What is a REIT?

Real estate investment trusts (REITs) are professionally managed portfolios that invest in real estate and mortgage-backed securities. Created by Congress in 1960, REITs let individuals participate in large-scale real estate investments, earning a share of the income produced by the property without actually having to buy and manage physical commercial real estate.

Mortgage-backed securities (noun): Bonds secured by home and other real estate loans. When a number of these loans are originated, those with similar characteristics are pooled together. A bank offering home mortgages might round up $10 million worth of such mortgages.

REITs historically have provided competitive returns and dividend yields higher than the average yield of S&P 500 funds. Investors also benefit from long-term capital appreciation. For many investors, REITs make an excellent addition to a portfolio, but no investment is risk-free. Here’s what you need to know to get started investing in REITs and what you should keep in mind before you invest.

How do REITs work?

A REIT typically owns and operates income-producing real estate or real estate-related assets. These can include, but are not limited to:

Invest in publicly traded REITs, nontraded REITs, REIT mutual funds and REIT exchange-traded funds (ETFs). Publicly traded REITs are registered with the SEC and are publicly traded on the stock market. Nontraded REITs are registered with the SEC but don’t trade on stock exchanges. Other REITs are private and are typically only sold to accredited investors.
Most REITs generate income through interest payments on real estate financing or mortgages or by leasing space and collecting rent. When you buy shares in a REIT, your shares represent ownership stake in the company, and you’re entitled to receive a share of the income produced in the form of dividends. REITs are required to pay out at least 90% of their taxable income to shareholders to maintain their status with the IRS. They also don’t pay taxes at the corporate level, which can mean a higher dividend payout for investors. This high, steady dividend income makes REITs a favorable investment strategy for long-term investors.
But since REITs pay out most of their profits in the form of dividends and don’t pay a corporate tax, there are certain tax consequences for investors. Namely, REIT dividends don’t qualify for the lower rate that most dividends typically qualify for. Insead, investors are taxed at their individual tax rate, the same rate as ordinary income.
REITs offer a unique approach to investing in real estate and are valued for the income they provide. But for a company to qualify as a REIT, it must operate according to a specific set of rules set by the IRS.

What qualifies as a REIT?

Companies must meet the following specific operating requirements to qualify as REITs with the IRS:

• Return at least 90% of income as dividends each year
• Be an entity that’s taxable as a corporation
• Be managed by a board of directors or trustees
• Have at least 100 shareholders after the first year of existence as a REIT
• Have no more than 50% of shares held by five or fewer individuals during the last half of the taxable year
• Invest at least 75% of its total assets in real estate
• Derive at least 75% of its income from real estate — including rents, mortgage interest and real estate sales

5 types of REITs

There are many types of REITs available, but here’s a look at the five main categories of REITs and their 2020 average returns.

REIT type	Description	2020 average returns
Retail	Shopping centers, malls or freestanding stores	-25.18%
Residential	Multi- or single-family homes	-10.69%
Health care	Medical offices, hospitals or senior-living or assisted-living properties	-9.86%
Office	Office buildings and properties	-18.44%
Mortgage	Debt securities backed by real estate	-18.77%

Returns can vary dramatically depending on the primary focus of the REIT and other technical factors and external conditions that alter its supply and demand. This was especially true in 2020 with the onset of the COVID-19 pandemic. Real estate was one of the worst-performing sectors in 2020, and retail REITs was its worst-performing subsector. Among the different REIT property sectors, retail REITs saw one of the largest drops in value year-over-year from 2019 as a result of strict COVID-19 measures.
But like any investment, REIT returns fluctuate. That doesn’t mean they’re bad investments. REITs that are currently selling at a lower price and meet your investing objectives may actually be buying opportunities. Instead of basing your investment decisions on one year’s return, try to allocate your investment between types that react differently to market forces. One of the main advantages of buying REITs instead of investing in real estate directly is that you can afford to diversify rather than putting all your capital in one investment.

How to analyze a REIT

With over 200 REITs in the FTSE Nareit All REITs Index to choose from, compare the following six factors before you invest:

• Market segment types. Through your research, decide which types of properties you expect to perform well. Don’t base your decision solely on how well a segment did last year — markets that lost value last year may be poised for a comeback.
• How dividends are treated by the IRS. Most REIT dividends are not IRS “qualified dividends” and are taxed at ordinary income tax rates. Consider purchasing REITs from your tax-advantaged retirement account to defer or avoid income tax on the gain.
• How the REIT is traded. Publicly traded REITs are the simplest type of REIT to buy, though crowdfunding platforms have made it easier to invest in public nontraded REITs as well.
• Funds from operations as an indicator of yield. For companies invested heavily in real estate, depreciation expense tends to make it appear they are losing asset value when they may not be. A more useful way to compare REIT yields may be to look at funds from operations, defined as net income less any sales of property and depreciation. It’s the actual amount of cash flow generated from the company’s business operations.
• Historical rates of return. Look for companies with a solid track record. Consider long-term trends, and not just last year’s results.
• Time in existence. A new, unproven company may be a riskier investment. There are always exceptions, but companies that have been in existence for decades or longer tend to stay in business. On the other hand, newer companies often have high growth potential along with higher risk.

REITs benefits and drawbacks

REITs have several positives but also a few downsides.

How to invest in REITs

The process to begin investing in REITs depends on the type of REIT you want to invest in.

Publicly traded REITs

Invest in publicly traded REITs by purchasing shares through a broker. Broker-specific fees and commissions will apply.

1. Sign up with a broker. Compare brokers by fees, commissions, reliability and educational tools and resources. When you’re ready to sign up, you’ll typically need to provide your personal information like your name, address, date of birth and Social Security number. You’ll also need to connect a bank account to fund your new brokerage account.
2. Decide on a REIT to invest in. Search and choose a REIT, a REIT mutual fund or a REIT ETF as you would a stock or other security.

Public nontraded REITs

With the proliferation of real estate crowdfunding platforms like Fundrise and DiversyFund, you can invest in public nontraded REITs online and with fewer fees than before.

1. Sign up with a real estate crowdfunding platform. Narrow down platforms that offer REITs and compare them by annual fee, investment options and minimum required investment amount.
2. Choose an investment. Some platforms offer one type of fund, while others offer different levels of funds with different minimum initial investments.

Special tax considerations

REIT shareholders are responsible for paying taxes on the dividends they receive and on any capital gains if a REIT sells any of its assets. Since these dividends are treated as ordinary income, consider purchasing REITs from your tax-advantaged retirement account to defer income tax on the gain. While you won’t avoid paying tax, you can defer paying taxes on the dividends you receive and any capital gains incurred until you start withdrawing money from your account.
Purchase publicly traded REITs in an IRA via a brokerage account. In addition, some crowdfunding platforms let you purchase public nontraded REITs via IRAs.

Alternatives to REITs

Investing in REITs might not make the most sense for you or maybe they don’t provide the type of exposure to real estate that you’re looking for. Alternatively, you can invest in:

• Rental properties. Rental properties can provide an additional source of income and the potential of capital appreciation. While they require more upfront cash, any additional money after expenses is profit.
• Flips. If you understand your local real estate market and have the time and knowledge to renovate a home, house flipping can provide relatively quick and big returns. But there’s always the possibility of getting stuck with the property and having to pay a mortgage on it until it sells.
• Other real estate investing platforms. Whereas some platforms focus solely on REITs, others take a different approach to real estate investing. For instance, Roofstock lets you invest in single-family rental properties. Yieldstreet, on the other hand, lets you invest in a multi-asset class fund that includes real estate, art, marine financing and more.

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Bottom line

REITs make it possible to invest in real estate without having to purchase and maintain physical properties yourself. They provide historically strong returns based on high dividends and capital appreciation. But taxes can be high compared to other dividend-paying securities, and market conditions can cause dramatic swings in the overall returns of REITs, making REITs ideal for long-term investors.
If you’re looking to take advantage of their significant long-term investment potential, trading in REITs might be an investment strategy worth considering. For individual guidance specific to your own financial situation, consult a financial advisor.