A Real Estate Investment Trust (REIT) is a company that owns or finances rental properties. Investors can purchase shares in the trust, entitling them to dividend income. REITs may be either publicly or privately owned.
How do REITs work?
There are two basic types of REITs. The first, known as an equity REIT, owns properties that produce rental income. Shareholders are then given a share of that income in the form of dividends. The REIT is responsible for managing the properties and collecting rents.
The second type of REIT, known as a mortgage REIT, produces income by financing real estate projects. Mortgage REITs also produce dividend income for their investors through the interest paid on the mortgages.
In both cases, investors buy shares of REITs to generate a reliable stream of real estate income. Equity REITs can appreciate alongside the underlying real estate assets. For most investors, though, the dividend income REIT shares produce is the main purpose of owning them.
REITs must also meet certain qualifications set by federal regulators. A company acting as a real estate investment trust must:
- Keep 75% or more of its invested assets in real estate or treasuries.
- Earn 75% or more of all revenues from real estate activities.
- Pay out 90% or more of taxable income as dividends.
- Be subject to corporate tax.
- Be governed by a board of directors or trustees.
- Have no fewer than 100 shareholders within one year after being founded.
- Prevent any more than 50 percent of all shares from being controlled by five or fewer shareholders.
Per these requirements, a REIT must engage primarily in real estate investment. This prevents trusts from branching out into other forms of investment that could dilute their real estate focus.
What kind of properties do equity REITs own?
Equity REITs can own several different types of income-generating properties. Residential and commercial rental properties are both staples in the real estate world. Apartment buildings, shopping centers, office buildings, and single-family homes are all fairly common assets held by REITs.
With that said, you’ll also find more niche types of real estate in some trusts. Farmland, for example, can generate significant cash flow for minimal maintenance costs. Other types of real estate you may find in a REIT include:
- Mobile homes.
- Cell towers.
- Wind energy farms.
- Timberland.
In some cases, REITs will focus on one specific niche of real estate. For instance, there are several REITs that specialize in cell towers. Other REITs invest in blends of different property types.
Advantages of investing in REITs
The primary advantage of investing in REITs is that they can deliver stable income with minimal volatility. Unlike dividend-paying stocks, a REIT is bound by federal regulation to pay at least 90% of its taxable income out in dividends. This means that investors are effectively guaranteed to receive dividends that closely track total rental incomes.
REITs provide some insulation from the ups and downs of the stock market. Because they are based on real estate, these trusts are usually fairly stable. They are also helpful as a hedge against inflation, as rents tend to rise alongside other prices.
Investing in REIT shares is also a good way to build real estate into your portfolio inexpensively. Even if you don’t have tens of thousands of dollars to put down on a rental, you can earn rental income through REIT dividends. Using REITs to invest in real estate similarly removes the burden of maintaining and managing properties yourself.
Downsides of REITs
Despite their advantages, REITs aren’t without downsides. To begin with, REIT shares can be somewhat illiquid. REITs that trade on public stock exchanges can be bought and sold relatively easily. Privately held trusts, however, can make it difficult to sell shares. Be sure to have an exit strategy for REIT investing in case you need to withdraw money for unexpected expenses.
REITs are also fairly sensitive to rising interest rates. Just as in traditional real estate investing, higher rates translate to larger expenses and slimmer profits for the properties REITs manage. As a result, share prices can suffer when interest rates climb.
Finally, REITs offer very little control when it comes to property selection. Whereas buying property directly lets you purchase only what you want, the properties bought by a REIT are purchased without shareholder input. This can prove difficult for investors who prefer total control over their assets.
How to get started with REITs
The easiest way to start investing in REITs is to buy shares of publicly traded trusts. These trusts trade on major stock exchanges, making them easy to find and relatively liquid. Publicly traded REITs also tend to be quite large, leading to more diversification in their underlying assets. If you have an IRA, you can even use your tax-advantaged retirement account to buy and hold REIT shares.
Before buying shares in any real estate investment trust, be sure to carefully evaluate the trust’s holdings and yields to be sure it’s a good fit for your portfolio. You should also explore alternative real estate investment options, such as fractional real estate shares (just our two cents).
Final thoughts
REITs are instruments that allow you to earn dividends from income produced by real estate investments. These trusts generate revenue either from rents or from interest paid on mortgages. In order to be considered a REIT, a company must earn 75% of its revenue from real estate and pay out 90% of its taxable income as dividends.
By buying shares in REITs, investors can include real estate in their portfolios without the expense and hassle of purchasing actual rental properties. While some REIT shares are illiquid, larger trusts that trade publicly are fairly easy to buy and sell.
