Buying shares of a real estate investment trust (REIT) company that owns or runs properties is a way for investors to get real estate into their portfolios—without actually purchasing real estate.
Even investors who have never heard of an REIT may already have exposure to them without realizing it, as REITs are popular with retirement and pension funds: 145 million Americans live in households with REIT investments through 401(k)s and other accounts as of the second quarter of 2022, according to the National Association of Real Estate Investment Trusts (Nareit). Some funds find REITs attractive for diversification and because they pay dividends.
What is a REIT?
A REIT is a company that owns, operates, or finances income-producing real estate such as apartment buildings, office parks, hotels, and healthcare facilities.
Investors can buy and sell shares of publicly traded REITs on the major stock exchanges, and shareholders can profit from any price gains while also receiving dividends. It’s a type of passive real-estate investing because someone else purchases and manages the properties.
How do REITs work?
REITs are structured similarly to mutual funds, pooling money from multiple investors. The trust may use that capital to buy properties outright or to finance real estate acquisitions.
Typically, a REIT company focuses on a particular type of income-producing property—shopping malls, hotels, infrastructure, warehouses, or more—but some do hold multiple types of property in their portfolios. Many REITs are traded like stocks on the major stock exchanges, so they give individual investors an opportunity to passively invest in real estate.
Investors can make money if the shares of a REIT they own rise in value. They can also make money through dividends on the shares. By law, REITs must pay at least 90% of their taxable income to their shareholders as dividends. By doing this, they are exempt from most federal corporate taxes.
Companies must follow several REIT requirements from the Internal Revenue Service to qualify. Structural requirements include but are not limited to:
- Must be a corporation, trust, or association
- Must be managed by one or more trustees or directors
- Must be held by 100 or more shareholders from its second tax year onward
- Would otherwise be taxed as a domestic corporation
Companies also have certain financial requirements to be considered a REIT. A company must:
- Pay at least 90% of the REIT’s taxable income to shareholders as dividends.
- Derive at least 75% of gross income from specified sources like tenants’ rent payments and property sales.
- Invest at least 75% of total assets in real estate, cash and cash equivalents, and/or government bonds.
- Have no more than 50% of shares held by five or fewer individuals.
What are the different types of REITs?
There are several types of REITs, and three of the most common include:
- Equity REITs. This category represents the majority of the asset class, and is sort of the “plain-vanilla” REIT: Publicly traded equity REITs own or manage real estate that produces an income. Industry association Nareit notes the broader market usually refers to equity REITs simply as “REITs.” Publicly listed REITs own $2.5 trillion of real estate assets, including more than 500,000 structures. These are traded on stock exchanges.
- Mortgage REITs. Also referred to as mREITs, these companies provide financing for income-generating properties. They do this by either buying or originating mortgages and mortgage-backed securities (MBS), and then earning income from the interest on these investments. MREITs usually aim to earn a profit from their net interest margin, which is the spread between interest income on their mortgage assets and their funding costs. As with equity REITs, investors can buy and sell mREITs on the major stock exchanges.
- Public, non-traded REITs. This less common category of REITs, often shortened to PNLRs, operate like other REITs in almost every way, save one important difference: They don’t trade on stock exchanges. PNLRs are registered with the Securities and Exchange Commission and follow the same IRS requirements as other REITs. But because they don’t trade on exchanges, they must also publish regular financial statements publicly, and they are also subject to “Blue Sky” reviews by state regulators. They are also less liquid than publicly traded REITs, as redemption is restricted and investors are also usually subject to a minimum holding period.
- Private REITs. Private REITs are exempt from registering with the SEC, and their shares do not trade on stock exchanges. Generally these are not available to individual retail investors, but rather only to institutional investors like banks, pension funds, and mutual funds.
Potential benefits of investing in REITs
REITs can be easy to invest in and introduce passive income to a portfolio. The potential benefits of investing in REIT include:
- Expertise. Investors need little knowledge of actual real estate investing because the actual buying and managing of the properties is done by an experienced professional.
- Portfolio diversification. Diversification aims to limit an investor’s exposure to risk by spreading their investments across different types of assets. REITs add exposure to real estate, which can be a benefit to a portfolio that already includes stocks, bonds, and cash equivalents.
- Lower cost of entry. Investors don’t need to save up for a down payment and monthly mortgage bills. Instead they can start investing in real estate passively by purchasing as little as one share of an REIT.
- Liquidity. Buying property is often a longer-term investment, and one that can’t be immediately cashed out. But because many REITs are bought and sold like stocks, investors can choose when to trade them or liquidate them.
Possible risks of investing in REITs
Like any other investment, purchasing REITs carries potential risks, including:
- Fluctuating prices. Although real estate values tend to increase over the long term, they do rise and fall like any other asset class. Property values are particularly tied to the health of the economy, so in a downturn, they may depreciate.
- Management and other fees. REITs charge fees of about 0.5% of all trust assets, and they may charge additional fees to set up the trust and cover administrative costs.
- Lack of control. REITs provide a way for investors to get into real estate without deep expertise, but that benefit comes with a flip side: Someone else is making the decisions about which properties to buy, how they’re maintained, and when to sell them.
The bottom line
A real estate investment trust (REIT) is a company that owns, manages, or finances income-producing real estate properties like apartment buildings, shopping malls, office parks, and hotels. It’s a type of passive investing that lets investors avoid directly purchasing or managing a property while helping to diversify their holdings. REITs must follow several requirements, including paying at least 90% of taxable income to shareholders as dividends.
Several categories of REITs exist, and many—including equity and mortgage REITs—are traded like stocks on the major stock exchanges. There are also public non-traded REITs, as well as private REITs that are available only to institutional investors. Along with the benefits, however, REIT prices may fluctuate in value and shareholders may have to pay management and other fees.
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