What Are REITs and How Do They Work?
Real estate investment trusts (REITs for short) are companies that invest in real estate and/or real estate financing and distribute at least 90% of their profits to shareholders as dividends. Many are publicly traded on major exchanges and can be bought and sold quickly and easily just like traditional stocks.
Some REITs make money by renting out real estate (e.g., homes, offices, cell towers, retail spaces, warehouses, etc.) that they own, while others do so by providing mortgages to property buyers in exchange for interest payments. Certain REITs utilize both types of income streams.
Because of their high and consistent dividends, REITs are a popular investment vehicle for investors who want the passive income that comes with owning real estate but don’t have the time or money to buy, maintain, and rent out a property of their own. They are also popular during periods of higher-than-usual inflation, as rent and real estate tend to go up in price alongside consumer goods, sometimes resulting in more money for REIT shareholders at a time when traditional stocks may be faltering.
One of the main benefits of qualifying as an REIT as a company is a waiver of corporate tax on all income that is paid out to shareholders as dividends. For this reason, many use 100 percent of their taxable income as dividends in order to avoid corporate taxation altogether.
Because most (if not all) of an REIT’s profits are distributed as dividends, little cash usually remains for investing in growth, so share price tends to have less potential to go up dramatically (i.e., they aren’t usually as volatile as traditional stocks). For this reason, REITs are much more popular with fixed income investors (those looking for regular dividend payments) than growth investors (those looking to see their principal investment grow substantially in value over time).
What Makes a Company an REIT?
Not all real estate-based companies are REITs. To qualify as an REIT, a company must use its real estate properties and or mortgages as income-generating investments. A company that builds and then sells housing developments, for instance, would not be considered an REIT.
To qualify as an REIT, a company must pay out at least 90% of its taxable income as dividends. REITs must also . . .
- “be managed by a board of directors or trustees,
- derive at least 75 percent of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property,
- invest at least 75 percent of its total assets in real estate assets and cash,
- have a minimum of 100 shareholders after its first year as a REIT,”
- and more.
The 3 Types of REITs
There are three main types of REITs—equity, mortgage, and hybrid. All three funnel profits to investors via dividends, but they differ in where their revenue comes from.
Equity REITs produce income by operating what is known as “income-producing real estate.” Essentially, this means buying and owning property, then leasing it out to individuals or businesses in exchange for rent payments.
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Most equity REITs specialize in a specific type of property (like apartment complexes or storage facilities), but some operate and lease many different types of property. The rent or lease payments an equity REIT collects are first used to cover costs, and then at least 90% of what remains is distributed to shareholders as dividends.
Mortgage REITs differ from Equity REITs in that they do not own and lease out real estate. Instead, they offer mortgages or other real estate loans to prospective property owners and collect interest payments. Alternatively, a mortgage REIT might not offer mortgages directly but might instead invest in real estate financing indirectly by purchasing mortgage-backed securities.
These REITs tend to use more leverage (borrowed capital) and derivatives hedging to fund their investments than equity REITs. For this reason, they can be riskier investments than equity REITs. Investors should make sure they fully understand a mortgage REIT’s financing model before deciding to invest.
Hybrid REITs are so called because they use both of the strategies detailed above. They purchase, maintain, and lease out physical real estate, and they also provide mortgages or other real estate loans to property buyers.
What Are the Benefits of Investing in an REIT?
- Dividends: The regular dividend payments provided by REITs make them popular among investors seeking additional income streams. Because they must, by definition, distribute at least 90% of their profits as dividends, REITs tend to have relatively high dividend yields when compared wto traditional stocks.
- Diversification: REITs are a unique investment class in that they offer easy exposure to the real estate market. For this reason, investing in them—in addition to stocks, bonds, commodities, and other asset classes—is a great way to diversify a portfolio to strengthen it in preparation for periods of volatility and inflation.
- Liquidity: Traditionally, real estate is not a very liquid asset class. It takes time to buy and sell property, and any pool of potential buyers is usually limited by location and budget. Tradable REITs, however, can be bought and sold in shares very quickly on major national exchanges, so they are convenient for investors who value portfolio liquidity.
- Inflation Protection: Because real estate (and rent) tend to rise in price alongside consumer goods during periods of high inflation, REITs are often more stable than traditional equity securities when inflationary fears abound. Their consistent passive income payments are also a plus during times when other companies may be lowering dividend payments.
What Are the Drawbacks of Investing in an REIT?
- Property Expenses: Property expenses—particularly property taxes—aren’t cheap, and the more an REIT has to pay to cover these expenses, the less profit they have leftover to distribute to shareholders as dividends. For this reason, it’s a good idea to check out a real estate company’s income statement before investing.
- Interest Rate Risk: REITs are prized for their passive income payments, so when interest rates rise, making treasury securities more appealing to fixed-income investors, money may move out of the REIT market, causing share prices to decline.
- Weak Growth: Because REITs spend at least 90% of their income on paying dividends, they usually don’t grow very quickly, which often translates into a share price that doesn’t grow very quickly either. For this reason, they are not extremely popular with growth investors.
- Dividend Taxes: Unlike qualified dividends, which are usually taxed at advantageous capital gains rates, REIT dividends are usually considered normal income and taxed as such according to each investor’s tax bracket. This means investors usually have to pay more tax on REIT dividend income than dividend income from traditional stocks.
How to Invest in REITs
Investors can buy shares of traded REITs just like they buy stocks—on a major exchange via a broker or a brokerage app like E-Trade or Robinhood. Since different REITs focus on different property types (e.g., commercial, residential, storage, office, etc.), investors can choose multiple companies to invest in or find an REIT exchange-traded fund (ETF) for instant exposure to many different REITs. Be sure to check expense ratios when considering any ETFs, as high fees can eat into potential gains.
5 Popular REIT ETFs to Check Out
Charles Schwab U.S. REIT ETF (SCHH)
Real Estate Select Sector SPDR Fund (XLRE)
Vanguard Real Estate ETF (VNQ)
iShares Mortgage Real Estate Capped ETF (REM)
Pacer Benchmark Industrial Real Estate SCTR ETF (INDS)
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about REITs that were not already covered in the sections above.
What’s a Good Dividend Yield for an REIT?
Since dividend yield changes with stock price, an REIT’s yield can change significantly even as it continues to pay stable dividends. Remember—dividend yield is the ratio of the dividends a company pays to its current share price, so drops in share price inflate dividend yield.
That being said, REIT yields tend to average around 3 to 5 percent, although higher and lower yields are also common.
Traded vs. Non-Traded REITs: What Are the Differences?
Traded REITs trade on national exchanges just like normal stocks. Therefore, they are liquid and transparent and are a good option for normal investors. Non-traded REITs, on the other hand, charge fees, have less liquidity, and do not have immediately available share prices. They also may require a fairly high initial investment. For most retail investors, non-traded REITs are not a good investment option.
Are REITs Good Inflation Hedges?
While no investment—save perhaps an I bond—is totally safe from inflation, REITs are usually considered a good inflation hedge because rent and real estate prices tend to rise during inflationary periods (which can boost both profits and share price) and consistent dividends provide a reliable income stream.