How Real Estate Investment Trusts Work
A real estate investment trust (REIT) is a company that owns, operates, or finances real estate. They work much like a mutual funds, in the sense that REITs pool the money of numerous investors.
This makes it possible for individual investors to earn dividends from real estate investments, but without having to buy, manage, or finance any properties themselves.
How REITs work
Many REITs are publicly traded on major exchanges, so you can buy and sell them like stocks.
In general, REITs focus on a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties.
Properties in a REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, office buildings, retail centers, self-storage, timberland, and warehouses.
Most REITs work on a pretty straightforward business model. The REIT leases space and collects rent on the properties, then distributes that income as dividends to shareholders.
Mortgage REITs don't own real estate, but instead finance real estate. These REITs earn income from the interest on their investments.
What qualifies as a REIT?
To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (IRC). These requirements include primarily owning income-generating real estate for the long-term and distributing income to shareholders. Specifically, a company must meet the following requirements to qualify as a REIT:
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasury Bonds
- Derive at least 75% of gross income from rent, 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
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
Be aware of REIT fraud
The Securities and Exchange Commission (SEC) recommends that investors should be wary of anyone who tries to sell REITs that aren't registered with the SEC.
You can verify the registration of both publicly traded and non-traded REITs through the SEC's EDGAR system.
Types of REITs
There are three types of REITs:
Equity REITs.
Most REITs are equity REITs, which own and manage real estate. Revenues are generated primarily through rents (not by reselling properties).
Mortgage REITs.
Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by the net interest margin, or 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.
REITs can also be categorized by how their shares are bought and sold:
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 also registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs. 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.
Pros and Cons of investing in REITs
REITs can play an important part in an investment portfolio because they can offer a strong, stable annual dividend and the potential for long-term growth.
However, as with all investments, REITs have their advantages and disadvantages.
Pros
It is easy to sell and buy REITs, as most trade on public exchanges, which makes them easier to invest in than traditional real estate.
Performance-wise, REITs offer attractive risk-adjusted returns and stable cash flow.
Also, a real estate presence can be good for your portfolio because it provides diversification and dividend-based income, and the dividends are often higher than you can achieve with other investments.
Cons
REITs don't offer much in terms of short-term growth. As part of their structure, they must pay 90% of income back to investors.
So, only 10% of taxable income can be reinvested back into the REIT to buy new holdings.
Additionally, REIT dividends are taxed as regular income, and some REITs have high management and transaction fees.
Before you invest
Before you start investing in REITs, it's wise to make sure you have a solid monthly budget in place, have an emergency savings fund, and fully understand the risks involved.
Investing wisely in the stock market could generate financial gains in the long run. Uninformed investing, however, could cost you.
Take advantage of our free online financial education courses to help you better understand investing.
