What Is a Real Estate Investment Trust (REIT)?

The term “real estate investment trust” (REIT) is a business that manages owns, or finance income-generating real property.

Based on mutual funds, REITs combine the funds of many investors. This allows individuals to earn dividends from their real estate investments without needing to purchase or manage the properties themselves.

KEY TAKEAWAYS

• The term “real estate investment trust” (REIT) is a business that owns, manages, or finances a property that earns income.
• REITs produce an income stream that is steady for investors, but they offer nothing in terms in terms of appreciation.
• The majority of REITs are traded publicly as stocks, making them extremely liquid (unlike physical real investment in real estate).
• REITs invest in all real estate types of property, which include cell towers, apartment buildings and hotels, data centers, medical buildings, offices, retail centers, and warehouses.

Investopedia / Eliana Rodgers

How REITs Work

Congress created REITs in the year 1960 by amending the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios–something that was previously available only to wealthy individuals and through large financial intermediaries.1

Properties within the REIT portfolio can comprise apartments and data centers, health establishments, hotel infrastructure in the shape of towers and fiber cable and pipelines for energy–office structures, retail centers, self-storage, timberland, and warehouses.

The majority of REITs are specialized in a particular sector. However, specialty and diversified REITs could have various types of properties within their portfolios, for example, a REIT, which consists of retail and office properties.

A large number of REITs are listed publicly through major exchanges for securities, and investors can purchase and sell them as stocks during trading. 2 These REITs generally trade in a large quantities and are regarded as highly liquid instruments.

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What Qualifies as a REIT?

The majority of REITs operate on a simple business model, which is that the REIT leases space pay, rents on properties, and then distributes the profits as dividends for shareholders. Mortgage REITs don’t have real estate but instead finance real estate. They earn money through the interest they earn on their investments.

To be REIT, a business must meet certain requirements within the Internal Revenue Code (IRC). These include the need to own real estate that generates income for the long term and to give dividends to shareholders. 3 Specifically, the company must satisfy the following conditions for being REIT:

• At a minimum, 75% of your total assets in cash, real estate, as well U.S. Treasuries
• At the minimum, 75% of the total income from rents or mortgage interest that provides financing for real estate or sales of real estate
• A minimum of 90 percent tax-free income in the form of dividends paid to shareholders every year
• Consider yourself an entity that is tax-deductible as a company.
• An executive board or trustees do the management of the company.
• At the very least, 100 shareholders in the first year of its existence.
• Do not exceed 50 percent of its shares owned by fewer than five individuals. 3

It’s estimated that REITs have around $3.5 trillion in assets. Publicly traded equity REITs are responsible for $2.5 trillion. 4

Types of REITs

There are three kinds of REITs:

• Equity REITs. Most REITs are equity REITs that are the owners and managers of income-producing real property. The majority of revenue is generated through rents (not through reselling of properties).
• Mortgage REITs. Mortgage REITs lend money to owners of real estate and operators, either directly through loans and mortgages as well as indirectly by acquiring secured mortgages. Their profits are generated principally through a gross interest margin–the gap between the interest they earn from loan mortgages as well as the expense of financing the loans. This type of model can make them vulnerable to increases in interest rates.
• Hybrid REITs. These REITs use the investment strategies used by both mortgage and equity REITs.

REIT Types Comparison

Type of REIT

Holdings

REITs are further classified on the basis of the way in which their shares are purchased and held

• REITs that are publicly traded. Shares of publicly traded REITs are sold on a national exchange and are sold by private investors. They are monitored through the U.S. Securities and Exchange Commission (SEC). 5
• Public REITs that are not sold. These REITs are also registered with the SEC, but they don’t trade on national exchanges for securities. They have less liquidity than REITs that are publicly traded. 5 Still, they are more stable since they aren’t affected by market volatility.
• Private REITs. These REITs aren’t registered with the SEC and aren’t listed on the national securities exchanges. In general, Private REITs are only sold to institutional investors.

How to Invest in REITs

You can buy shares of REITs that are traded publicly, as well as REIT mutual funds and REIT exchange-traded funds (ETFs)–by buying shares from an intermediary. You can purchase shares of the non-traded REIT through a financial advisor or broker who is a participant in the REIT’s non-traded offering.

REITs are also part of increasing numbers of defined-benefit and defined-contribution plans for investment. The estimated number of around 145 million U.S. investors own REITs either directly or through pension savings and other assets, as per Nareit, the Washington, D.C.-based REIT research firm. 4

Pros and Cons of Investing in REITs

REITs can be an integral component of an investment portfolio due to their steady, solid annual dividend and also the potential to enjoy capital appreciation over the long term. The REIT’s return on investment over the past 20 years has surpassed other indices, including the S&P 500 Index, as well as rates of inflation. 6 As with any investment, REITs come with their pros and cons.

On the positive side, REITs are relatively easy to purchase and sell since they trade on public exchanges, a feature that helps to alleviate some of the drawbacks of real property. In terms of performance, REITs provide attractive risk-adjusted returns as well as a steady cash flow. Additionally, a real estate presence is a good option for an investment portfolio since it offers diversification and dividend-based income. Additionally, the dividends tend to be greater than what you could get from other investments.