Real estate investment trusts (REITs) provide a way to invest in real estate without actually buying any property. They generate income and can help to diversify one’s overall portfolio, which makes them popular among investors.
“They have a nice place in a portfolio in terms of their risk-return profile,” said Noreen Brown, a chartered financial analyst (CFA) and the co-chief investment officer at Summit Financial. REITs can be a stabilizer relative to volatile stocks but still generate a nice yield on an after-tax basis relative to taxable bonds, she added.
REITs collectively own more than $4 trillion in gross assets across the United States, and public REITs specifically own an estimated 575,000 properties and 15 million acres of timberland, according to the National Association of Real Estate Investment Trusts (Nareit).
But before you consider REITs, it’s important to understand how to invest in REITs, the ins and outs of how they work, the different types, and their pros and cons.
What is a REIT and how does it work?
REITs are companies that own and often operate income-generating real estate — think your local shopping mall or apartment, the hotel you visited on your last vacation or the office space down the street. Like a mutual fund, a REIT will pool your money with that of other investors. Then, the REIT typically leases the property and pays a steady income to investors via the rent that the REIT collects.
Some REITs will finance properties instead of outright owning them. REITs will often specialize in a certain type of real estate, such as retail or office spaces, but there are also diversified REITs that invest in a wide range of real estate.
REITs are a way for everyday investors — not just Wall Street professionals and the wealthy — to invest in real estate. But these securities have to meet certain standards to qualify as REITs.
Per the US Securities and Exchange Commission (SEC), a REIT must:
- Pay out at least 90% of its taxable income as dividends to investors.
- Be managed by a board of directors.
- Have a minimum of 100 shareholders after its first year.
- Have no more than 50% of its shares held by five individuals or fewer during the last half of the taxable year.
- Invest at least 75% of its assets in real estate and cash, with no more than 25% in nonqualifying securities or stock in taxable REIT subsidiaries.
- Derive at least 75% of its gross income from real estate, including rents and interest on mortgages.
- Derive a minimum of 95% of its gross income from these sources and dividends and interest from any source.
- Be an entity that would be taxable as a corporation if it didn’t have its REIT status.
Types of REITs
There are several different types of REITs, since they come with different structures and can either be traded publicly on an exchange like stock or kept private for a small universe of investors.
Equity REITs
Equity REITs own or manage real estate properties, collect rent and pay that money out to shareholders. Most REITs are publicly traded equity REITs, and equity REITs are often referred to simply as REITs, according to Nareit. They can be volatile, just like stocks.
Mortgage REITs
Mortgage REITs, also referred to as mREITs, don’t own the properties themselves. Instead, they provide financing to the people who own and operate the properties via mortgages or mortgage-backed securities. The payments they receive are from interest payments, which makes them more sensitive to interest rate risks than equity REITs.
Hybrid REITs
Hybrid REITs own properties as well as mortgages, making them a combination of equity and mortgage REITs.
Publicly traded REITs
Publicly traded REITs are traded like stocks and bonds on the public market. They’re registered with the SEC and come with more liquidity and transparency about factors like their market prices than a nontraded or private REIT would.
Nontraded and private REITs
Nontraded REITs may be registered by the SEC like their public counterparts, but they’re not traded on an exchange like a stock or bond, meaning they tend to have less liquidity and transparency than publicly traded REITs. You can buy them via a brokerage that offers non-publicly traded REITs.
Private REITs have an even smaller investor universe since they’re not registered with the SEC and are not sold on exchanges. They’re generally only available to accredited and institutional investors and tend to be less volatile than publicly traded REITs.
The benefits of investing in REITs
One of the biggest benefits of REITs is how they’re able to offer investors strong annual dividends on top of long-term share price appreciation. Over the last 20 years, the total return performance of REITs topped that of the , according to Nareit. REITs can offer those stable dividends in part because of their tax structure: They’re structured like corporations, but they don’t typically pay the same corporate income taxes (since they have to pay out 90% of their taxable income to shareholders).
Due to the Tax Cuts and Jobs Act of 2017, REIT investors currently benefit from the qualified business income (QBI) deduction, which allows them to deduct up to 20% of their QBI plus 20% of their REIT dividends, according to the Internal Revenue Service (IRS).
REITs are also considered a stable hedge against inflation, since rents and property values tend to increase alongside prices.
Finally, they can help diversify a portfolio, which is important to ensure that when one part of your portfolio falls, others hold steady or even increase in value. While REITs usually follow real estate’s market cycle of a decade or more, the cycles in the stock and bond markets last an average of around 5.8 years, according to Charles Schwab.
The disadvantages of investing in REITs
REIT dividends may be a stable source of income, but they are also taxed — usually as ordinary income, which is up to the maximum of 37% and determined by your tax bracket (though they can also be taxed as capital gains or return of capital). If you’re going to invest in REITs, you have to be prepared to pay taxes on those dividends each year.
Like nearly all investments, REITs are also subject to risk. Much of their risk is tied to the real estate market, and their values can drop due to changes in real estate demand, property value, rent prices, occupancy levels and changes to business management. They can also be focused on one geographic area or sector, which can increase risk even more.
“You never know what’s going to happen,” Brown said. “No one would have predicted what would have happened with office spaces during Covid-19.”
REITs are also subject to interest rate risks.
“All else being equal, higher interest rates tend to decrease the value of properties and increase REIT borrowing costs,” according to researchers at S&P Dow Jones Indices. “In addition, higher interest rates make the relatively high dividend yields generated by REITs less attractive when compared with lower-risk, fixed-income securities, which reduces their appeal to income-seeking investors.”
| Pros | Cons |
|---|---|
Must pay out 90% of taxable income to investors as dividends | Payouts may be made as ordinary income, capital gains or return of capital, complicating tax treatment |
Publicly traded REITs are easily accessed in regular brokerage accounts | Subject to interest rate risks, as higher rates may reduce property values and increase borrowing costs |
Long-term total return potential competitive with the stock market | May be concentrated in certain geographic areas or sectors |
May provide a hedge against inflation as rents and property values rise | May be affected by declines in property values, rent prices, occupancy levels and changes to business management |
May add diversification to an investor’s overall portfolio | Nontraded and private REITs not available to all investors |
Getting started with REIT investing
Investors can buy publicly traded REITs via traditional brokerages like Charles Schwab and Fidelity Investments. For nontraded REITs, investors have to go through a broker who specifically trades those types of securities.
Most publicly traded REITs have websites where investors can look at reports that outline what they’re invested in and whether or not they are concentrated in one sector or region, or diversified. A common way to get exposure to REITs is through REIT mutual funds and exchange-traded funds (ETFs), including low-cost funds that mirror REIT indexes.
“You can get exposure to lots of different sectors, lots of different geographical areas and lots of different individual properties,” Brown said of these funds. “There’s a diversification benefit.”
It’s important to diversify because even though the REITs universe is fairly concentrated, which makes it somewhat easy for investors to screen for what they want, there are many different types of real estate that investors may not be getting exposure to. Brown also said that there’s currently a strong benefit to investing in higher-quality sectors within real estate, like multi-family properties that have strong supply and demand characteristics, and areas that are growing demographically in the US.
Like any investment, it’s also important to look at cost, like management fees, Brown said.
Frequently asked questions (FAQs)
While some publicly traded REITs may require a minimum investment, investors can start getting exposure to REITs via brokerages with the price of a single share. Public nontraded REITs typically come with a $1,000 to $2,500 minimum investment, and for private REITs, that jumps to $1,000 to $25,000, according to Nareit.
Before investing in REITs, investors should make sure they’re diversifying across sectors and regions, check the cost of the investment (including management fees if investing through funds) and understand the associated risks.
Equity REITs own or manage real estate properties, while mortgage REITs own mortgages and mortgage-backed securities instead of the underlying properties.
Yes, investors can invest in publicly traded REITs through a brokerage account. However, nontraded REITs may only be available through some participating brokers, and private REITs are typically only available to accredited or institutional investors.
