What Is a REIT?
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. REITs allow everyday investors to earn income from real estate without the hassle of buying, managing, or financing properties themselves. By purchasing shares of a REIT, you gain exposure to a diversified portfolio of real estate assets, much like buying shares of a stock gives you ownership in a company.
Congress created REITs in 1960 to give all investors the opportunity to benefit from income-producing real estate. To qualify as a REIT, a company must distribute at least 90% of its taxable income to shareholders as dividends, which is why REITs are known for their attractive dividend yields. This requirement makes REITs a popular choice for income-focused investors seeking regular cash flow.
"REITs democratize real estate investing, allowing anyone with a brokerage account to own a piece of commercial property." — National Association of Real Estate Investment Trusts
Types of REITs
Equity REITs
Equity REITs own and operate income-generating real estate. They make money primarily through collecting rents from tenants and, over time, from property appreciation. Equity REITs represent the vast majority of the REIT market and invest in a wide range of property types including office buildings, shopping centers, apartments, warehouses, data centers, cell towers, and healthcare facilities.
Mortgage REITs (mREITs)
Mortgage REITs provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities. They earn income from the interest on these financial instruments. Mortgage REITs tend to be more sensitive to interest rate changes and carry higher risk than equity REITs, but they often offer higher dividend yields to compensate.
Hybrid REITs
Hybrid REITs combine the strategies of both equity and mortgage REITs. They own properties and hold mortgages simultaneously. While less common, hybrid REITs offer diversified exposure across both real estate ownership and real estate financing.
Public vs Private REITs
Publicly traded REITs are listed on major stock exchanges and can be bought and sold like any stock. They offer high liquidity, regulatory transparency, and easy access through any brokerage account. Public non-traded REITs are registered with the SEC but do not trade on exchanges, making them less liquid. Private REITs are not registered with the SEC and are typically available only to accredited investors with higher minimum investments.
How REITs Make Money
REITs generate income through two primary channels:
- Rental Income: Equity REITs collect rent from tenants occupying their properties. Long-term leases provide predictable, stable cash flow. Many commercial leases include built-in rent escalations that increase income over time.
- Interest Income: Mortgage REITs earn the spread between the interest they charge on mortgage loans and their own borrowing costs. This net interest margin is their primary source of revenue.
- Property Appreciation: Over time, the properties owned by equity REITs may increase in value. When properties are sold at a gain, shareholders benefit from the capital appreciation.
- Development Profits: Some REITs develop new properties and profit from the difference between development costs and the completed property's market value.
REIT Dividends and Tax Treatment
REIT dividends are one of the primary reasons investors are drawn to these investments, but their tax treatment differs from typical stock dividends:
- Higher Yields: Because REITs must distribute at least 90% of taxable income, they typically offer dividend yields of 3-8%, significantly higher than the average stock dividend yield of around 1.5-2%.
- Ordinary Income Tax: Most REIT dividends are taxed as ordinary income rather than at the lower qualified dividend rate. This means REIT dividends may be taxed at your marginal tax rate, which can be up to 37%.
- Section 199A Deduction: Under current tax law, individual investors may be able to deduct up to 20% of REIT dividend income through the qualified business income deduction, effectively lowering the tax rate on REIT dividends.
- Tax-Advantaged Accounts: Because of the higher ordinary income tax rate, many advisors recommend holding REITs in tax-advantaged accounts like IRAs or 401(k)s, where the tax treatment is less impactful.
Advantages of REIT Investing
- Accessible Real Estate Exposure: Invest in commercial real estate with as little as the price of one share, rather than the hundreds of thousands needed to buy property directly
- High Dividend Income: The 90% distribution requirement creates reliable, attractive income streams for investors
- Portfolio Diversification: REITs have historically shown low correlation with stocks and bonds, improving overall portfolio risk-adjusted returns
- Liquidity: Publicly traded REITs can be bought and sold instantly on stock exchanges, unlike physical real estate which can take months to sell
- Professional Management: Experienced real estate teams handle property acquisition, management, and leasing decisions
- Inflation Hedge: Real estate values and rents tend to rise with inflation, protecting purchasing power over time
Disadvantages and Risks
- Interest Rate Sensitivity: Rising interest rates can increase REIT borrowing costs and make their dividend yields less attractive compared to bonds
- Tax Inefficiency: REIT dividends taxed as ordinary income can reduce after-tax returns compared to qualified dividends from stocks
- Market Volatility: Publicly traded REITs can experience stock market-like volatility even when underlying property values remain stable
- Sector Concentration Risk: REITs focused on a single property type (like retail or office) face risks specific to that sector
- Leverage Risk: REITs often use significant debt to finance property acquisitions, which amplifies both returns and risks
How to Evaluate REITs
Traditional stock metrics like price-to-earnings ratio are less useful for REITs. Instead, investors rely on specialized metrics:
- Funds from Operations (FFO): The REIT industry's standard measure of operating performance. FFO adds depreciation and amortization back to net income and subtracts gains from property sales. A healthy REIT should show consistent FFO growth.
- Adjusted Funds from Operations (AFFO): A more refined version of FFO that accounts for capital expenditures needed to maintain properties. AFFO provides a clearer picture of sustainable cash flow available for dividends.
- Net Asset Value (NAV): The estimated market value of a REIT's properties minus its liabilities. Comparing share price to NAV per share indicates whether the REIT trades at a premium or discount to its underlying asset value.
- Dividend Yield: Annual dividends divided by share price. Compare yields across similar REITs, but be wary of extremely high yields, which may signal financial distress.
- Debt-to-Equity Ratio: Measures the REIT's leverage. Lower ratios generally indicate a more conservative, less risky investment. Look for ratios below 1.0 as a general guideline.
- Occupancy Rate: The percentage of rentable space that is leased. Higher occupancy rates indicate strong demand and reliable income streams.
REITs vs Direct Real Estate Investment
| Feature | REITs | Direct Real Estate |
|---|---|---|
| Minimum Investment | Price of 1 share (often under $100) | Tens of thousands to hundreds of thousands |
| Liquidity | Buy and sell instantly on exchanges | Months to complete a sale |
| Management | Professional management included | You handle or hire a property manager |
| Diversification | Instant access to multiple properties | Typically one property at a time |
| Control | No control over property decisions | Full control over your property |
| Leverage | Already built into REIT structure | Available through mortgages |
| Tax Benefits | Section 199A deduction possible | Depreciation, 1031 exchanges, mortgage interest deduction |
REIT ETFs: An Easy Entry Point
For investors who want broad REIT exposure without selecting individual REITs, REIT ETFs offer an excellent solution. These funds hold dozens or hundreds of REITs in a single investment, providing instant diversification across property types and geographic regions.
Popular REIT ETFs track indexes like the FTSE Nareit All Equity REITs Index or the MSCI US REIT Index. They offer low expense ratios, typically between 0.07% and 0.40%, making them a cost-effective way to add real estate to your portfolio.
Getting Started with REIT Investing
- Determine your allocation: Financial advisors commonly suggest 5-15% of a diversified portfolio in real estate, including REITs
- Choose your approach: Decide between individual REITs for targeted exposure or REIT ETFs for broad diversification
- Consider tax placement: Hold REITs in tax-advantaged accounts when possible to minimize the impact of ordinary income taxation
- Evaluate the fundamentals: Focus on FFO growth, occupancy rates, and debt levels rather than just dividend yield
- Diversify across property types: Spread investments across residential, industrial, healthcare, data center, and other REIT sectors
- Reinvest dividends: Use dividend reinvestment plans (DRIPs) to compound your returns over time
