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

Investing

Nov 6

What You Need to Know About Real Estate Investment Trusts (REITs) financial planning investment management CFP independent RIA retirement planning tax preparation financial advisor Ridgewood Bergen County NJ Poughkeepsie NY fiduciary

Diversifying your portfolio means spreading your investments across various financial instruments such as stocks, bonds, mutual funds, and their short-term counterparts like money market accounts—or targeting specific segments of the economy such as technology and real estate. Its purpose? To (ideally) maximize returns and minimize risks so you’re better positioned to achieve 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 (an association that represents these) data estimates that over 170 million adult Americans (or 50% of American households) own REIT stocks.

What is a Real Estate Investment Trust (REIT)?

Real estate investment trusts (REITs) are companies that own, operate, or finance income-producing real estate across a wide range of sectors spanning apartments, hotels, shopping malls, office buildings, and warehouses. We’ll discuss specific requirements for these shortly.

How REITs work

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 therefore bought and sold like stocks, with REITs thus giving any investor the opportunity to earn income produced from real estate without the need to own or manage property.

Company REIT prerequisites

To be considered a REIT, a company must comply with strict provisions that include:

· Paying out a minimum of 90% of their taxable income (in the form of dividends) to shareholders

· Investing 75% of the company’s total assets in real estate, cash, or U.S. Treasuries

· Generating at least 75% of gross income from rent, interest on mortgages that finance property, and/or real estate sales

· Having a minimum of 100 shareholders, with no more than 50% held by five or fewer people

· Being taxed as a corporation and managed by trustees or a board of directors

Despite these stringent compliance requirements, companies are highly incentivized to form a REIT. One significant benefit? REITs are permitted to deduct dividends paid to stockholders from their taxable income, therefore reducing 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

Equity REITs are the most common overall. Companies within this segment purchase, manage, build, renovate, and sell income-producing real estate, with revenue primarily taking 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

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

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 are further segmented by how investors purchase them.

Publicly traded REITs

Many REITs are registered with the SEC and publicly traded on various stock exchanges. Known as “publicly traded REITs,” they’re thus purchased with a brokerage account and more liquid (with the ability to buy and sell more quickly) and transparent (given SEC registration) than others.

Public non-traded REITs

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 their publicly traded counterparts.

Private REITs

Private REITs are generally exempt from SEC registration and unlisted. Their performance is sometimes difficult to evaluate—therefore carrying more risk—due to a lack of disclosure requirements, with these REIT types also featuring steeper fees and higher account minimums (usually $25,000) than others. Restrictions mean they’re often only available to high-net-worth individuals.

It's also possible to categorize REITs into various subsectors. For example, while healthcare REITs primarily invest in hospitals, medical centers, and nursing facilities, residential REITs focus on single-family home, multi-family unit, apartment, and student housing investments. Commercial REITs, on the other hand, invest in office buildings, data warehouses, and shopping malls.

REIT ownership advantages

Diversification

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

Potential for higher dividends

REITs also offer steady dividends as they’re required to give back at least 90% of their annual income to shareholder dividends, with many high-performing REITs known to pay high returns that often outperform equity indexes.

Liquidity

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

Inflation hedging

Some REITs, particularly those with commercial properties, have agreements that permit rent increases in line with inflation.

REIT ownership disadvantages

Generally taxable dividends

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

Market fluctuations

As with stocks, REITs are 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, with company profits taking a hit if short-term rates rise. As 90% of taxable income is given back to investors as dividends, equity REITs primarily grow by raising capital—though sources can potentially dry up if investors aren’t willing to buy shares during recessions or sluggish economies.

Private and non-traded REIT challenges

As non-traded and private real estate investment trusts must be held for longer periods and aren’t traded on stock exchanges, they’re difficult to value and aren’t nearly as liquid as publicly traded REITs—also lacking their higher standards. Many also summon significant upfront fees that can climb to up to 15% of the offering price, per the SEC website.

How to find REITs

If you’re searching for a REIT list, a good place to start is the Nareit.com directory; you can sort and filter this by sector, stock performance (private, public, etc.), and listing status.

How to invest in REITs

Investing in REITs is a straightforward process. If you know the ticker symbol, you can purchase REIT shares just as you would with any other stock. You can also invest in top REITs via exchange-traded funds (ETFs) or (depending on your options) allocate a portion of your 401(k) contributions to a REIT.

In sum: are REITs good investments?

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

Still have questions about REITs, how they fit into your investment strategy, and/or how to begin investing in them? Schedule a FREE discovery call with one of our financial advisors to get them answered.

People Also Ask

According to Nareit (an association representing REITs), over 1,021 listed REITs existed as of December 2024—and the number continues to grow (with only 671 back in 2015).
REIT dividends are generally taxed as ordinary income rather than lower qualified dividend rates.
No, REIT dividends are generally not qualified dividends and typically taxed as ordinary income.