REIT: What It Is and How To Invest

What Is a Real Estate Investment Trust (REIT)?

Real estate investment trusts (REITs) are companies that own, operate, or finance income-producing real estate across a wide range of property sectors. These investments allow you to earn income from real estate without having to buy, manage, or finance properties themselves.

Created by a 1960 law, REITs were designed to make real estate investing more accessible so smaller investors could invest in a portfolio of skyscrapers, shopping malls, or apartment complexes with the same ease as buying stocks. By pooling capital from many investors, REITs have changed and funded much of American real estate, often in ways few in the public understand. Below, we'll explore how they work, what benefits and risks you need to know about, and how to invest in them.

How REITs Work

Congress established REITs in 1960 through an amendment to the Cigar Excise Tax Extension. The provision enabled firms to pool capital from investors to buy large real estate portfolios. REITs operate like mutual funds—firms manage pools of funds for the sake of many investors—but for real estate instead of stocks and bonds. Investors earn returns in two ways: from dividends or an increase in the value of the REIT's shares.

Central to REITs is that they take the quintessential example of illiquid assets—real estate—and make them liquid. REITs invest in all kinds of properties: apartment complexes, data centers, healthcare facilities, hotels, infrastructure (fiber cables, cell towers, and energy pipelines), office buildings, retail centers, self-storage units, timberland, and warehouses. REITs tend to specialize in specific real estate sectors, like commercial properties. However, many hold diversified portfolios of many kinds of properties.

As you can see below, the amount investors have pooled in REITs has risen significantly in the past quarter century—almost exactly tenfold. Also notable is the undulation of the line graph as market bubbles inflate, crises and recessions arrive, and interest rates shift. Often thought of as the most stable of stock assets—after all, the sector includes the ground beneath your feet—the value of real estate and, thus, the returns from REITs are certainly not.

What Qualifies As a REIT?

Most REITs lease space, collects rent on properties, and distribute that income as dividends to shareholders. A small percentage of REITs, called mortgage REITs, earn money from financing real estate, not owning it. In the mid-2020s, they account for about 4% of REIT assets in the U.S.

To qualify as a REIT, a company must meet several requirements set by the Internal Revenue Service (IRS). These include the following:

• Invest at least 75% of total assets in real estate, cash, or U.S. Treasurys
• Derive at least 75% of gross income from rent, interest on mortgages that finance real estate, or real estate sales
• Pay a minimum of 90% of their taxable income to their shareholders through dividends
• Be a taxable corporation
• Be managed by a board of directors or trustees
• Have a minimum of 100 shareholders
• Have no more than 50% of its shares held by five or fewer individuals

What Are the Types of REITs?

While REITs are categorized by the different kinds of properties they invest in, there have traditionally been three major types:

• Equity REITs. Most REITs are equity-based and own and manage income-producing real estate. Revenues are generated primarily through rent, not by reselling properties.
• Mortgage REITs. Mortgage REITs lend money to real estate owners and operators directly through mortgages and loans or indirectly through acquiring mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them sensitive to interest rate increases—though equity REITs are also greatly affected by rate change.
• Hybrid REITs. These REITs mix strategies from both equity and mortgage REITs. After the 2007–2008 Financial Crisis, these trusts, already on the wane, largely disappeared as regulations changed and REITs became more, not less, specialized.

How To Invest in REITs

Within the above types are REITs that have different ways of attracting funding. These differences will be important when we next go through our tips for how to begin investing in REITs:

• Publicly traded REITs. Shares of publicly traded REITs are listed on a public exchange, where they are bought and sold by individual investors. These fall under U.S. Securities and Exchange Commission (SEC) regulations.
• Public non-traded REITs. These REITs are registered with the SEC but don’t trade on exchanges. As a result, they are less liquid than publicly traded REITs. As such, they tend to be more stable because they’re not subject to market volatility. Shares of a non-traded REIT can be bought through a broker or financial advisor who participates in the non-traded REIT’s offering.
• Private REITs. These REITs aren’t registered with the SEC and don’t trade on securities exchanges. In general, private REITs can be sold only to institutional investors. They are also the site of many REIT-related frauds. While most, of course, are legitimate investments, it's easier for con artists to ply their trade in this area of real estate than within the regulated markets.

In addition, REITs may be included in defined-benefit and defined-contribution plans through mutual and exchange-traded funds (ETFs). Thus, many U.S. investors own shares in REITs through their retirement savings.

Tips on Starting To Invest in REITs

If you're new to REIT investing, here are tips to get you started:

1. Begin With Publicly Traded REITs

For newcomers, publicly traded REITs offer the easiest way to get started. You don't need a vast amount of money—the cost of entry is the trust's share price that interests you. Private REITs, meanwhile, are only open to accredited investors and have minimums starting in the low thousands.

When investing in publicly traded REITs, here are strategies to consider:

• Do your homework: Examine a REIT's portfolio, management team, debt levels, and dividend history before investing.
• Think of the long-term: REITs are customarily best suited for long-term strategies because of how they generate income.
• Examine the fees: There are no direct fees beyond standard brokerage commissions when buying or selling shares. REIT management fees are built into operating expenses, affecting your overall returns. As such, you'll want to review how comparatively efficient the trust is with managing its expenses—that is, your fees.

2. Start Small and Scale Up

It's prudent to begin with a modest allocation and gradually increase your exposure over time. You might begin by investing a small percentage of your portfolio—perhaps 2% to 5%—in a broadly diversified REIT or REIT fund. You can then take the time to get familiar with the real estate market—its income potential, its ups and downs, and how its shifts correlate with stocks, bonds, and other assets.

As you do this, pay attention to how your REIT investments affect your risk profile and other parts of your portfolio. Some financial advisors suggest a well-diversified portfolio might include a 5% to 15% allocation to real estate. However, the right amount depends on your financial goals, risk tolerance, and investment timeline. In addition, the real estate market is often cyclical, so scaling up gradually should help you avoid being overexposed when a downturn arrives.

3. Diversify Across REIT Categories

You might also spread investments across real estate sectors (e.g., residential, commercial, healthcare, etc.) to balance your portfolio. This table gives you a quick view of the different property categories and their characteristics:

4. Invest in REIT Funds for More Diversification

For investors aiming to diversify their portfolios with real estate, REIT mutual funds and ETFs can help spread risk even further than individual REITs. Both options expose you to a broad spectrum of real estate sectors through a single financial product. However, they come with specific characteristics you'll need to consider.

• REIT mutual funds, such as the T. Rowe Price Real Estate Fund (TRREX), offer the advantage of professional management. Many fund managers actively select and adjust holdings, potentially capitalizing on market trends or mitigating risks. Some funds are accessible through 401(k) plans (depending on your employer), allowing automatic investing via payroll deductions. This ease of access and expert management is a good way to get into the real estate market while leaving the choice of properties and other assets to the professionals.
• REIT ETFs are either actively managed or passively follow an index. For example, the Pacer Benchmark Industrial Real Estate SCTR ETF (INDS) invests at least 85% of its funds in industrial real estate properties, including warehouses and distribution centers. Pacer's managers actively oversee the fund, picking the assets they think will outperform the market.

5. Explore Real Estate Index Funds for Low-Cost Diversification

These funds passively track real estate indexes, offering broad market exposure at lower fees than their actively managed peers. For example, the Vanguard Real Estate ETF (VNQ) mimics the MSCI US Investable Market Real Estate 25/50 Index, which covers a wide swath of American real estate.

If you want international exposure, the iShares Global REIT ETF (REET) tracks the NAREIT Global REIT Index, which covers REITs in both developed and emerging markets.

6. Be Tax Savvy

REITs have specific tax implications that should be considered since they can greatly impact your returns. These trusts are not typically subject to corporate income tax as long as they distribute at least 90% of their taxable income to shareholders as dividends.

This pass-through structure can result in higher dividend yields for investors. However, unlike qualified dividends from stocks, which are often taxed at lower capital gains rates, most REIT dividends are taxed as ordinary income. This could result in higher tax bills, especially for investors in higher tax brackets.

Many hold REITs in tax-advantaged individual retirement accounts (IRAs) or 401(k)s to mitigate these tax impacts. This way, REIT dividends can compound tax-free (e.g., in Roth accounts) or tax-deferred (traditional IRAs). This strategy can significantly improve your long-term returns by allowing you to reinvest more of your dividends.

In addition, the Tax Cuts and Jobs Act of 2017 introduced a qualified business income (QBI) deduction with specific benefits for those holding REITs. The deduction is the QBI plus 20% of qualified REIT dividends or 20% of the taxable income minus net capital gains, whichever is less. This deduction allows eligible taxpayers to deduct up to 20% of their qualified REIT dividends, potentially lowering their effective tax rate on REIT income.

The combination of these factors—the QBI deduction, the REIT's tax-advantaged design, and the taxing of dividends—creates a complex but potentially beneficial tax situation for many REIT investors. However, balancing this approach as part of your overall investment strategy and liquidity needs is crucial, especially since retirement account funds have withdrawal restrictions. As always, it's wise to consult a tax professional to understand how any of this would apply to your tax situation.

7. Stay Up to Date

You'll want to keep abreast of real estate trends to make informed decisions about your REIT investments. Keep an eye on basic economic indicators like interest rates, inflation, and unemployment since these significantly impact real estate values and rental income. You'll want to key in on the fundamentals for the sectors where your REITs hold property. That might mean following demographic shifts like urbanization and gentrification, changes in households (people living with their parents longer, etc.) that will affect demand in different parts of the country, keeping an eye on how office work is migrating to the ex-urbs, or any number of economic and social changes that affect subsets the real estate sector.

The chart for year-over-year returns for 2023 below suggests why: sectors that seem very alike—like shopping malls and shopping centers—often perform very differently, and investors need to keep an eye on the specific dynamics for each part of the real estate sector their REITs are invested in.

Advantages and Disadvantages of REITs

Shares in REITs are relatively easy to buy and sell, as many trade on public exchanges. REITs offer attractive risk-adjusted returns and stable cash flow. Including real estate in a portfolio provides diversification and dividend-based income.

However, REITs don't offer capital appreciation since REITs must pay 90% of their income back to investors. Only 10% of taxable income can thus be reinvested into the REIT to buy new holdings. In addition, REIT dividends are taxed as regular income, and some REITs have high management and transaction fees. Here's a summary of their pros and cons:

The Bottom Line

REITs have taken something only the richest historically could afford—properties—and packaged shares in them to trade like other assets on U.S. stock markets and among private investors. They don't just alleviate the amount of funding you would need to buy real estate but the effort and time needed to manage them.

REITs deliver diversification for your portfolio, potentially generate steady income through dividends, and give you exposure to a range of properties. REITs can also serve as a hedge against inflation and have historically delivered competitive long-term returns. However, like all investments, they come with risks, including sensitivity to interest rate changes, and REITs can face challenges when there are dips in industries where they hold property—trusts holding downtown office space in the early 2020s are a prime example. For those considering them, it's crucial to approach the decision with careful consideration and research. Seeking the advice of a financial advisor is prudent as well.