Takeaways
- REITs are investment companies that own income-producing real estate properties.
- REITs distribute most of their rental income to shareholders through dividends.
- REITs come in many flavors: mortgage, retail, office, residential, and commercial.
- REITs offer investors diversification, passive income, and the potential for capital appreciation.
- Investors can invest in REITs via publicly traded stocks, mutual funds, crowdfunding platforms, and other direct participation programs.
There are many opportunities to diversify your investment portfolio. One of those avenues is through real estate. Investing in real estate can seem intimidating and farfetched for beginner investors. The good news is that Real Estate Investment Trusts (REITs) offer an excellent solution to gain exposure to the real estate market without actually having the headache of purchasing and managing a property yourself.
REITs in the U.S. own more than $4.5 trillion in gross real estate assets. According to global accounting firm E&Y, publicly traded REITs have had an increase in market capitalization at an approximately 17% compound rate from 1990 to 2021 [1]. The opportunity to invest in REITs only seems to be growing.
What is a REIT?
So, what exactly is a REIT? A REIT is a company that owns, operates, or finances income-producing real estate [2]. REITs provide a way for individual investors to access real estate assets without having to directly own or manage properties themselves, making the process of adding investments in real estate very easy. They are highly accessible, and you can even invest in publicly traded REITs through your online stock brokerage account. REITs are required by law to distribute a significant portion of their rental income to shareholders in the form of dividends.
How to Qualify as a REIT
To qualify as a Real Estate Investment Trust, companies must adhere to stringent criteria outlined by the Internal Revenue Service (IRS). These criteria serve as the foundation for ensuring that REITs operate in a manner consistent with their intended purpose (e.g., they invest in real estate). Here's an expanded look at the requirements
Investment in Real Estate Assets
One of the first qualifications of a REIT is that it must invest in real estate. Investing in real estate is defined as allocating a substantial portion of its assets to real estate investments. A REIT is supposed to invest a minimum of 75% of the total assets into real estate properties. These properties may include various types of investments, such as commercial properties (e.g., office buildings, shopping malls), residential properties (e.g., apartment complexes, single-family homes), or specialized properties (e.g., healthcare facilities, industrial warehouses).
Create Income from Real Estate Activities
In addition to investing in real estate assets, REITs must derive a significant portion of their gross income from real estate-related activities. This includes income generated from rents collected from tenants occupying the REIT's properties, interest earned from mortgage loans secured by real estate assets, and proceeds from the sale of real estate properties. To meet the IRS criteria, at least 75% of the REIT's gross income must come from these sources.
Dividend Distribution Requirement
One of the distinguishing features of REITs is their obligation to distribute a substantial portion of their taxable income to shareholders in the form of dividends. To qualify for REIT status, companies must adhere to this distribution requirement by distributing at least 90% of their taxable income as dividends to shareholders. However, most REITs pay 100% of their taxable income to shareholders [3].
If you are trying to build a portfolio with passive income, investing in publicly traded REITs can help you make more income. Dividend payments ensure that REIT investors benefit from regular income distributions, making REITs an attractive option for income-oriented investors seeking steady cash flow.
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7 Types of REITs
The popularity of REITs has exploded since the 1960s. There are now over 20 different kinds of REITs available for investors. And if you need liquidity, you can focus on investing exclusively in publicly traded REITs on stock exchanges (e.g., NASDAQ or NYSE). Here are seven popular types of REITs to investigate:
1. Equity REITs
These REITs are primarily engaged in the ownership and management of income-producing real estate properties across various geographies and industry sectors. Equity REITs invest in a wide range of properties, including apartments, office buildings, shopping malls, hotels, industrial warehouses, and other commercial real estate assets.
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Equity REITs generate revenue primarily from rental income from leasing these properties to tenants. They offer investors the opportunity to gain exposure to the real estate market and earn returns through both rental income and potential property appreciation.
2. Mortgage REITs (mREITs)
Unlike equity REITs, mortgage REITs focus on providing financing for real estate transactions rather than owning physical properties. mREITs invest in mortgage loans, mortgage-backed securities (MBS), and other real estate-related debt instruments. They earn income primarily from interest payments on these investments.
mREITs may leverage their capital by borrowing funds at short-term rates to invest in higher-yielding mortgage assets, amplifying potential returns. However, they are also exposed to risks such as interest rate fluctuations and credit defaults. Only invest in REITs that align with your investment risk appetite.
3. Hybrid REITs
Hybrid REITs combine features of both equity and mortgage REITs, diversifying their investment strategies across both real estate properties and real estate-related debt instruments.
These REITs invest in a mixture of physical real estate properties, mortgage loans, mortgage-backed securities, and other real estate-related securities. By diversifying across different asset classes, hybrid REITs seek to mitigate risks and optimize returns for investors.
4. Retail REITs
Retail REITs specialize in owning and operating retail properties, including shopping centers, malls, strip malls, and standalone retail stores. These REITs get rental income from leasing these spaces to tenants, like retail chains, restaurants, and entertainment venues.
Retail REITs can focus on different types of retail properties, including regional malls, community centers, and outlet malls, catering to diverse consumer needs and preferences. The “Amazon effect” on retail spaces has been significant over the last decade, but pools of capital like retail REITs can find the hot spots of the retail market.
5. Office REITs
Office REITs concentrate on owning and leasing – you guessed it – office buildings and commercial office spaces to tenants, such as businesses, corporations, and government agencies. These REITs generate rental income from leasing office spaces on a short-term or long-term basis.
There has been a major shift for many companies to allow employees to work from home. There has been significant debate on how this will affect office REIT incomes in the future. Office REITs can focus on targeting specific markets or submarkets, such as central business districts, suburban office parks, or mixed-use developments, based on demand dynamics and economic trends.
6. Residential REITs
Residential REITs invest in residential properties, including apartment buildings, single-family homes, townhouses, and condominiums. These REITs cater to the rental housing market, providing housing options for individuals, families, and communities.
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Residential REITs generate rental income from leasing residential units to tenants, offering amenities and services tailored to residents' needs and preferences. Residential REITs may target different segments of the housing market, such as luxury apartments, affordable housing, student housing, or senior living communities.
7. Healthcare REITs
Healthcare REITs specialize in owning and managing healthcare-related properties, including hospitals, medical office buildings, skilled nursing facilities, assisted living facilities, and senior housing communities. These REITs provide essential real estate infrastructure for the healthcare industry, supporting medical providers and healthcare services.
Healthcare REITs generate rental income from leasing healthcare facilities to operators, healthcare providers, and healthcare systems, serving diverse patient populations and healthcare needs.
Advantages of REITs
Investing in real estate investment trusts has multiple advantages. Investors have noticed this and surged to place capital in this investment vehicle because of its potential rate of return and differentiated exposure to the real estate market. Here are four primary advantages of REITs:
- Diversification: REITs provide exposure to a diversified portfolio of real estate assets, reducing investment risk.
- Passive Income: REITs generate consistent income through dividends, providing a reliable source of passive income for investors.
- Liquidity: REITs are traded on major stock exchanges, offering liquidity compared to direct real estate investments.
- Potential for Capital Appreciation: In addition to dividends, REITs offer the potential for capital appreciation as property values increase over time.
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Disadvantages of REITs
There are opportunity costs to investing in REITs. While you could pick a fund that soars through the roof, you could also place your investment funds in a dud. Knowing how to choose the right REITs is critical for long-term payoffs. Plus, depending on your existing investment portfolio, REITs might not be the ideal place to park your capital. Here are four cons to investing in REITs:
- Interest Rate Sensitivity: REITs are sensitive to changes in interest rates, which can impact their financing costs and property valuations.
- Market Risk: REIT prices are influenced by market trends and investor sentiment, leading to volatility in stock prices.
- Economic Downturns: Real estate markets can be cyclical, and REITs may experience declines in property values and rental income during economic downturns.
- Tax Considerations: Dividend income from REITs is taxed at ordinary income rates, which may be higher than capital gains tax rates.
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Where Can You Invest in REITs?
Investing in REITs can be simple. Publicly-trade REITs must register with the Security and Exchange commission before being listed on an exchange. Your brokerage account isn’t the only place to invest in REITs. Here are four places you can invest in REITs:
- Publicly Traded REITs: Purchase shares of REITs listed on major stock exchanges, such as the NYSE or NASDAQ.
- REIT Mutual Funds: Invest in mutual funds or exchange-traded funds that hold a portfolio of REIT stocks.
- Real Estate Crowdfunding Platforms: Participate in real estate crowdfunding platforms that offer opportunities to invest in private REITs or real estate projects.
- Direct Participation Programs (DPPs): Invest in private REITs or real estate partnerships through DPPs offered by brokerage firms or investment companies.
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Smart Summary
REITs offer you a convenient and accessible way to invest in real estate assets in a hands-off fashion. By allocating part of your investment portfolio to REITs you can enjoy the benefits of diversification, passive income, and potential for capital appreciation. However, you should consider the advantages and disadvantages of REIT investment and tether those investments to your financial goals. Read about investment strategies for beginners.
(1) Ernst & Young. REITs contribute 3.2 million jobs and $229.0 billion to the U.S. Economy. Last Accessed March 13, 2024.
(2) Investor.gov. Real Estate Investment Trusts (REITs). Last Accessed March 13, 2024.
(3) U.S. Securities and Exchange Commission. Real Estate Investment Trusts (REITs). Last Accessed March 13, 2024.
