Published by Business Insider | July 20, 2024
REITs offer investors a liquid way to profit from real estate, without management hassles. Here's how they work and ways to invest.
A real estate investment trust (REIT) allows people to invest in real estate without having to buy or manage any property themselves. Given that landlord duties go beyond the level of work most are interested in taking on, REITs are often the real estate investment of choice for individual investors. According to the National Association of Real Estate Investment Trusts (NAREIT), as of October 2020, an estimated 145 million Americans, or roughly 44% of US households, own REIT shares, most of which trade on major stock exchanges.
Many investors decide to add REITs to their portfolios because these products combine the ease and liquidity of investing in stocks with the opportunity to own, and profit from, real estate. Geared to generating income, REITs offer regular returns and outsized dividends.
What is a REIT?
REITs are companies that own, operate, or finance income-producing properties and real estate ventures. Like mutual funds or exchange-traded funds (ETFs), they own not just one, but a basket of assets. Investors purchase shares of a REIT and earn a proportionate share of the income produced by those assets.
REITs were created in 1960 when Congress established them as an amendment to the Cigar Excise Tax Extension, which allowed investors to buy shares in commercial real estate portfolios. Since then, REITs have grown to the point where, today, NAREIT estimates that REITs collectively own about $3.5 trillion in assets across the US.
REITs are appealing to investors who want to put money into the real estate market without having to own real estate. They’re also appealing because of the unique way that they are taxed. While most stock dividends are in effect taxed twice — first when the company pays its corporate taxes, then when the investor pays their income tax — REIT payouts are only taxed through investors. A REIT is structured as a pass-through entity, an entity that passes all of its income to investors or owners — which means, it doesn’t pay any corporate tax. This effectively means higher returns for its investors.
The rules of REITs
There are certain Internal Revenue Code (IRC) rules that a company must comply with in order to qualify as a REIT (and avoid those corporate taxes). They must be registered as corporations, and be managed by a board of trustees or directors.
A REIT must also:
- Distribute at least 90% of its annual taxable income in dividends
- Rent at least 90% of the property to people who are not subsidiaries of the REIT
- Derive at least 75% of its gross income from real estate
- Invest at least 75% of its total assets in real estate ventures, cash vehicles (bonds, etc.), or government securities
- Have at least 100 shareholders
- Have no more than 50% of its shares held by less than five individuals
Varieties of REITs
All REITs are oriented to producing income, but they do so in different ways. In total, there are three types.
Equity REITs
The vast majority of REITs fall into this category (and are what most people mean when they discuss REITs). This type actually owns and operates real estate properties. Its revenues come from rents, but it also offers the potential for capital appreciation from building sales.
Mortgage REITs
More of a strict income play, mortgage REITs, sometimes written as mREITs, don’t own property; rather, they offer or own mortgages on properties. Sometimes they hold actual mortgages, sometimes mortgage-backed securities. The revenues come from the mortgage payments, especially the interest on them. In general, mortgage REITs tend to be more leveraged than equity REITs, which makes them riskier.
Mortgage REITs profit by capturing the spread between their borrowing interest rate and the mortgage interest rates. If they’re borrowing money at a 1% interest rate to buy a mortgage with a 4% interest rate, they can pass that 3% spread onto their investors. This also means that mortgage REITs are particularly sensitive to interest rate changes. They lose value when interest rates drop.
Hybrid REITs
As the name suggests, hybrid REITs use a mix of investing strategies, owning both actual properties and mortgages. These are appealing to generalist investors who can’t decide one way or another between equity and mortgage REITs, though hybrid REITs tend to lean one way or another.
What do REITs invest in?
As long as a REIT complies with the IRC rules, it can invest in any sort of real estate property.
