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Real estate investment trusts (REITs) are companies that purchase, finance, and operate income-producing real estate properties. Although REITs are very similar to mutual funds in their structure, there are several significant differences.
So, what is a REIT? REITs generate profit for their investors by paying out dividends. REITs are attractive to investors who don’t have the liquidity to purchase an income property with their own assets.
They give investors more diversification without having to manage or buy property directly.
With the revenue generated from rents, leases, or interest, REITs distribute profit through dividends to their investors.
How Does a REIT Work?
If you find yourself wondering what a REIT is, you’re also probably wondering how they work. REITs first became investment opportunities in 1960 when Congress passed the Cigar Excise Tax Extension.
The bill received an amendment that allowed individual investors to buy and realize returns from real estate projects without having to finance these projects entirely.
REITs collect income from real estate. After collecting the income, they pay their expenses. These costs include management fees, financing costs, and property costs.
After paying the expenses, REITs distribute all taxable profits to their investors.
They pass that burden to their investors. When you purchase a REIT, you must be aware that you’ll be responsible for paying taxes. Dividends from REITs count as ordinary income for tax purposes.
REITs can include all types of property in their portfolio. Some types of property include shopping malls, apartment buildings, self-storage, office buildings, healthcare facilities, and any other type of real estate.
Although REITs can operate many property types, they normally focus on one kind. For example, residential REITs purchase apartment buildings or single-family homes, whereas retail REITs focus on malls or other similar properties.
There are three common classifications of REITs—equity REITs, mortgage REITs (mREITs), and hybrid REITs. Equity REITs generate income through rents and leases, while mREITs generate income through interest from mortgages or mortgage-backed securities.
Hybrid REITs earn income through both rent and mortgage interest payments. REITs can also come in the form of REIT exchange-traded funds (ETFs), also known as REIT funds.
REIT ETFs passively track an index of REITs in which the fund has different levels of investment. Individual investors can purchase shares in REITs on most trading platforms because many are publicly traded REITs.
Investors then receive either monthly or quarterly dividends depending on the REIT’s management structure.
What is an Example of a REIT?
One of the largest REITs is Prologis. The company currently has over $165 billion in assets under management, with $3.7 billion in net operating income. In total, it has over 4,900 properties in its portfolio.
Prologis began in 1983 by purchasing commercial and office real estate properties. Now, it primarily focuses on industrial and logistical real estate.
It operates in numerous countries, including Mexico, Japan, China, and the Netherlands. Such REITs as Prologis use shareholder capital to purchase new properties to add to their expanding portfolio.
Large-scale projects, such as airport logistics centers, require millions of dollars of cash flow to finance the real estate, which shareholders provide through investments.
If you’re interested in Prologis, you can purchase shares on major stock exchanges, such as the New York Stock Exchange. Prologis is a public REIT, which means it needs to abide by all applicable Securities and Exchange Commission (SEC) codes and rules.
As of 2022, Prologis had an annual dividend yield of 2.6% or $3.16 per share. A yield of 2.6% is only slightly lower than the average REIT dividend yield, which stood at 2.91%.
Prologis pays out its dividends quarterly, which means each share yielded $0.79 per quarter. Some REITs are not on major stock exchanges.
These REITs are known as private REITs because they don’t have listings on public exchanges.
That means they don’t need to publicly distribute business information required by the SEC for public REITs. Because publicly traded REITs are on stock exchanges, you can buy and sell them just like stocks.
Some REITs, such as Prologis, have massive trading volumes, which makes them liquid assets. Not all REITs are public, which makes those assets less liquid.
REIT Company Qualifications
When defining a REIT, the U.S. government classifies REITs as any entity (corporation, partnership, trust, etc.) that purchases real estate with the intent to receive income from that asset.
These entities must be domestic taxable entities in the USA. Domestic taxable entities are liable under the internal revenue code (IRC).
The IRC dictates all applicable laws and codes for financial instruments, including REITs. Most of these laws concern the distribution of dividends and information to the public.
Public REITs must abide by all IRC citations on real estate investment. To qualify as a REIT, companies must meet certain criteria:
- Have more than 100 shareholders after the first fiscal year.
- Five or fewer individuals can hold no more than 50% of the REIT’s shares.
- At least 75% of the assets must be real estate, government securities, or cash.
- Produce 75% of their annual income from leases, interest on mortgages, or property sales.
- Have a board of directors that manages assets and protects shareholder interests.
- Distribute 90% of their taxable income as dividends to investors.
Private REITs must follow some of these rules, but not all. They aren’t obligated to register with the SEC or send filings to the SEC, and they don’t have to follow the same ownership rules.
However, private REITs must still pay dividends to their investors. Corporate shareholders must pay the U.S. capital gains tax, which stands at 20%.
For individual investors, dividends get taxed as ordinary income. The maximum income tax rate for ordinary income is 37%. If you meet a certain income threshold, you must also pay a 3.8% surtax.
Until then, they only need to pay ordinary income tax on their dividend payments. For individual shareholders, there are ways to reduce the tax burden.
You can deduct certain income up to 20% through the Qualified Business Income Deduction, which includes REIT dividends until 2025.
You may qualify for more deductions on your taxable dividend returns if:
- You qualify for a reduced income tax schedule
- The REIT pays a capital gains distribution
- The REIT pays corporate taxes
Types of REITs
REITs invest in all types of property, which means investors can choose from a host of assets. Of those, there are three primary categories—equity REITs, mREITs, and hybrid REITs.
There are also different REIT trading methods. Each type and method focus on a certain type of investor. Publicly traded REITs appeal to investors with stock market experience who want to enter the real estate market.
In contrast, private REITs appeal to institutional investors who want more risk.
- Manage income-generating real estate
- Revenues primarily come from rents and leases
- Equity REITs are the most common on the market
Mortgage REITs (mREITs)
- Generate income from interest on mortgages or through mortgage-backed securities
- Act as a lender, so other corporations can purchase property
- mREITs are sensitive to interest rate increases
- Generate income through a combination of rents, mortgages, and mortgage-backed securities
- Often in the form of REIT ETFs
Publicly Traded REITs
- Shares are listed, bought, and sold on national securities exchanges
- Individual investors can purchase these REITs
- Registered and regulated by the SEC
Public Non-Listed REITs
- Registered and regulated by the SEC
- Not listed on national securities exchanges
- Have less liquidity than publicly traded equity REITs
- Are less volatile than publicly traded REITs
- Not registered or regulated by the SEC
- Not listed on national securities exchanges
- Difficult for individual investors to purchase
- Designed for institutional investors
Pros and Cons of Investing in REITs
REITs can play a key role in a diversified portfolio. Compared to other asset classes, the performance of REITs is solid.
Over the past 20 years, an S&P index fund generated an annual average return of 8.41%. However, the last five years generated annual returns of over 20%.
Since its inception 18 years ago, one of the largest REIT ETFs is Vanguard Real Estate ETF. It has an annual average return of 14.18% over this span. REITs can be an integral part of any investor’s diversification plan.
REITs also benefit investors by producing income through dividends. Not all assets in the stock market generate passive income like REITs, which makes them much more hands-off.
REITs lend themselves to investors who don’t want to watch the markets every day.
Equity REITs also have much higher dividend rates than stocks. The average S&P dividend yield in 2022 was 1.82%, while REITs stood at 2.91%.
Like any investment, REITs also have downsides. For example, REITs have slower capital appreciation than stocks.
Due to shifts in real estate markets and interest rates, REITs can be volatile, but stocks are generally a more volatile investment.
REITs also charge management fees for their services. Fees depend on the type of REIT you choose to purchase.
Non-traded REITs can have upfront fees as high as 15%, although the average is between 9% and 10%. Publicly traded REITs have the same brokerage fees that apply to stock and bonds.
Brokers can charge different levels of fees, but the average is between 1% and 2% of the total transaction cost.
Avoiding REIT Fraud
REIT fraud is a more common occurrence than most investors believe. REIT fraud usually occurs when brokers or REITs advertise their product fraudulently, such as by giving it a higher evaluation than its worth or misleading investors with fraudulent reports.
You must know what to look for so you can avoid bad or predatory investments. The SEC warns potential investors to avoid private REITs that haven’t registered under SEC regulations.
Although most unregistered REITs aren’t fraudulent, you should be wary of them. To help investors avoid fraudulent investments, the SEC set up the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR).
EDGAR helps potential investors to start investing in REITs by allowing them to view the annual and quarterly reports of all registered REITs.
The SEC suggests using EDGAR whenever you’re interested in investing in a public REIT. That way, you’ll have access to all public records, including payouts, gross income, total assets, total return, shareholder dividends, and past performance.
If your broker or financial advisor suggests a REIT, the SEC recommends doing research on EDGAR and searching its free brokerage registration tool.
That way, you’ll know whether your broker is properly licensed.
How to Invest in REITs
Now that you know what a REIT is, you probably want to know how to invest in them. Individual investors can purchase public REITs, REIT mutual funds, or REIT ETFs.
The most common way to purchase REITs is through a brokerage. Brokers purchase shares in public REITs for their clients for a fee. If you’re interested in buying REITs, talk to your broker or financial advisor to find out how.
They can help you find essential information on what exchanges to use and how to minimize the effects of fees and taxes. Unlike traditional investments in the stock market, many investors use REITs for passive investments.
That’s because REITs distribute dividends, meaning they don’t require active management to make returns for investors. REITs are also common long-term investments.
Because of their high dividend yield and long-term appreciation, investors generally hold on to REITs for longer than stocks.
REITs aren’t considered the best short-term investments because their capital appreciation isn’t as fast as stocks. If you’re looking for short-term gains in terms of capital appreciation, most financial advisors will suggest you invest in stocks.
Individual investors can also purchase REIT ETFs through retail investing platforms. These platforms allow retail investors to purchase stocks, securities, and ETFs without having to go through brokerages.
They still require fees, but they are often lower than brokers. Brokerages can also purchase private REITs for their clients if they meet certain criteria.
Brokerages must participate in an offering for non-public REITs to allow their clients to purchase non-traded REITs.
There has been an increase in people purchasing REITs for their retirement portfolio. The National Association of Real Estate Investment Trusts is a REIT advocacy group.
It found that 145 million Americans invested in REITs, primarily through their 401(k). Since REITs are becoming a more common investment vehicle, their trading volumes are increasing.
Higher trading volumes give assets more liquidity but have the added benefit of reducing volatility.
Is a REIT a Good Investment?
Investing in a REIT is a good way to diversify your investment portfolio, particularly if you don’t hold any real estate assets.
REITs are more liquid than traditional real estate investments, and they generally avoid fluctuations in the stock market with strong long-term capital appreciation.
REITs are also negatively affected during changes in the real estate markets, such as interest rate increases. In general, however, REITs give investors another option for an asset to hedge against potential losses in the stock market.
If you’re interested in REITs, you should talk to your broker or financial advisor to see whether they’re a good investment for you.
Here are some of the most common questions investors have when it comes to purchasing and investing in REITs.
What does REIT stand for?
REIT stands for “real estate investment trust.” They are investment vehicles that allow investors to buy into an income-producing property that they otherwise would not be able to afford with their capital.
Are REITs better than stocks?
Investing in a REIT differs significantly from investing in the stock market. REITs are for investors who are interested in real estate and want to receive dividends and require less hands-on work compared to stocks.
How much is the minimum investment for a REIT?
The minimum investment you need to make in a REIT depends entirely on the REIT’s management. The minimum investment for public REITs is one share, and the average minimum investment for non-traded REITs ranges from $1,000 to $25,000.
Do REITs have to pay you a dividend?
All REITs operate on a dividend structure. They must distribute at least 90% of their taxable income to their investors in the form of dividends.