What is a REIT?

In a nutshell

A real estate investment trust (REIT) is a professionally managed portfolio of real estate properties, mortgages, or both that allows investors to benefit from real estate appreciation and recurring income without having to own individual properties.

• Many investors want to invest in real estate, but they don't want the responsibilities of managing rental units.
• In the U.S. REITs are legally required to pay at least 90% of their taxable income to shareholders.
• Some REIT shares are only available to accredited investors, but many can be bought through a brokerage account.

What is a REIT?

A real estate investment trust (REIT) is a professionally managed portfolio of real estate properties, mortgages, or both. REITs allow investors to own fractional shares of the underlying investments, similar to how a mutual fund offers fractional ownership of companies. Investors receive recurring income relative to their ownership stake in the REIT.

REITs have unique tax advantages and pass through their income to investors. REITs avoid paying taxes as long as they distribute at least 90% of taxable income to investors. Distributions are ordinary income, which has the highest tax rates.

How does a REIT Work?

REITs raise money from investors and buy properties to rent, lend money to buy properties or purchase mortgage-backed securities (MBS). These funds have professional management that researches and analyzes potential investments and selects those that best fit the fund's strategy.

Equity REITs purchase properties for rent. Sometimes, these properties are rent-ready upon acquisition, while other times, the REIT must rehab the property to make it marketable.

What qualifies as a REIT?

According to the Securities and Exchange Commission (SEC), for an investment fund to qualify as a REIT, it must own income-producing real estate properties or real estate-related assets, like mortgages or mortgage-backed securities. A REIT must primarily develop properties for its own portfolio versus building or rehabbing properties for sale to other owners.

Additional qualifications are:

• No more than 50% of its shares may be held by five or fewer shareholders.
• After one year, the REIT must have at least 100 shareholders.
• At least 75% of its assets must be in real estate or cash.
• It must derive at least 75% of its income from real estate investments.
• It must distribute at least 90% of its taxable income each year to investors.

Pros and cons of investing in REITs

Pros

• Professional management.
• Immediate diversification of your investment.
• Receive regular, recurring income.
• Avoid the responsibilities and risks of owning individual properties.

Cons

• Dividends are ordinary income.
• Investors do not control what investments are within the portfolio.
• Investors miss out on the tax benefits of direct ownership in real estate.

Types of REITs

Investors have three broad categories of REITs to choose from:

Mortgage REITs

A mortgage REIT originates mortgages or purchases mortgage-backed securities. It does not own any properties directly. Investors receive distributions from the income that the mortgages create

Equity REITs

Equity REITs purchase properties and rehab them to optimize rental income. They manage the properties and find tenants to maximize occupancy.

Hybrid REITs

Hybrid REITs have the freedom to invest in Mortgage REITs, Equity REITs, or both. Their portfolio allocations may change based on current market trends, interest rates, the overall economy, and other factors.

There are many different categories of Equity REITs. Some focus on specific geographies, while others specialize in certain industries. Here are a few of the niches available when investing in Equity REITs:

• Residential.
• Commercial.
• Hotels.
• Geography-based properties.
• Healthcare.
• Office buildings.

How to buy REITs

Investors who want to invest in real estate through REITs have several options. Here are a few of the most common:

Purchase REIT stocks

Investors can purchase shares of REIT stocks through their brokerage account. Some REITs also allow the direct purchase of shares through DRIPs (dividend reinvestment programs). These stocks trade publicly and can be bought or sold at any time, just like any other stock. Some brokerages and investing apps allow small-dollar investments and the purchase of fractional shares.

Invest in REIT funds

Picking individual stocks can be a challenge for some investors, so they turn to REIT mutual funds or ETFs instead. This gives the investor immediate diversification and a fund manager to analyze the company's financials. REIT funds are also highly liquid, but some fund companies may require a minimum investment amount to buy shares.

FinTech apps

Many FinTech apps launched in the last few years offer REIT investors the ability to invest directly in individual properties and REITs. This provides immediate diversification and often lower minimums than investing in private REITs through a broker. Most average investors can invest through these FinTech apps. This makes it easier for smaller investors to start investing in real estate projects.

Private REITs

Private REITs are exempt from SEC registration, and their shares are not for sale on a stock exchange. These shares are sold through brokers, and they generally require a minimum investment amount and a long-term commitment. In many cases, the investor must be an accredited investor in order to purchase shares.

The AP Buyline roundup: Professional management, instant diversification

A real estate investment trust (REIT) is a fund that holds a diversified pool of rental real estate, mortgages, mortgage-backed securities, or all three. It is an attractive option for investors because it provides professional management, instant diversification, and regular income distributions. However, the downside is that distributions are ordinary income, which has the highest tax rates. To offset this, many investors choose to invest in REITs in tax-advantaged accounts, like a 401(k) or IRA.

Frequently asked questions (FAQs)

Why Should I Invest in REITs?

Investors choose to invest in REITs to diversify their portfolios in non-correlated assets and to generate recurring revenue. Real estate returns are non-correlated with the stock or bond market, which makes them a good investment for diversification. REITs provide regular distributions from the income that the real estate properties generate each month.

How Are REIT Dividends Taxed?

REITs must distribute at least 90% of taxable income in order to maintain their unique tax status. Dividends from REITs are ordinary income, which typically has the highest tax rates. Because of that reason, many investors hold REITs in tax-advantaged accounts, like a 401(k) or an IRA, to minimize their taxes owed.

How Much of Your Portfolio Should Be in REITs?

An analysis by Morningstar Associates, sponsored by Nareit, found that the ideal allocation of REIT investments is 4% to 13% of the portfolio. This allocation optimizes returns without dramatically increasing risks in the portfolio.

What Are the Risks of Investing in REITs?

The biggest risks of investing in REITs are that you don't have control of the real estate assets in the portfolio, the distributions are ordinary income for tax purposes, and rising interest rates can affect valuations.