What are REITs?

A real estate investment trust (REIT) allows people to invest in real estate without the hassle of directly buying or managing a physical property. REITs are often the real estate investment of choice for individual investors, particularly those looking to trade real estate similar to stocks.

According to the National Association of Real Estate Investment Trusts (NAREIT), around 170 million Americans, or roughly 50% of the U.S. population, own REIT shares, such as through retirement and other investment accounts. Even if you don't directly own REIT shares, there's a decent chance you're invested in some mutual funds or ETFs that do.

With the best real estate investing apps, you can invest in REITs and generate passive income streams. But, ensure you understand the fees, time horizon, and liquidity risks of investing in real estate.

What are REITs? An introduction to real estate investment trusts

REITs came about due to a 1960 Congressional law that created this structure, making it easier for investors to invest in real estate portfolios. Today, REITs remain a popular investment option for those looking to participate in the real estate market without the significant upfront costs and complexity of direct property ownership.

The structure of REITs also helps from a tax perspective. For example, while most corporate earnings are taxed twice — first when the company pays its corporate taxes, then when the investor pays their income tax on dividends — eligible REIT payouts are only taxed at the investor level, not via corporate income taxes. That can result in higher returns for investors, all else being equal.

REIT rules

Certain Internal Revenue Code (IRC) rules must be met for a company to qualify as a REIT and obtain the benefit of no corporate income taxes. In particular, a REIT must:

• Be registered as a corporation, trust, or association
• Be managed by a board of trustees or directors
• Distribute at least 90% of its annual taxable income in dividends
• Derive at least 75% of its gross income from real estate, with limits on rent from related parties
• Invest at least 75% of its total assets in real estate ventures, cash vehicles, or government securities
• Have at least 100 shareholders after the first taxable year
• Have no more than 50% of its shares held by five or fewer individuals after the first taxable year

How do REITs work? Understanding real estate investment trusts

Let's examine REITs' workings, including their structure, investment focus, and potential for generating income.

Structure of REITs

REITs, or real estate investment trusts, are companies that specialize in owning, operating, or financing income-producing real estate. They are generally structured as corporations, trusts, or associations, and to an investor, they often resemble investment funds.

Like mutual funds and ETFs, REITs offer instant diversification by investing in a portfolio of properties. Investors purchase shares of a REIT, often via a stock exchange, much like any other stock purchase, although they can also be privately traded. Investors then can receive a portion of the income generated by these properties, both through potential share price appreciation and dividends.

Investment focus of REITs

REITs generally focus on one type of real estate sector, but some invest across different types of properties. Here are some primary real estate sectors and their associated property types:

Yuqing Liu/Business Insider

A REIT can invest in any real estate property, as long as it complies with the IRC rules.

Generating income and/or price appreciation

Many investors add REITs to their portfolios because these products combine the ease and liquidity of investing in stocks with the opportunity to own and profit from real estate. Meanwhile, REITs often generate consistent income, primarily from rent or mortgages, depending on the assets.

REITs can be compared to both stocks and bonds, as they have characteristics of both. Depending on factors such as the risk level of the REIT, the company might lean more toward trying to provide consistent payouts via dividends — similar to bond yields — or the company might have a larger focus on growing the value of the underlying properties to ultimately boost the share price, like stocks. Still, the requirement of REITs to pay out at least 90% of taxable income as dividends often gives them bond-like qualities.

Types of REITs

While all REITs involve generating income from real estate in some way, they do so via different approaches. The three main types of REITS include:

Equity REITs

Most REITs fall into this category (and are what most people mean when they discuss REITs). Equity REITs generally own and operate real estate properties. Revenue comes from rent, but it also offers the potential for capital appreciation from building sales.

Mortgage REITs

Mortgage REITs (mREITs) are investment vehicles primarily focusing on income generation from issuing or investing in mortgages and mortgage-backed securities. Unlike equity REITs, they do not own properties directly. Mortgage REITs tend to be more leveraged, which can increase their risk but also potentially boost returns.

Hybrid REITs

As the name suggests, hybrid REITs invest in a mix of equity real estate (owning actual properties) and mortgages/mortgage-backed securities. These might appeal to generalist investors who can't decide between equity and mortgage REITs, or those who want a more diversified approach. Note, however, that hybrid REITs might not be perfectly balanced but rather lean one way or another toward equity or mortgages.

Why invest in REITs? Key benefits and advantages

Before you can decide whether investing in REITs is right for you, it's crucial to understand their advantages and disadvantages. Some of the top benefits of REITs typically include:

Diversification

REITs can be a good vehicle for diversifying your portfolio beyond traditional stocks and bonds. Investing in the real estate sector can provide exposure to different areas of the economy and market factors, which can mitigate risk and volatility without necessarily diminishing long-term returns. For example, if stocks are down due to low consumer demand hurting corporate profits, it's possible that some REITs are more insulated, at least temporarily, as they could continue to collect rent on owned properties, even if those owners aren't profiting as much. Of course, there are risks, such as a prolonged downturn leading to delinquencies.

Dividend income

Since REITs must pay at least 90% of their taxable income to shareholders, they tend to have high dividend yields. In addition, they have the potential for capital appreciation if the value of their underlying assets grows over time. But meanwhile, that dividend income could be helpful for some investors, like those looking to supplement their monthly income without having to sell assets.

Liquidity

Real estate is a notoriously illiquid investment. Buying and selling buildings takes a while. But the structure of REITs means they trade like stocks, so if you need to unload a REIT, doing so is often as easy as clicking a button or calling your broker. And with publicly traded REITs, you can measure your investment's worth daily. That said, not all REITs are liquid, so be sure you understand what applies to a specific company before investing.

Inflation hedge

REITs can serve as a hedge against inflation, because real estate income can increase as prices rise more broadly. For example, an equity REIT might increase rent charges during periods of high inflation, meaning the additional income can counteract the rising cost of living for shareholders.

Transparency

REITs are often subject to SEC regulations and reporting requirements, offering investors enhanced transparency. This transparency, although not always available with private REITs, allows investors to make informed decisions based on detailed information about the properties being invested in, historical performance, investment strategy, and potential risks. This type of information might not be as easily accessible if trying to source your own real estate deals.

What are the risks of REIT investing?

While REITs offer benefits such as portfolio diversification, high yields, and a hedge against inflation, there are also notable risks to consider, such as the following:

Market risk

Like any investment, REITs are subject to market fluctuations and economic cycles. Overall market trends and changes in the real estate market can influence the price of REITs, impacting their performance and potential for appreciation.

While REITs offer a valuable way to diversify your portfolio, it's important to note that individual REITs may not be well-diversified. If a specific corner of the commercial real estate market is struggling, it can negatively impact the performance of REITs focusing on that sector. To mitigate this risk, consider investing in REITs with properties in multiple real estate sectors.

Interest rate sensitivity

REITs, especially mortgage REITs, are significantly impacted by interest rate changes. If interest rates rise, the current income from existing mortgages may end up being less than what you could earn from newly issued loans. For one, that could mean certain REITs underperform those that have the flexibility to issue new mortgages at higher rates. But another downside is that as interest rates rise, assets like Treasury securities become more appealing investments, which can draw funds away from REITs and cause their share prices to decline.

Property-specific risks

In addition to market risk, REITs are exposed to property-specific risks, such as property damage, vacancies, and economic downturns. Real estate properties are also susceptible to natural disasters, such as hurricanes, earthquakes, or floods, which can cause substantial damage that insurance might not fully cover, or the REIT might not be able to collect rent during periods of repair.

The best way to mitigate property-specific risks in your REITs is to choose well-diversified ones or invest in different types of REITs that own multiple property types in multiple locations.

Taxes and fees

The REIT itself gets a break from paying taxes, but the investor doesn't. Since REIT payouts typically don't meet the IRS definition for qualified dividends, your returns are taxed as ordinary income, which is generally a higher rate than long-term capital gains that you might get from other assets, including directly owned real estate. Plus, REITs can have relatively high fees, including asset management fees and property-related fees.

How to invest in REITs

Regarding how to invest in REITs, there are two main approaches:

Individual REITs

You can buy shares of specific REITs through a brokerage account. Within this option, there are several ways to invest in REITs, including:

• Publicly traded REITs: These are the most common REITs and the ones often most appropriate for retail investors, though you should still be mindful of what you're getting into. They are regulated by the Securities Exchange Commission (SEC) and typically have a low minimum investment.
• Public non-traded REITs: Public non-traded REITs, or non-listed REITs, are subject to SEC regulation and reporting requirements but not traded on public exchanges. This makes them less liquid than regular public REITs and requires investors to purchase shares directly from the REIT or a third-party dealer. Non-listed REITs often have longer holding periods and may involve higher upfront transaction fees.
• Private REITs: Private REITs are not subject to SEC registration requirements, making them more of a vehicle for institutional or accredited investors. These REITs typically have a higher minimum investment threshold, often in the five-figure range, and are associated with higher risks than public REITs.

REIT ETFs or mutual funds

There's a mutual fund or exchange-traded fund (ETF) for essentially every asset (including cryptocurrencies), and REITs are no exception. Offered by investment companies like Vanguard and Fidelity, these managed funds invest most of their assets into REIT securities, real estate companies, and/or related derivatives.

A REIT ETF or mutual fund could be a good option if you want to maximize diversification or don't want to research individual REITs.

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