What Is a REIT and How Does It Fit Into Your Investments?
REITs own, operate or finance income-producing real estate and then share income in the form of REIT dividends with their shareholders.
June 6, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
When people think about investing, they usually think of stocks, bonds and mutual funds. But there’s another investment option you might not have heard of — real estate investment trust (REIT) dividends. Or, perhaps you’ve heard of them, but don’t know what they are.
REITs allow investors to invest in real estate without having to actually buy, manage or sell property.
This article will break down everything you need to know about REITs so you can decide whether they might be a good fit for your investment strategy.
A REIT is an investment vehicle that owns, operates or finances a portfolio of income-producing properties. These properties could include:
REITs tend to specialize in one type of property; some may also specialize in a specific geographical region.
Income generated from REITs is usually passed along as dividends to shareholders. In fact, REITs are required by law to pass along at least 90% of their income to shareholders in the form of REIT dividends.
How are REITs different from other investment types?
The IRS has actually set several provisions that an entity must meet to qualify as a REIT. For example, a REIT must:
Be taxable as a corporation
Be managed by a board of directors or trustees
Have shares that are fully transferable
Have at least 100 shareholders after the first year as a REIT
Have no more than 50% of its shares held by 5 or fewer individuals in the second half of the fiscal year
Invest at least 75% of its total assets in real estate assets and cash
Derive at least 75% of its gross income from real estate-related sources such as rents and interest from mortgage financing
As per the SEC, a company that meets these rules and thus qualifies as a REIT is allowed to deduct from its taxable income all dividends paid to its shareholders.
Because of this preferential tax treatment, most REITs distribute almost 100% of their taxable income to shareholders and thus do not pay corporation tax.
Types of REITs
There are three major types of REITs.
Equity REITs own and operate income-producing real estate such as office buildings, apartments and malls. They generate income for investors from rental and lease payments and from any price appreciation in these properties.
Mortgage REITs, unlike equity REITs, do not own real estate. Rather, they provide funds to others to enable them to buy real estate. This can either be directly, in the form of mortgages or other real estate loans, or indirectly, via the acquisition of mortgage-backed securities. The REITs then derive income from the fees and interest on these investments.
Hybrid REITs own a combination of equity and mortgage REITs — i.e., they own property and make loans to real estate owners and operators. In general, hybrid REITs tend to be weighted toward one investment type.
Other REIT classifications
REITs can be classified further on the basis of whether they are registered with the SEC and publicly traded.
Publicly traded REITs
These are REITs that are registered with the SEC and whose shares trade on national stock exchanges, such as the New York Stock Exchange (NYSE) or the NASDAQ.
These REITs are also registered with the SEC, but they don’t trade on national stock exchanges. As a result, they have limited liquidity.
These REITs are not registered with the SEC and don’t trade on national stock exchanges. Typically, they are only available to institutional investors.
How have REITs historically performed compared to stocks?
Over long periods of time — 20 and 25 years — REITs in the U.S. have outperformed stocks.
According to the National Association of Real Estate Investment Trusts (Nareit), “REITs underperformed [stocks] in a 10-year period for March 2020, but outperformed in every period longer than 16 years.”
Why invest in a REIT?
Investors may choose to add REITs to their portfolios for a variety of reasons.
REIT dividends provide an easy and effective way to diversify your portfolio.
In general, real estate has a low, and sometimes negative, correlation with other assets. For example, when stocks are struggling, you may find real estate to be up. As a result, REITs can serve as an effective hedge against negative stock market movements.
The requirement for REITs to pay out at least 90% of their income to shareholders in the form of dividends means that they can provide high dividend yields to income-seeking investors.
One major drawback of conventional real estate investments is that they are quite illiquid. Purchasing and selling property can be a tedious and time-consuming process that can possibly tie up your cash flow.
On the other hand, REITs, specifically publicly-traded REITs, are extremely liquid — you can buy and sell them with the press of a button.
Do REITs have drawbacks?
Like all other investments, REITs are not without their downsides.
High tax burden
Most REIT dividends don’t meet the IRS definition of qualified dividends and are thus taxed like ordinary income. Though REITs are eligible for the20% pass-through deduction, you will still have to pay substantial tax on your REIT earnings unless you invest within a tax-advantaged account such as an IRA.
Interest rate risk
Mortgage REITs are quite sensitive to interest rates. For example, when the Federal Reserve hikes interest rates to curb inflation, the values of REITs tend to fall.
Different types of REITs may be subject to property-specific risks. During economic downturns, for example, REITs invested in certain property types, such as hotels, might underperform, lowering the value of your portfolio.
How can you invest in a REIT?
You can buy publicly traded REITs through a brokerage account just as you would buy any other publicly traded company’s shares.
You can buy individual REIT stocks, or you can opt for REIT mutual funds or exchange-traded funds (ETF) that invest in a pool of different REITs.
The benefit of investing in REITs through a mutual fund or an ETF is that you get instant diversification, which may help reduce the risk of your overall portfolio underperforming or losing money.
REITs offer a unique way to invest in real estate without having to buy or manage the property yourself. However, as with all investments, they may not be suitable for everyone. Do your research and consult with a professional advisor before investing in REITs.
For more investment insights and up-to-date personal finance information delivered right to your inbox, sign up for Tally’s monthly newsletter.