When you’re looking for alternative ways to get into real estate — ways that don’t have you swinging a hammer or dealing with toilets and tenants — a real estate investment trust can be a great strategy.
In this guide, we’re going to deep dive into exactly what REITs are, how they work, what you can expect when you’re investing in them, as well as a few advantages and disadvantages.
We’ll help you see exactly who they’re for, who shouldn’t invest in them, and what all you need to know before you start putting money into one of these trusts.
By the time you’re done reading, you’ll know exactly how to approach this investing strategy and whether or not they make sense for you and your financial goals.
To kick things off…
What Is A Real Estate Investment Trust?
A REIT, or real estate investment trust, is a holding company that finances, owns, and/or operates real estate that generates an income.
Similar to a mutual fund, a REIT pools together the capital of a group of investors.
The REIT model opens the door for individual investors to start earning dividends from traditional real estate investments without having to actually finance, manage, or buy any of the properties themselves.
For people who are primarily interested in the financial returns that are possible in real estate but have little-to-no desire to actually oversee, renovate, or maintain the properties themselves, real estate investment trusts have become a great way for passive investors to experience real ROI.
Key Takeaways From This Guide
- A REIT is a company that buys, operates, and finances revenue-generating properties.
- A real estate investment trust provides a steady income stream for passive investors but offers minimal in the way of actual long-term appreciation.
- Since REITs are publicly traded — similar to stocks — they tend to be highly liquid while investing in physical properties keeps your capital tied up until the properties sell.
- REITs make investing into most types of property accessible to the public by purchasing everything from apartment buildings, to data centers, hotels, offices, warehouses, retail centers, medical facilities, etc.
How REITs Work
In 1960, Congress established the real estate investment trust to amend the Cigar Excise Tax.
They began to allow investors to purchase shares in commercial real estate portfolios which was once reserved only for the most wealthy individuals.
Typically a REIT will focus on one specific sector of the real estate industry, investing in properties like healthcare facilities, or hotels, or infrastructure, or a wide range of other property types.
Some more diversified REITs, though, may hold a wide range of properties in their portfolio and consist of both retail and office space.
Since most REITs are publicly traded on major stock exchanges, investors can purchase them like stocks and know that the trading volume will keep their investment as liquid as possible.
What Qualifies As A Real Estate Investment Trust?
REITs, for the most part, are a relatively straightforward investing strategy.
The REIT will lease or purchase space and then collect rent on the property. That income then gets distributed as dividends to any shareholders inside of the trust.
REITs typically do not own the real estate but, instead, will fund the real estate deals to ensure they generate interest on the money they’re making available to investors that are physically purchasing the properties.
To qualify, a REIT must comply with specific provisions of the IRC. The Internal Revenue Code requires trusts to own income-generating real estate assets and hold them long-term, distributing the generated income to their shareholders.
Specifically, a real estate investment trust must:
- Invest at least 75% of their total assets into Treasuries, cash, or real estate.
- Derive at least 75% of their income from interest on mortgages, rents, or real estate sales.
- Pay out a minimum of 90% of their taxable income as shareholder dividends.
- Be taxable as a corporation.
- Maintain a board of directors and/or trustees.
- Attract at least 100 shareholders during their first year of operation.
- Maintain no more than 50% of its shares by five or less individual investors.
Different Types Of Real Estate Investment Trusts
In general, there are 6 different types of REITs available to invest in.
- Private REIT: A private REIT is a real estate investment trust that isn’t registered with the Securities & Exchange Commission and isn’t offered for trade on national exchanges. This means private REITs can typically only be purchased by institutional investors.
- Public Non-Traded REIT: A public non-traded REIT is a REIT that has registered with the SEC but is not available for trade on national exchanges. This means they provide less liquidity than other publicly traded trusts but also tend to be more stable because they aren’t subject to fluctuations in the market.
- Public Traded REIT: A public traded REIT will be listed on national exchanges where they can be purchased and sold by private individual investors. Since they are publicly traded they are heavily regulated by the United States Securities and Exchange Commission.
- Equity REIT: For the most part, a standard REIT will be an Equity REIT. These trusts manage and own income-generating real estate and revenues are primarily generated through rent on the properties rather than reselling properties inside of the trust.
- Mortgage REIT: A Mortgage REIT will lend money to individual real estate investors, owners, and operators, either through loans and mortgages or more indirectly through acquiring mortgage-backed securities. They generate revenue on the spread between what they’re earning in interest on the loans and what they spend to fund the loans. This makes them incredibly sensitive to mortgage rate hikes.
- Hybrid REIT: A Hybrid REIT will combine the Mortgage REIT and Equity REIT strategies, wherein they own and operate income-generating real estate while also holding the mortgages on properties they’ve invested in.
How To Invest In Real Estate Investment Trusts
There’s multiple different ways to invest in real estate investment trusts, ranging from publicly traded REITs to mutual funds and exchange-traded funds.
You’re also able to purchase non-traded REIT shares through your broker or financial advisor who participates in the offering.
REITs are also being included inside of contribution-based investment plans and retirement accounts.
As of 2022, nearly 145 million people are actively investing into REITs either directly on their own or through their individual retirement accounts being managed by a broker or advisor, making these one of the most popular investing strategies for the general public.
The Pros And Cons Of REITs
While REITs can provide a strong and stable annual return with huge potential for long-term gains, there are distinct advantages and disadvantages to this type of investing strategy.
As a general rule of thumb, you can expect a REIT to outperform the S&P 500 and the rate of inflation which makes a REIT a great store of value to protect your income.
Advantages
On the upside, a REIT is incredibly easy to buy and sell on most public exchanges which helps mitigate some of the more traditional disadvantages of real estate investing — like having your capital tied up in the property until it rents or sells.
In terms of performance, a REIT offers an attractive return and stable cash flow that’s hedged against more risky investing strategies.
REITs help provide great diversification in your portfolio and provide steady dividend-based income with the dividends often being higher than what you may be able to achieve through other investing strategies.
On top of this, taxpayers can take advantage of the QBI — or qualified business income — deduction on their taxes which lets them deduct the QBI plus 20% of their dividends or taxable income after subtracting their total net capital gains.
Disadvantages
On the other side of the equation, though, REITs tend to fall on the lower side of the capital appreciation category.
Because of the way they are structured, a REIT must pay out at least 90% of their income back to investors inside of the trust.
That means only 10% of their taxable income can be reinvested back into the trust in order to purchase new holdings and grow the fund.
Another potential downside is that dividends from a REIT are taxed as standard income and some REITs may have incredibly high transaction and management fees.
Potential Fraud
One of the other big drawbacks to investing in real estate investment trusts is the potential for fraud.
The SEC recommends that you should be wary of brokers or advisors who are attempting to sell REITs that aren’t currently registered with the Securities and Exchange Commission.
You can verify their registration status for both non-traded and publicly traded REITs through EDGAR — the SEC’s registration verification system.
You’re also able to use EDGAR to review the performance, quarterly, and annual reports as well as the REITs offering prospectus.
Before you invest in a REIT, you’ll want to perform due diligence on the advisor or broker who is recommending the REIT to ensure there are no conflicts of interest and that the REIT is registered.
You can go to https://www.sec.gov/check-your-investment-professional to verify the registration status of a REIT, as well as look into your broker or advisor who may be recommending the trust.
Real World Example
When it comes to how real estate investment trusts actually work, stop and take a look at some of the hottest sectors in real estate right now — healthcare.
Healthcare is currently one of the fastest-growing industries in the United States, especially when you consider the number of outpatient care centers being built and bought, eldercare facilities, medical buildings, and retirement communities.
There are several REITs that focus solely on the healthcare industry.
For instance, Healthpeak Properties currently has a market cap of $18.9 billion at a daily trading volume of more than 4 million shares. Their portfolio is focused heavily on medical offices, science facilities, and senior housing with more than 600 properties under their portfolio.
By investing in this REIT, you can gain access to one of the fastest growing sectors in the real estate industry without sinking millions (or billions) of dollars into securing the properties yourself.
Frequently Asked Questions
While REITs are typically a simple investing model, there are still a couple questions that get asked over and over again.
Do REITs HAVE To Pay Dividends?
Yes. Due to regulation and how REITs are established, the trusts must disperse at least 90% of their profits back to shareholders through dividends.
This also means that REITs are exempt from standard corporate income tax.
What Is A Paper Clip REIT?
A “Paper Clip” REIT helps increase a REIT’s tax advantages by allowing it to own and operate properties that would normally be out of reach.
The name is derived from two separate trusts being “clipped” together through a binding agreement that allows one trust to purchase the properties and another trust to manage and oversee the properties.
Due to the arrangement, there is far stricter oversight on this type of trust since the potential for conflicts of interest exists — which also makes these types of trust uncommon to encounter.
Should You Invest In A Real Estate Investment Trust?
If you’re looking for a passive investing strategy that lets you gain access to fast-growing real estate sectors without pouring millions (or billions) of dollars into accessing those sectors, investing in a real estate investing trust can be a great strategy.
Likewise, diversifying your retirement portfolio and including at least one REIT in your strategy is a great, conservative way to grow your retirement nest egg.
If you’re looking for more active investing strategies and potentially higher returns, take a look at some of the guides we’ve written on the most popular real estate investing strategies below:
