and are what most people mean when they discuss REITs). This type actually owns and operates real estate properties. Its revenues come from rents, but it also offers the potential for capital appreciation from building sales.

Mortgage REITs

More of a strict income play, these REITs don't own property; rather, they offer or own mortgages on properties. Sometimes they hold actual mortgages, sometimes mortgage-backed securities. The revenues come from the mortgage payments, especially the interest on them. In general, mortgage REITs tend to be more leveraged than equity REITs, which makes them riskier.

Hybrid REITs

As the name suggests, hybrid REITs use a mix of investing strategies, owning both actual properties and mortgages.

What do REITs invest in?

As long as a REIT complies with the IRC rules, it can invest in any sort of real estate property.

While REITs usually focus on one of these real estate sectors, some of them do hold multiple types of properties in their portfolios.

Are REITs right for you?

Before you can decide whether or not investing in REITs is right for you, it's crucial to understand their advantages and disadvantages.

The advantages of investing in REITs

High returns: Since REITs are required to 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.
Portfolio diversification: Although REITs are technically stocks, they are considered a different asset class — part of the real estate sector, rather than general equities. So they provide a way to diversify your portfolio, always a good risk-offsetting strategy.
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.

The disadvantages of investing in REITs

Higher taxes: The REIT itself gets a break on paying taxes. Unfortunately, the investor doesn't. Since REIT payouts typically don't meet the IRS definition for "qualified dividends," your returns are taxed as ordinary income, which is a higher rate than other types of investments. Sales of your REIT stock are taxed like other stocks, as capital gains — but at the maximum capital gains rate of 20% (plus the 3.8% Medicare tax) on any profit.
Interest rate sensitivity: REITs are generally very sensitive to interest rate fluctuations, especially those that invest in mortgages. In a rising interest rate environment, Treasury securities tend to become more attractive, which draws funds away from REITs and lowers their share prices.
Sector risk: Although REITs are a great way to diversify your portfolio, they are rarely diversified within themselves. This means that if one type of commercial real estate is struggling, it can be bad for your REIT.

How to invest in REITs

Several ways exist to invest in a REIT.

Publicly traded REITs

These are the most common REITs, and the ones most individuals should consider. These REITs are regulated by the Securities Exchange Commission (SEC) and typically have a low minimum investment.

Public non-traded REITs

Also known as non-listed REITs, this type is still regulated by the SEC and subject to its reporting requirements, but the companies are not traded on a national stock exchange and are subject to certain investment limits. Inventors must purchase shares directly from the REIT or a third-party dealer.

Private REITs

Private REITs are not required to register with the SEC. As such, they are designed for institutional or accredited investors and typically have a much higher minimum investment amount — often, in the five figures.

REIT funds

There's an ETF or mutual fund for just about every asset, and REITs are no exception. Offered by investment companies like Vanguard or Fidelity, these vehicles are managed funds that invest the majority of their assets into REIT securities and related derivatives. If you want the maximum in diversification (and hence, safety), or just don't want to research individual REITs, a REIT fund could be a good option.

The financial takeaway

REITs offer something that's traditionally been a contradiction in terms: a liquid, transparent real estate investment. They can be a way to diversify your portfolio while gaining access to steady income and a little long-term capital appreciation.

However, while they eliminate many of the customary drawbacks of real estate, REITs also come with downsides. These include a higher tax rate and an inherent sensitivity to both interest-rate risk and market sector risk. Overall, though, they remain a relatively safe way for individual investors to make a property play.