Everything You Need To Know About REITs

A REIT, or real estate investment trust, is a company that owns and operates income producing real estate, finances income producing real estate, or does both. A REIT is similar to a mutual fund in that it pools money together from many investors to buy and operate real estate.

When you invest in a REIT, you are not buying real estate as an individual. Instead, you buy shares of the REIT which then pays you a dividend for being an owner in the REIT itself. Dividends are typically derived from the income that the real estate the REIT owns.

In other words, you and other investors give your money to the REIT by purchasing shares. The REIT then uses all of this money to go and buy income producing real estate. The money that the REIT makes is then given back to you for being a shareholder.

REITs may own and operate a variety of real estate investments including apartment buildings, data centers, healthcare facilities, office buildings, retail centers, storage facilities and warehouses. Some REITs may focus on a specific type of real estate, where others may be more diversified in the real estate they own.

REITs are required to follow rules of the Internal Revenue Code which are enforced by the IRS in order to qualify as a REIT. REITs must invest at least 75% of total assets in real estate, cash, or US Treasuries. Additionally, 75% of gross income must be derived from rents, interest on mortgages, or real estate sales.

REITs are also required to pay out 90% of taxable income to their shareholders in the form of dividends each year. REITs are corporations that are managed by a board of directors and trustees. There must be at least 100 shareholders of the REIT after its initial year of experience and no more than 50% of the REIT can be owned by 5 or less individuals.

1) Equity REITs - The majority of REITs are equity REITs. Equity REITs are REITs that own and operate income producing real estate, such as apartment buildings. The income that is generated from these properties is passed onto the shareholders of the REIT.

2) Mortgage REITs - Mortgage REITs lend money to real estate owners and operators by acquiring mortgage backed securities. Mortgage REITs make their money through interest margin. For example, a Mortgage REIT may borrow money at 3% and then sell that money at a 6% rate which creates a 3% profitable spread.  

3) Hybrid REITs - Hybrid REITs combine the strategies of both Equity and Mortgage REITs. Hybrid REITs will often own and operate real estate themselves, but may also engage in the business of lending money to other real estate owners and operators.

The main advantage to a REIT is the cashflow that they provide in the form of dividends. If you are looking to invest in real estate, but don't want the headache of being a landlord yourself, a REIT may make sense. Since REITs are primarily focused on providing cash flow from income producing real estate, they can allow investors to diversify their portfolio if the REIT is suitable for them.

Additionally, if a REIT is an exchange traded REIT, it is typically a liquid investment. This means that it is easy to buy and sell REITs through a broker when it makes sense for you to do so. This liquidity means that you will have an option to move out of the investment if it no longer makes sense for you to own it.

Since REITs focus on providing cash flow for their shareholders, they typically are not suitable investments for capital appreciation. In other words, you should not invest in a REIT with the hopes that your share price will go up allowing you to sell it for a profit as REIT shares do not appreciate like stocks do.

Secondly, the dividends that you receive from a REIT are subject to your ordinary income tax rate which may be higher than capital gains tax rates depending on your income. You may be able to avoid these taxes by holding them in a tax advantaged account such as a Roth IRA.  

If you own income producing real estate yourself, you are usually able to get tax breaks for things like maintenance costs and depreciation. However, since you do not own the real estate when you buy a REIT, you do not get the same tax breaks. Remember, the REIT owns the property and you are a shareholder in the REIT itself.

Keep in mind that REIT taxes can be complicated so make sure to consult a tax professional before investing in them. Finally, some REITs may charge high management or transaction fees which can eat away at your profits so be sure to look out for those.

There are three ways that you can invest in REITs.  A public non-traded REIT is registered with the SEC, but does not trade on a national exchange. This makes them less liquid than an exchange traded REIT which is a risk as an investor if you need liquidity in your investments.

The second type of REIT is a private REIT. This type of REIT is not registered with the SEC, does not trade on an exchange and can typically only be bought by institutional or accredited investors. The final type of REIT is a publicly traded REIT.

As the name implies, this type of REIT trades on a national exchange and is registered with the SEC. If you are an everyday retail investor, this type of REIT is typically your best option. The first step to practically invest in REITs is to open an investment account.

If you want the ability to buy and sell REITs a brokerage account may be viable, but a better starting point would be something like a Roth IRA as it is tax advantaged and designed to help you build wealth for your retirement.

Once your investing account is opened, you can use an online broker to research and buy REITs. As we mentioned before, there are a few different types of REITs, but a good starting point is an equity REIT as it focuses on owning income producing real estate that will be passed onto you as a shareholder.

If you need help finding the REIT that is right for you, it is a good idea to work with a financial advisor. Also keep in mind that REITs are not suitable for every investor. It makes sense for some investors, but not for others. An advisor can also help navigate this issue.  

The bottom line is that a REIT, or real estate investment trust, is a company that owns and operates income producing real estate, finances income producing real estate, or does both. When you invest in a REIT, you buy a share of that REIT but you do not own any real estate directly.

Instead, the REIT pays you the income they make from the real estate the REIT owns in the form of a dividend which is taxable to you as ordinary income. REITs may be a good investment for you as they can diversify your portfolio, but it comes down to your individual needs as an investor.

REITs can provide you a steady form of cash flow and are typically a liquid investment if you buy them on a national exchange. However, the shares typically do not have much capital appreciation, the dividends are taxable, and some REITs have high management fees.