What is a Real Estate Investment Trust (REIT)?
Real Estate Investment Trusts (REITs for short) are companies that invest in real estate and/or real estate financing and distribute at least 90% of their profits to shareholders as dividends. Many are publicly traded on major exchanges and can be bought and sold quickly and easily like traditional stocks.
Some REITs make money by renting out properties (e.g., apartments, offices, cell towers, retail space, warehouses, etc.) they own, while others do so by providing mortgages to homebuyers in exchange for interest payments. Certain REITs utilize both types of income streams.
Because of their high and consistent dividends, REITs are a popular investment vehicle for investors who want the passive income that comes with owning real estate but don’t have the time or money to buy, maintain, and rent their own property. They’re also popular during periods of above-average inflation, as rents and real estate tend to rise in price alongside consumer staples, sometimes making more money available for REIT shareholders when traditional stocks may falter.
One of the key benefits of qualifying as a REIT as a company is the exemption from corporation tax on any income paid to shareholders as dividends. For this reason, many use 100 percent of their taxable income as dividends to avoid corporate taxation altogether.
Because most (if not all) of a REIT’s profits are paid out as dividends, there’s typically little money left to invest in for growth, so the stock price tends to have less potential to rise dramatically (ie, they typically aren’t as volatile as traditional stocks). ). For this reason, REITs are much more popular with fixed-income investors (looking for regular dividend payments) than with growth investors (looking for significant appreciation in the value of their investment over time).
What makes a company a REIT?
Not all real estate companies are REITs. To qualify as a REIT, a company must use its real estate and/or mortgages as income-generating investments. For example, a company that builds housing developments and then sells them would not be considered a REIT.
To qualify as a REIT, a company must distribute at least 90% of its taxable income in dividends. REITs also have to . . .
- “Administered by a board of directors or trustee,
- obtain at least 75 percent of their gross income from real estate-related sources, including rent from real estate and interest on mortgages used to finance real estate,
- invest at least 75 percent of their total assets in real estate assets and cash,
- have at least 100 shareholders after the first year as a REIT”,
- and more.
For a complete list of the requirements a company must meet to qualify, see the SEC’s Investor Bulletin on REITs.
The 3 types of REITs
There are three main types of REITs — equities, mortgages, and hybrids. All three funnel profits to investors through dividends, but they differ on where their income comes from.
Equity REITs generate income by operating what are known as “income-generating real estate.” Essentially, this means buying and owning real estate and then renting it out to individuals or businesses in exchange for rent payments.
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Most equity REITs specialize in a particular type of property (such as apartment complexes or storage facilities), but some operate and lease many different types of property. The rental or lease payments that an equity REIT collects are first used to cover costs, and then at least 90% of the remaining amount is paid out to shareholders as a dividend.
Mortgage REITs differ from equity REITs in that they do not own and lease real estate. Instead, they offer mortgages or other real estate loans to prospective homeowners and collect interest payments. Alternatively, a mortgage REIT might not offer mortgages directly, but instead invest indirectly in real estate financing by buying mortgage-backed securities.
These REITs tend to use more leverage and derivative hedging to fund their investments than equity REITs. Because of this, they can be riskier investments than stock REITs. Investors should ensure they fully understand a mortgage REIT’s funding model before making an investment decision.
Hybrid REITs are so called because they use both of the strategies described above. They buy, maintain, and rent physical real estate, and also provide mortgages or other real estate loans to homebuyers.
What are the benefits of investing in a REIT?
- Dividends: REITs’ regular dividend payments make them popular with investors looking for additional sources of income. Because they are, by definition, required to pay out at least 90% of their profits as dividends, REITs tend to have relatively high dividend yields compared to traditional stocks.
- Diversification: REITs are a unique asset class because they offer easy exposure to the real estate market. Because of this, investing in them — in addition to stocks, bonds, commodities, and other asset classes — is a great way to diversify a portfolio to strengthen it in preparation for periods of volatility and inflation.
- Liquidity: Real estate has traditionally not been a very liquid asset class. Buying and selling real estate takes time, and any pool of potential buyers is usually limited by location and budget. However, tradable REITs can be bought and sold very quickly in stocks on the major national stock exchanges, making them suitable for investors who value portfolio liquidity.
- Inflation protection: Since not only consumer goods but also real estate (and rents) tend to rise in price in times of high inflation, REITs are often more stable than traditional equities in times of high inflation fears. Their consistent passive income payments are also beneficial during times when other companies may be cutting dividend payments.
What are the disadvantages of investing in a REIT?
- Property costs: Real estate expenses — particularly property taxes — don’t come cheap, and the more a REIT has to pay to cover those expenses, the less profit it has left to distribute to shareholders as dividends. For this reason, it’s a good idea to review a real estate company’s income statement before investing.
- Interest rate risk: REITs are valued for their passive income payments. So when interest rates rise and government bonds become more attractive to fixed income investors, money can drain out of the REIT market and stock prices can fall.
- Weak growth: Because REITs spend at least 90% of their income paying dividends, they typically don’t grow very quickly, which often results in a stock price that’s not very fast. Because of this, they’re not as popular with growth investors.
- Dividend Taxes: Unlike qualifying dividends, which are typically taxed at favorable capital gains rates, REIT dividends are typically considered ordinary income and are taxed as such according to the individual investor’s tax bracket. That means investors on REIT dividend income typically have to pay more taxes than dividend income from traditional stocks.
How to invest in REITs
Investors can buy stocks in traded REITs just as they would stocks — on a major exchange through a broker or brokerage app like E-Trade or Robinhood. Because different REITs focus on different property types (e.g. commercial, residential, warehouse, office, etc.), investors can choose multiple companies to invest in or find a REIT exchange-traded fund (ETF) to invest in immediately to invest in many different REITs. Be sure to check expense ratios when considering ETFs, as they can hamper potential gains.
5 popular REIT ETFs to try
Charles Schwab US REIT ETF (SCHH)
Real Estate Select Sector SPDR Fund (XLRE)
Vanguard Real Estate ETF (VNQ)
iShares Mortgage Real Estate Capped ETF (REM)
Pacer Benchmark Industrial Real Estate SCTR ETF (INDS)
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about REITs that have not been addressed in the sections above.
What’s a good dividend yield for a REIT?
Because the dividend yield changes with the stock price, a REIT’s yield can change significantly even if it continues to pay stable dividends. Remember, dividend yield is the ratio of the dividends a company pays to its current stock price, so a fall in stock price pushes the dividend yield higher.
However, REIT yields average around 3 to 5 percent, although higher and lower yields are also common.
Traded vs. non-traded REITs: What are the differences?
Traded REITs are traded like normal stocks on national stock exchanges. Therefore, they are liquid and transparent and a good option for regular investors. Non-traded REITs, on the other hand, charge fees, have less liquidity, and don’t have readily available stock prices. They can also require a fairly large initial investment. For most individual investors, non-traded REITs are not a good investment option.
Are REITs good inflation hedges?
While no investment — except perhaps bonds — is completely safe from inflation, REITs are typically considered a good hedge against inflation, as rents and house prices tend to rise during inflation (which can boost both earnings and stock prices) and consistent dividends provide a reliable source of income.