What is a real estate investment trust (REIT)?

REIT meaning

Real estate investment trusts (REITs) are companies that own or finance income-producing real estate. REITs allow investors to pool together funds by purchasing shares in the REIT, and the funds are used to invest in real estate properties.

“A REIT is an investment that owns real properties like apartment buildings or shopping centers,” said Carman Kubanda, a financial planner at Innovative Wealth Building. “To qualify as a REIT, they must distribute at least 90% of their income to shareholders.” These payments come in the form of regular dividends to shareholders.

REITs are designed to make residential and commercial real estate investing more accessible, and shares are priced in a way that average investors can participate.

How does a REIT work?

REITs are packaged as securities, which means you can invest in them just like a mutual fund. Some are part of an exchange-traded fund (ETF). REITs purchase income-producing real estate or offer financing for real estate investors and charge interest on those loans.

The result is that REITs earn monthly income from rents, leases or loan payments. That earned income is used to pay operational costs, and the net income is paid out to REIT investors.

REITs are required by law to distribute at least 90% of their taxable income, though many pay out 100% of it to shareholders. These payments are distributed as dividends to investors, making REITs a great income-focused investment vehicle.

Publicly traded REITs can be traded on major stock exchanges, such as the New York Stock Exchange (NYSE), while private REITs are less liquid and may not be as easy to sell to other investors.

What are REIT dividends?

REIT dividends are regular distributions from the REIT to shareholders in the form of a dividend payment. This typically happens on a monthly, quarterly or semiannual basis.

How are REIT dividends taxed?

REIT dividends are taxed as ordinary income to shareholders. They are not eligible to be treated as qualified dividends, which can offer lower tax rates. But REITs can also distribute capital back to shareholders, and these are reported as capital gains by the REIT.

On the corporate level, REIT dividends to shareholders are deducted from the corporate taxable income, allowing the entity to lower (or eliminate) any income tax owed.

Because of the income that a REIT produces, individuals (especially higher earners) may not want to hold this investment in a taxable (nonretirement) account,” said Kubanda.

» MORE: How to minimize capital gains on real estate

Types of REITs

Most REITs focus on a specific market sector, such as commercial real estate, residential real estate, multifamily homes, office buildings, health care facilities or other real estate markets. There are also hybrid REITs that offer diversified holdings in many different real estate markets.

There are three main types of REITs:

• Equity REITs own commercial or residential real estate and rent or lease out the property to tenants paying monthly rent. These REITs own and manage the property, and net profits are sent to investors.
• Financing REITs, or mortgage REITs, lend money to businesses and real estate investors to purchase a property and collect monthly payments (plus interest) on the loans. The income earned is more steady but may not come with the same upside as an equity REIT.
• Hybrid REITs offer a mix of both equity and financed real estate investments, giving owners a more balanced real estate portfolio.

How to invest in a REIT

You can invest in REITs through most online brokers. Since publicly traded REITs are available on major exchanges, you can buy and sell them when the stock market is open.

Here’s how to buy REITs:

1. Open an account with your favorite online broker.
2. Deposit funds for investing.
3. Use your broker’s stock screen to filter by available REITs.
4. Research ones that offer what you’re looking for. This may include high dividend yield, high overall returns or diversification.
5. When you find a REIT you like, purchase the REIT.
6. Once you own a REIT, you will receive regular dividend payments into your brokerage account.

Private REITs require investing directly through the private company and typically have very high minimums.

It’s important to understand the risks of buying private REITs before investing your money. This includes low liquidity and the potential for fraud if the REIT is not registered with the Securities and Exchange Commission (SEC).

REIT returns

REITs are known for their high dividend payments, but they also benefit from capital appreciation of the real estate owned. REIT returns are largely uncorrelated with the stock market; therefore they can be a great way to diversify outside of stock investing.

Different REITs offer different returns. But the overall REIT market has shown solid performance over the past decade.

For example, the Dow Jones All Equity REIT Index shows a 6% average annual return over the past 10 years. Much of that return can be attributed to strong dividend performance, as just the price return alone shows a 2.20% annual return as of publishing, instead of the total 6% return.

As for dividends, REITs can pay out from 3% to 5% in annual dividends, depending on the REIT chosen. Comparing this to dividends paid from the S&P 500 with an average 1.54% dividend payout as of publishing, this is a far better dividend return than investing in the stock market.

On the other hand, the total return (dividends and appreciation) of the S&P 500 has averaged over 11% annually, so it has been a better investment over the past 10 years.

Over a longer time horizon, though, the National Association of Real Estate Investment Trusts (NAREIT) shows that the 30-year performance of equity REITs has kept pace (and even outperformed) the stock market.

» MORE: What is a good investment?

REIT pros and cons

REITs can be a great way for average investors to invest in real estate without the headache of owning and operating it themselves. But REITs aren’t for everyone, and they come with risks, too.

Bottom line

REITs have been around for decades, giving investors access to commercial and residential real estate investments without having to fork over a ton of money. You can own an entire portfolio of real estate investments within a single fund.

But REITs aren’t for everyone, and they have underperformed a red-hot stock market over the last decade. If you are looking for a way to diversify your portfolio into real estate, REITs are the easiest way to make it happen. Just be aware of the risks and do your research before investing in a REIT.