REIT: What It Is and How to Invest?

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What Is a Real Estate Investment Trust (REIT)?

A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool capital investors who earn dividends from real estate investments. Investors do not individually buy, manage, or finance any properties.

KEY TAKEAWAYS

  • A REIT is a company that owns, operates, or finances income-producing properties.
  • REITs generate a steady income stream for investors but offer little capital appreciation.
  • Most REITs are publicly traded like stocks, which makes them highly liquid, unlike real estate investments.
  • REITs invest in apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.

How REITs Work

Congress established REITs in 1960 as an amendment to the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios, previously available only to wealthy individuals and through large financial intermediaries.

Properties may include apartment complexes, data centers, healthcare facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses. REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios.

Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks throughout the trading session.

What Qualifies As a REIT?

The REIT leases space, collects rents on the properties and distributes that income as dividends to shareholders. Mortgage REITs don’t own real estate but finance real estate, instead. These REITs earn income from the interest on their investments. Should the REIT retain any long-term capital gains, they are reported to the shareholders on IRS Form 2439.

A REIT company must comply with the Internal Revenue Code (IRC) which includes owning income-generating real estate for the long term and distributing income to shareholders and meet the following requirements:

  • Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
  • Derive at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
  • Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
  • Be an entity that’s taxable as a corporation
  • Be managed by a board of directors or trustees
  • At least 100 shareholders after its first year of existence 
  • Have no more than 50% of its shares held by five or fewer individuals

REIT Types

  • Equity REITs. Most REITs are equity REITs, which own and manage income-producing real estate. Revenues are generated primarily through rents and not by reselling properties.
  • Mortgage REITs. Mortgage REITs lend money to real estate owners and operators directly through mortgages and loans or indirectly through acquiring mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
  • Hybrid REITs. These REITs use the investment strategies of both equity and mortgage REITs. 
REIT Types Comparison
Type of REITHoldings
 Equity Owns and operates income-producing real estate
 Mortgage Holds mortgages on real property
 Hybrid Owns properties and holds mortgages

Investing in REITs

  • Publicly Traded REITs. Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
  • Public Non-Traded REITs. These REITs are registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs.6 Still, they tend to be more stable because they’re not subject to market fluctuations.
  • Private REITs. These REITs aren’t registered with the SEC and don’t trade on national securities exchanges. In general, private REITs can be sold only to institutional investors.

Investors can choose publicly traded REITs, REIT mutual funds, and REIT exchange-traded funds (ETFs). Shares of a non-traded REIT can be purchased through a broker or financial advisor who participates in the non-traded REIT’s offering. REITs may be included in defined-benefit and defined-contribution investment plans. U.S. investors can own REITs through their retirement savings.

Advantages and Disadvantages of REITs

REITs are easy to buy and sell, as most trade on public exchanges. REITs offer attractive risk-adjusted returns and stable cash flow. Including real estate in a portfolio provides diversification and dividend-based income.

The Tax Cuts and Jobs Act of 2017 allows taxpayers to claim the qualified business income (QBI) deduction. The deduction is the QBI plus 20% of qualified REIT dividends or 20% of the taxable income minus net capital gains, whichever is less.

However, REITs don’t offer capital appreciation since REITs must pay 90% of their income back to investors.1 Only 10% of taxable income can be reinvested into the REIT to buy new holdings. Additionally, REIT dividends are taxed as regular income, and some REITs have high management and transaction fees.

REIT companies will frequently use leverage as they buy and sell properties. When comparing investment opportunities in REITs it is important to look at their debt-to-equity (D/E) ratios to ensure they are on a solid footing.

Pros

  • Liquidity
  • Diversification
  • Stable cash flow through dividends
  • Attractive risk-adjusted returns

Cons

  • Low growth
  • Dividends are taxed as regular income
  • Subject to market risk
  • Potential for high management and transaction fees

How Can Investors Avoid REIT Fraud?

The Securities and Exchange Commission (SEC) recommends that investors be wary of anyone who tries to sell REITs that aren’t registered with the SEC. It advises that “You can verify the registration of both publicly traded and non-traded REITs through the SEC’s EDGAR system. You can also use EDGAR to review a REIT’s annual and quarterly reports as well as any offering prospectus.”

Do REITs Have to Pay Dividends?

By law and IRS regulation, REITs must pay out 90% or more of their taxable profits to shareholders as dividends. As a result, REIT companies are often exempt from most corporate income tax. An increasing number of REITs offer the reinvestment of shareholder dividends. Shareholders of REITs who receive dividends are taxed as ordinary dividends.

What Is a Paper Clip REIT?

A “paper clip REIT” increases the tax advantages afforded to a REIT while allowing it to operate properties that such trusts normally cannot run. It involves two entities “clipped” together via an agreement where one entity owns the properties and the other manages them. The paper clip REIT entails stricter regulatory oversight since there can be conflicts of interest and, as a result, this form of REIT is uncommon. It is similar but more flexible in structure to a “stapled REIT”.

The Bottom Line

REITs, or real estate investment trusts, own or finance income-producing real estate across property sectors, such as healthcare facilities or warehouses. These companies must meet several requirements to qualify as REITs. Most REITs trade on major stock exchanges.

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