Real Estate Investment Trusts (REITs) - What Is It & How It Works (2024)

A real estate investment trust (REIT) is a type of investment that allows average people to invest in real estate affordably. These trusts own income-producing property, and they pay dividends to shareholders based on profits from the properties they lease or rent. Most real estate investment trusts focus on a single type of commercial real estate, such as multifamily homes, but there are some that diversify to include a range of property classes.

When investors add real estate investment trusts to their portfolios, they diversify their assets to include real estate but with less risk than what’s typically involved with buying and selling individual properties. There’s also less of a time investment with these types of trusts because you don’t have to manage any properties yourself. Some people may have money in a real estate investment trust without even realizing it, as pensions and 401(k)s often include these investment types. Let’s look at what REITs are so you can decide if this is the right investment strategy for your portfolio.

What Are Real Estate Investment Trusts (REITs)

REITs are real estate holding companies run by real estate operators/real estate investors who invest in specific asset classes, typically within a specific geographic concentration. The IRS exempts REITs from paying income taxes at the corporate level as long as they hold at least 75% of their investment portfolio in “qualifying” real estate investments. By law, REITs must also disburse 90% of their income or more to shareholders as dividends.

How Do REITs Work?

REITs buy and own real estate that produces income. This can include apartment buildings, retail or office space, cell towers, data centers, hotels, and basically anything else they can rent or lease to make a profit. These investment portfolios leverage the money of lots of investors to purchase properties that individual investors can’t afford or don’t want to buy themselves.

The REIT collects the rent money and then disperses it to investors in the form of dividends. A REIT may contain all of the same real estate class or several real estate classes. Because real estate investment trusts must pay out at least 90% of their taxable income in dividends, they can be a lucrative addition to your portfolio.

Types of REITs

We know that REITs are required to have at least 75% of their portfolios in qualifying real estate investments, but the operative word here is qualifying, as real estate operators can invest in assets, mortgages, liens, or other REITs. And like the other types of assets and investments, not all REITs are created equally.

There are five major types of REITs you should know about:

1. Equity REITs: These REITs buy real assets like retail, industrial, office, and multifamily housing. Most REITs fall into the category of equity REITs, which own and actively manage income-producing commercial real estate property.
2. Mortgage REITs: Mortgage REITs, or mREITs, invest in debt instruments. This means they provide financing for real estate that produces an income through purchasing mortgages or mortgage-backed securities and then earning income based on the interest.
3. Public nonlisted REITs: A public nonlisted REIT doesn’t trade on major stock exchanges, but it is registered with the SEC.
4. Private REITs: Private REITs aren’t traded on a national stock exchange, and they’re exempt from having to register with the SEC. These are only available to qualified investors.
5. Hybrid REITs: Hybrid REITs invest in both equity and debt assets, making money on both monthly income and lending interest.

Pros and Cons of Investing in REITs

As with any investment strategy, you have to consider the pros and cons of investing in REITs to determine whether to add them to your portfolio. First, let’s go over the advantages of including REITs in your portfolio:

• Easier than buying commercial property: You can use REITs to get into the commercial real estate market without having to finance real estate.
• Diversifies your portfolio: Including REITs in your portfolio provides you with more diversification, and REITs are great because they don’t always correlate with other market trends.
• Improves return potential: Most REITs have a history of providing higher returns than other stock exchange investments, so having them in your portfolio improves your chance of earning high returns on your investment.
• Provides dividend payments: Because REITs have to pay out 90% of their profits to investors, the dividend payouts are usually higher than other investments may provide.
• Offers a chance for passive income: The high rate of return on REITs means they can offer investors a great opportunity to earn passive income.
• Allows for liquidity: REITs are fairly liquid, as you can sell your shares on the open market to another investor if you like, whereas owning property doesn’t have the same potential for a quick sale.

You also need to look at the downsides of REITs before you incorporate this type of investment into your portfolio:

• Taxes: Investors need to know that their REIT income is taxed as ordinary income, so the larger the amount of dividends your REIT earns for you, the more you’ll be on the hook for at tax time.
• Interest rates: The current interest rate can have a big impact on a REIT due to the amount of debt load they can carry at any given time, which causes fluctuations in dividend payouts.
• Fees: Depending on the type of REIT, you may be responsible for fees that are associated with having the investment in your portfolio, so be aware of these to make sure it’s worth it.
• Trends: Like with the interest rates, real estate market trends can also affect REITs more than other investment types, as the economy plays a large part in the need for commercial real estate leases.

How Do REITs Make Money

How REITs make money is pretty basic. The process starts with the REIT investing in an income-producing property. Once the property is on the books for the REIT, it can start collecting income based on the rental price of the building or other assets. Then, anything the REIT makes over 10% is distributed to investors in the form of dividends. Some REITs may payout 100% of their profits as dividends.

A REIT that owns financial real estate in the form of mortgages makes money from the interest that borrowers pay on those mortgages. These REITs pay investors from the interest income earned.

How To Invest in REITs

Before you go to Yahoo Finance to look through random REITs stock tickers, it is important to develop your target asset investment thesis. The thesis should define what you are looking for when you invest in REITs. The thesis can be specific or basic:

Specific thesis: “Seeking to gain exposure to the Class B office buildings in New York City, as there is growth in the startup offices that will be requiring this type of office space.”

Basic thesis: “Seeking to invest in buildings targeting student renters regardless of geographic location, as the student housing market is poised for growth given the need for higher secondary education.”

By defining the investment thesis, you will be able to filter down REITs with asset holdings and strategies that match your thesis.

Finding REITs

After defining your investment thesis, the next step is to find REITs that match your thesis. For the sake of simplicity, we will use the basic thesis from above as our template example.

We’re seeking REITs that invest in student housing assets. We can find potential REITs using one of three methods:

1. Search through finance.yahoo.com.
2. Complete a keyword search on Seeking Alpha.
3. Google search: Student Housing REITs.

By using search method two, we find a few potential REITs. The three REITs that invest in student housing are:

• American Campus Communities.
• Education Realty Trust.
• Campus Crest Communities.

Once we have a list of REITs to consider, we’ll need to analyze them to see which one fits our thesis and provides the best returns.

Analyzing REITs

We have the REITs that match our investment thesis, but how do we know which is investable? To answer that question, we need to complete Funds From Operations (FFO), or the real measure of the profitability of a REIT, and the dividend growth rate. FFO is calculated as follows:

Net Income – gains on sales of assets – income from mortgage-backed securities + depreciation and amortization = FFO

REITs are dividend/current-yielding investments. Because of the importance of dividends, it is necessary to analyze the company’s annual dividend growth. You want to make sure that the firm has been constantly paying its dividends and growing them every year.

How Have REITs Performed Historically?

Overall, REITs have outperformed stocks historically, with data dating back to the early 1970s as proof. They often have less volatility, making them a safer avenue for investors looking for something with less risk and higher returns. A few of the highest returns were made from 1994 to 2021 in these real estate subcategories:

• Storage units: 18.8%.
• Industrial: 15.8%.
• Residential: 14.4%

Health care, office, and retail REITs were all in the 12% returns range. Although the S&P has outperformed REITs over the last 10 years, this wasn’t the case if you look at the last 20 to 50 year periods. This means that REITs are excellent for long-term investors who want to earn dividends for the duration of their stock ownership.

Tips for Avoiding Fraud

Unfortunately, there are a lot of unsavory people out there who commit fraud, especially where investing is concerned. To avoid getting scammed by someone with a great deal on a REIT investment who is really trying to take advantage of you, use these tips:

Ask for details

If you get offered a REIT investment opportunity, ask a lot of questions about the deal. For someone to offer you this type of investment, you should be familiar with what it is. So you can ask for details, such as the asset classes the investment will hold and the region or location of the properties. By asking questions that demonstrate you know what a REIT is, you could deter a fraudster from going any further.

Do your own research

Knowing about REITs and other types of investments can prepare you to deal with someone trying to commit fraud. When you have a good grasp on a variety of investments, you can ask questions that let the fraudster know you’re intelligent and informed. You’ll also be able to listen for key terms that tell you whether the fraudster knows what they’re talking about.

Thanks to the internet, you may even be able to look up details on what someone is trying to sell you while you’re talking to them to determine if it’s legit or a scam.

Understand the product

Just because a fraudster is running a scam doesn’t mean they might not be trying to sell you a real product. So understanding the product they’re offering can help you avoid making a purchase that isn’t legal or ethical without realizing it. If you’ve never heard of what they’re offering, it’s more likely to be a scam, as most REITs aren’t going to offer an investment opportunity to someone who hasn’t shown previous interest.

If you have researched the product in the past, you may not be surprised that someone is contacting you about an investment opportunity. This is when your research of the product will pay off. You can determine through your interaction whether you’re being offered the REIT you have an interest in or something that might be a scam.

Don’t be pressured

A salesperson who tries to pressure you into an investment is more likely to be a fraud. While salespeople can be pushy, someone offering you a REIT isn’t likely to be overly determined. REITs are the ideal investment for many, so there’s no need to force them on anyone.

Listen for clues

As you’re communicating with a potential fraudster about a REIT, you can listen for key terms that tell you they don’t know how to invest in REITs or the necessary investment strategies. If they don’t seem to know much about real estate or they can’t answer your questions, it’s definitely a red flag.

Never provide personal information or cash

Fraudsters often ask for personal information like bank accounts or credit card numbers. This is the first sign that you need to walk away from whatever they’re offering. Another sure sign that the REIT deal is a scam is if you’re asked to provide cash or a cash equivalent, like gift cards. You never want to provide cash to someone offering you an investment opportunity.

Fees and Taxes

Knowing the fees and taxes that go along with investing in REITs is important if you want to understand your true earning potential. The dividends that you earn can all be taxed at different rates depending on whether they’re considered income, capital gains, or return of capital. Most REIT dividends are considered income, and they can be taxed up to a maximum rate of 37%. However, with the 20% tax break that lasts through 2025, this rate should not exceed 29.6%.

These factors can help lower your dividend tax rate:

• An individual taxpayer has a lower income tax rate than what the dividend tax rate is.
• The REIT pays a capital gains distribution or a return of capital distribution with a 20% maximum rate plus a 3.8% surtax.
• The REIT pays dividends that it receives from a taxable REIT subsidiary or corporation.
• A REIT pays corporate taxes but retains its earnings.

Some REITs will also have fees, such as commission, that you’ll have to pay. These rates can vary depending on the REIT and who you invest with but are often a percentage of the total investment.

REITs are a great asset class that allows investors to passively invest in varied asset classes and geographic regions without leaving their computers. Do your homework and enjoy the REIT investment process!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.