What is a REIT and how does it work?
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Investing in real estate can be an attractive way to put your money to work for you — but what if you don’t have enough money to buy property outright? One way to start investing in real estate without the need for a large chunk of capital is to buy shares of a real estate investment trust, or REIT. They pay out substantial dividends, which can make them a great pick for income investors, although they come with a fair share of disadvantages, too.
Here are the details on REITs, their pros and cons and how much you could earn on them.
What is a real estate investment trust (REIT)?
A real estate investment trust (REIT) is a company that owns, finances or manages properties and then is required by law to pay most of that income to investors. This income can come from the rents that the properties’ tenants pay or even from mortgage payments on loans owned by the REIT.
In exchange for paying out most of its taxable income, the REIT is able to avoid taxation on its earnings at the corporate level. This legal structure makes it easier and cheaper for REITs to acquire real estate, meaning they can acquire property more easily than non-REITs can.
In essence, a REIT profits from its real estate holdings and shareholders have a chance to profit as well. You can enjoy capital appreciation when the REIT’s share price increases as well as benefit from regular quarterly dividend payouts.
Many REITs specialize in a specific type of property but others have more diverse portfolios. With a REIT, you have access to real estate investment opportunities without the need for a substantial amount to actually purchase property or buy into a real estate investment club. Shares of publicly traded REITs can be bought and sold on major exchanges.
How REITs work
In order to be considered a REIT, a company must meet certain criteria:
- At least 75 percent of the company’s assets must be invested in real estate.
- At least 75 percent of the company’s gross income must come from interest on mortgages, sales of real estate or rents received from properties.
- The company must be taxed as a corporation and managed by trustees or a board of directors.
- There must be at least 100 shareholders, and no more than 50 percent of its shares can be held by five or fewer people.
- At least 90 percent of a REIT’s taxable income each year must be paid out to shareholders as dividends.
As long as it meets these criteria, a company can elect to be treated as a REIT, though it doesn’t have to. Then it may enjoy no corporate taxation and generate hefty dividend payouts.
Types of REITs
There are two main types of REITs:
- Equity REITs – These REITs actually own properties that produce income, such as apartment buildings, commercial buildings and other types of properties, like storage facilities. They own these assets and make money as their tenants pay rent, or when they sell properties at a gain.
- Mortgage REITs – Rather than buying properties and charging rent, mortgage REITs (mREITs) provide financing for real estate. They might purchase mortgages, or even originate them, or buy mortgage-backed securities, to produce income.
REITs can also be classified on whether they’re publicly traded, non-traded or private:
- With a publicly traded REIT, any investor can purchase the REIT’s stock on an exchange.
- Non-traded REITs, also called public non-listed REITs, don’t trade on exchanges, even though they’re registered with the Securities and Exchange Commission (SEC)
- Private REITs aren’t registered with the SEC and can be bought without going through an exchange. However, these might be less liquid and transparent than public REITs, so they come with serious risks.
Along with their status, a REIT can fall into the following property sub-sectors:
- Data centers
- Diversified (or a combination of properties)
- Industrial (e.g., warehouses)
- Infrastructure (e.g., energy pipelines)
- Mortgage (mREIT)
- Specialty (e.g., casinos)
And new sub-sectors may develop at any time, as the industry evolves.
How to find REITs
If you’re looking to find a list of all REITs, you’ll find them on the website of NAREIT, an association that represents REITs. You’ll be able to filter them on basic criteria such as their filing status, returns and sub-sector.
You’ll also be able to find information on any REIT registered with the SEC, including non-traded REITs and publicly traded REITs. Each type of REIT files financial disclosures with the SEC, so investors and others can see how they are performing. You can find the filings in the SEC’s EDGAR database, which goes back more than two decades.
How to invest in REITs
Investing in REITs is fairly straightforward, especially if you focus on publicly traded companies. In that case, all you need to know is the ticker symbol. You can then go to your broker and buy shares, placing an order like you would for any other stock. You can also buy shares in REIT ETFs, including one of the most popular, the Vanguard Real Estate Index Fund (VNQ).
On top of that, you might be able to allocate a portion of your regular 401(k) contribution to a REIT. Some plans include a REIT fund as an option. However, while individual equities aren’t always included in a 401(k), if your administrator does allow them, you can purchase REITs.
Do REITs have a good track record?
REITs have a good track record over time. The FTSE Nareit All Equity REITs index recorded annualized returns of approximately 11.5 percent over the 40-year period ending June 2021, according to Nareit. By comparison, the S&P 500 historically sees annualized returns closer to 10 percent. While some indexes, like the Russell 2000, outperform REITs over shorter periods of time, REITs tend to see better performance in the long run.
It’s important to note, however, that past performance isn’t a guarantee that REITs will perform well in the future.
Advantages and disadvantages of REITs
REITs can be an attractive investment, but like all investments, they can also come with their own risks and disadvantages. Here are some key advantages and disadvantages of REITs:
Advantages of REITs
- High dividend yields: REITs typically offer some of the highest yields in the stock market, because they’re obligated to make payouts and they have consistent cash flow from their rentals.
- Diversification: By owning a REIT you may own dozens, even hundreds, of properties, meaning that your own risk is reduced by diversification, unlike if you owned one or two properties in a single geographic area.
- Lower correlation with other assets: With less correlation to other assets, REITs can add some lower volatility to your portfolio. When stocks zig, REITs may zag, or at least zig a little less than stocks.
- No self-management: If you’re managing your own property, you may be called on at any point to fix something, which may require you to get out and do it or otherwise pay someone else to do it. You may also be on the hook for serious money if something breaks. So REITs can be a great alternative to investing directly in real estate.
- No commissions (on publicly traded REITs): Unlike real estate and private and non-traded REITs, you can move in and out of REITs with effectively no commissions. That’s a huge contrast with traditional real estate, where you can expect to pay 6 percent every time you sell.
Disadvantages of REITs:
- High debt loads: It’s normal for REITs to operate with high debt loads, just like regular homeowners do. But investors need to check to make sure the REIT can sustain the debt load and keep on paying its dividend, or the stock will fall.
- Beholden to market to grow: Because REITs pay out so much of their cash flow, they must raise money from the market to acquire more buildings and grow. When the market is uncooperative – with low stock prices or high interest rates – then it’s hard for REITs to make attractive deals.
- Unsustainable dividends: Investors must remain on the lookout for unsustainable dividends. A dividend cut (or a potential one) will hurt the REIT stock price quickly.
- Rising rates: Rising rates may hurt REITs in a few ways, by raising the cost of their financing, reducing the value of their assets (buildings) and depressing their stock price.
- Governance issues: Non-traded REITs and private REITs have potentially serious governance issues and don’t have the same higher standards as publicly traded REITs.
- High commissions and no secondary market: If you’re buying non-traded or private REITs, you should also watch out for massive sales commissions and understand that it will be difficult for you to exit the position, regardless of what the salesperson says.
REITs can be an attractive investment, but you’ll want to steer clear of the biggest mistakes in investing in them.
Should you invest in REITs?
Depending on your risk tolerance and portfolio goals, adding some real estate exposure through REITs could help you further diversify and provide exposure to another asset class that may lower risk in your portfolio. Carefully consider your individual situation and consult with an investment professional to decide if investing in REITs makes sense for you, and how much you should allocate to them.
— Miranda Marquit wrote a previous version of this story.