A real estate investment trust (REIT) is an entity that owns and operates income-producing real estate properties like offices, malls, hotels, self-storage facilities, and apartments. Reliable REITS have a proven record of paying dividends to investors, who appreciate the income without the responsibility and stress of managing a property.
REITs originated in 1960 when Congress amended the Cigar Excise Tax Extension to allow investors to buy shares in commercial real estate, which previously was only accessible to wealthy, connected investors.
How Does a REIT Work?
Like mutual funds, REITs pool the money of multiple investors to invest in a trust. The trust itself holds real estate investments and individual investors have no duty to actively purchase, maintain, or finance these investments. Investors earn dividends on a passive investment product without having to personally conduct due diligence or identify opportunities with a high potential for return.
Different Types of REIT
Some types of REITs concentrate on a specific real estate class, such as retail spaces or residential properties, while others might hold products across multiple sectors. Investors can typically choose among three types of REITs:
Equity REITs
The most common type of REIT, equity REITs allow the organizing entity to identify cash-flowing properties to purchase and manage, while investors receive a share of the dividends. An equity REIT can include just one or two large properties, or it may include a wider range of properties.
Mortgage REITs
With a mortgage REIT, the organizing entity does not own the real estate properties outright. Rather, the portfolio owner secures financing and holds a mortgage on the properties, and investors earn income from interest on the loans.
Hybrid REITs
As the name implies, a hybrid REIT includes owned properties that earn rent and mortgaged properties, both of which generate investment income.
Investing in a REIT
Many REITs are publicly traded, which means investors can use a broker to purchase or sell shares on major securities exchanges, just like they would buy and sell stocks. Publicly traded REITs are highly liquid and vulnerable to stock market volatility.
Other public non-traded REITs are regulated by the Securities and Exchange Commission but are not traded on national securities exchanges. Investors can purchase these REITs directly through a financial advisor or broker, as well as through the organization that owns the REIT. Considered less liquid than publicly traded REITs, non-traded REITs offer more stability, as their value is not tied to stock market fluctuations.
Private REITs, usually available only to institutional investors, do not appear on securities exchanges and are not subject to SEC regulations.
Benefits of Investing in a REIT
Performance
REITs have historically performed well, allowing investors to achieve diversified portfolios without adopting the typical risks of a real estate investment. As measured by the FTSE NAREIT Composite Index, REITs have proven particularly advantageous in long-term performance compared to stocks.
In the last 45 years, REITs have achieved a compound annual average total return of 11.4 percent, just under the S&P 500’s 11.5 percent annual return over the same period. In certain periods, REITs have outperformed stocks, and they have outperformed bonds consistently over the last four decades.
Diversification
REITs provide an outstanding opportunity for diversification across asset classes, protecting investors against the risks associated with stocks and bonds. A REIT might include a mix of property types, including offices and industrial properties, which offers investors exposure to a range of real estate asset types.
Over the past 20 years, a traditional portfolio of 60 percent stocks and 40 percent bonds has achieved a 7.8 percent return. Meanwhile, a portfolio that evenly splits 33.3 percent among stocks, bonds, and REITs produces an average 9 percent annual rate of return.
Liquidity
Traditional real estate investment is illiquid, which means investors cannot cash out quickly. To sell a real estate asset, investors must list a property and wait for an offer, potentially waiting months until they can convert the asset to cash. With a REIT, investors can sell REIT shares online, converting assets to cash whenever the market is open. Further, they do not pay real estate agent fees or commissions on selling REIT shares.
Steady Income
REITs produce higher average dividends than other equities. Further, investors can be confident they will have a steady stream of passive income, as REITs must distribute at least 90 percent of their taxable income to investors. Shareholders are also less subject to income loss during unfavorable market conditions and less vulnerable to inflation.
Transparency
REIT shareholders know exactly what they are agreeing to, unlike many private real estate investments. REIT performance is subject to monitoring by independent analysts, directors, and auditors, all of whom report to the SEC. This oversight ensures that REIT management teams cannot act against their investors’ best interests without their knowledge.
Tax Benefits
IRS tax requirements for REITs are straightforward; shareholders must fill out a Form 1099-DIV for all dividends they receive, while corporations must pay ordinary income taxes on distributed income as well as capital gains taxes on qualified dividends. Most dividends investors receive from their REIT are taxed at their individual tax rate as ordinary income.
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