What You Need to Know About Real Estate Investment Trusts (REITs)

Diversifying your portfolio simply means spreading your investments across various financial instruments such as stocks, bonds, mutual funds, and short-term investments like money market accounts—or by targeting specific segments of the economy such as technology and real estate. The purpose of diversification is to ideally maximize returns and minimize risks so you are better positioned to reach your goals.

One popular investment often used to help diversify portfolios is a real estate investment trust—also known as a REIT. In fact, recent Nareit data estimates that over 150 million adult Americans (or 45% of American households) own REIT stocks.

REIT overview

Real estate investment trusts are companies that own, operate, or finance income-producing real estate across a wide range of sectors: including apartments, hotels, shopping malls, office buildings, and warehouses.

A REIT typically collects money—such as rent from tenants or interest from investments—and then distributes the same as dividends to shareholders. Many real estate investment trusts are publicly traded on major securities exchanges and are therefore bought and sold like stocks. As a result, REITs afford any investor the opportunity to earn income produced from real estate without the need to own or manage property.

To qualify as a REIT, a company must comply with strict provisions. These include allocating a minimum of 90% of their taxable income in the form of dividends and investing at least 75% of total assets in real estate, cash, or U.S. Treasuries. They must also generate at least 75% of gross income from rent, interest on mortgages that finance property, and/or real estate sales.

Despite these stringent compliance requirements, companies are highly incentivized to form a REIT. One significant benefit is that a REIT is permitted to deduct dividends paid to stockholders from its taxable income, therefore reducing the amount of Federal corporate taxes. This is one reason why most REITs distribute 100% of their profits to shareholders—and thus don’t pay Federal corporate income tax. Another benefit is that becoming a REIT makes it easier for a company to attract capital from a variety of investors and investment sources.

Types of REITs

Real estate investment trusts are divided into three general categories investors can purchase: equity, mortgage, and hybrid REITs.

Equity REITs are the most common overall, and companies within this segment purchase, manage, build, renovate, and sell income-producing real estate. Revenue from these organizations primarily takes shape as property rental income. Most equity REITs specialize in a single property type such as industrial and office space, malls and shopping centers, apartments, hotels/lodging, or self-storage facilities.

Mortgage REITs—also known as mREITs—provide financing to real estate owners and operators on income-producing real estate by originating mortgages or purchasing mortgage-backed securities. As a result, this REIT segment earns money from interest made on these investments. mREITs are riskier than equity REITs but tend to pay out higher dividends.

Hybrid REITs are simply a combination of equity and mortgage REITs, the majority of which are weighted more heavily toward one type of investment than the other.

Each of these three categories can also be further split by how investors purchase them.

Many REITs are registered with the SEC and publicly traded on various stock exchanges. Known as “publicly traded REITs,” they are thus purchased with your brokerage account. As a result, this REIT category tends to be more liquid (meaning you can buy and sell more quickly) and is more transparent (given SEC registration).

Public non-traded REITs are another category also registered with the SEC. However, these don’t trade on national stock exchanges and must often be purchased from brokers that participate in such offerings. Public non-traded REITs are also held for longer periods—often eight years or more—making them less liquid than publicly traded REITs.

Private REITs are generally exempt from SEC registration and unlisted. Due to a lack of disclosure requirements, their performance is sometimes more difficult to evaluate—therefore carrying more risk. In addition, these types of REITs also include steeper fees and higher account minimums (usually $25,000) than their counterparts. They are also restricted and often only available to high-net-worth individuals.

Advantages of REIT ownership

One benefit of investing in a REIT is diversification, as these types of investments are often less volatile than traditional stocks.

REITs also offer steady dividends, as they’re required to give back at least 90% of their annual income to shareholder dividends. Many high-performing REITs also have a track record of paying high returns that often outperform equity indexes.

Publicly traded REITs have high liquidity and are very transparent, thus making it easier for investors to evaluate, buy, and sell shares.

REIT ownership risks

One drawback to earning a steady flow of dividends is the taxes you’ll need to pay on them, especially since dividends are generally taxed as ordinary income.

Like stocks, REITs are also subject to various market factors such as interest rate fluctuations and economic cycles. Take, for example, mREITs that borrow money at low short-term rates and lend in longer-term mortgages at higher rates. The difference (also known as the “spread”) between rates is their profit. If short-term rates rise, company profits are hit.

Because 90% of their taxable income is given back to investors as dividends, equity REITs primarily grow by raising capital. However, during recessions or sluggish economies, sources of capital may dry up if investors aren’t willing to buy shares.

Non-traded and private real estate investment trusts must be held for longer periods and aren’t traded on any stock exchanges. Consequently, they are difficult to value and aren’t nearly as liquid as publicly traded REITs. Many also summon significant upfront fees that often range up to 15% of the offering price, per the SEC website.

In sum: REIT investment basics

While they do carry risk, real estate investment trusts are sometimes an excellent portfolio diversification strategy. REITs are also a solid choice for investors who need income or want to reinvest their dividends and see their gains compound over time.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business. 

Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.