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REITs: What They Are & How They Work

Sarah Li Cain6-Minute Read
May 10, 2021

Investing in real estate can feel extremely risky, especially if you’re putting all your assets into one property. While this route can be a worthwhile venture, there are other ways to invest in real estate that can be more diversified. One such investment is a REIT. These types of investments allow investors to put their money towards real estate and earn dividends without having to manage the property itself.

What Is A REIT?

A REIT, or real estate investment trust, is a company that finances, owns or operates real estate for the purpose of generating income. These types of investments are created similarly to how mutual funds operate; it takes capital from multiple investors towards dividend-earning assets. Because of this, REITs help to make real estate investments more accessible to investors — you can purchase shares of REITs to access properties costing millions of dollars and generate dividends off them.

REIT companies need to meet certain requirements within the Internal Revenue Code, or IRC. Some of these provisions include the company’s main business model being to own income-generating real estate with the goal of holding onto them long term, and to distribute income generated to their shareholders.

More specifically, the company needs to generate at least 75% of its gross income from interest on mortgages that finance real estate sales or from rent. Plus, the company needs to invest a minimum of 75% of the assets in U.S. Treasuries, real estate, or cash.

Other requirements include:

  • After its first year, the company needs to have a minimum of 100 shareholders
  • The company can’t have more than 50% of its shares owned by five or fewer individuals
  • At least 90% of taxable income needs to be paid each year as shareholder dividends
  • Needs to be an entity that’s taxable and managed by trustees or a board of directors

How Do REITs Work?

REITs serve as a real estate investment opportunity for interested investors who want to diversify their portfolio. These types of companies invest in a wide range of properties such as apartment buildings, data centers, hotels, medical facilities, retail centers, and warehouses. Most REITs focus on a type of property — for instance, commercial or residential buildings — whereas some house multiple types in their portfolio. For example, some REITs focus on specific types of risk tolerance and will invest in properties (no matter the type) to help meet portfolio objectives.

So, how do REITs work? The RIET leases out their properties and collects rent on them. This income is then distributed to their shareholders as dividends. Some, like mortgage REITs, will finance real estate by lending money to those who purchase properties. It earns income from interest, which then gets passed on to investors.

Anyone can invest in REITs much in the same manner as other types of securities. Individuals can invest in a real estate portfolio as they would when purchasing individual stocks in an exchange traded fund (ETF) or mutual fund. REIT shareholders or stockholders can earn a share of income and don't have to manage, finance or purchase the properties themselves.

Types Of REITs

Investors can choose from many different types of REITs depending on their preferences and risk tolerance, including the specific types of properties desired. Here are a few main types you may come across in your research.

Equity REIT

Equity REITs manage or own properties that produce income — but the types of properties can vary. It leases space to its tenants and uses the proceeds to manage the property. The profit will be paid out annually to its shareholders as dividends. Income is also generated through selling long-term properties.

Mortgage REIT

Also called mREITs, mortgage REITs take a pool of money and lend it to real estate owners or operators through mortgages, loans, or by purchasing mortgage-backed securities. Its objective is to earn income through the net interest margin — the difference between interest earned and the cost of funding them.

Hybrid REIT

A hybrid REIT combines both income producing models from equity and mortgage REITs. Depending on the specific portfolio, it will have varying assets that derives its income from owned properties, loans, or mortgage-backed securities. The goal is to diversify across multiple types of investments in order to reduce risk.

Residential REIT

These types of REITs primarily invest in manufactured housing and multifamily rental units. Most companies tend to purchase these types of properties in urban areas since home affordability tends to be lower compared to other areas in the U.S.

 

Retail REIT

Retail REITs primarily invest in commercial properties such as shopping malls and other free standing retail buildings. As such, it’s one of the largest investment types in the U.S. Income is produced by rental income tenants pay.

Health Care REIT

Health care REITs will be an interesting subsector to watch as Americans age and health care costs continue to climb. Health care REITs invest in the real estate of hospitals, medical centers, nursing facilities and retirement homes. The success of this real estate is directly tied to the healthcare system.

Public REIT

Public REITs are listed on national securities exchanges where they can be purchased and sold by individuals. These types of REITs are regulated by the SEC, or the U.S. Securities and Exchange Commission.

Public Nontraded REIT

Shares of public nontraded REITs can be purchased by individuals but aren’t traded on national securities exchanges. They are, however, registered with the SEC and aren’t as liquid than publicly traded ones.

Private REIT

Private REITs are sold to institutional or accredited investors. They’re not traded on national securities exchanges nor registered with the SEC.

Are REITs A Good Investment?

Investing in REITs can be a good investment for investors because it can help round out a portfolio. They offer strong potential to earn income (in the form of dividends) and long-term appreciation. Most publicly traded REITs have performed well, with many outperforming the S&P 500.

In addition, investors can easily buy and sell most REITs as many are traded on public exchanges — much like you would with mutual funds and ETFs. Even publicly nontraded ones offer decent liquidity and attractive returns. Investors looking to diversify their portfolio will also benefit from investing in REITs.

However, REIT investments may lose their value, though that’s common with most investments. It also doesn’t have much capital appreciation potential since REIT companies need to pay 90% of their income back to investors. Plus, dividends will be taxed as regular income, and depending on the REIT, investors may have to pay high management fees. For private REITs, there may be less liquidity compared to other securities since it could take longer to sell them, compared to other types like REIT mutual funds or ETFs.

How To Invest In REITs

Investors can purchase shares of publicly traded REITs through a broker — plenty of brokerage firms offer one such as REIT ETFs and REIT mutual funds. Nontraded REITs can also be easily purchased directly from the company itself, through a broker or a financial advisor that offers these types of securities. If you have an employee-sponsored retirement plan, check to see if REITs are offered there too.

When doing your research, be sure to look at the REIT’s track record, plus how the management team is being compensated. If it’s based on performance, chances are the team will work to ensure the best investment strategies, helping improve both investors and their bottom line. Other numbers to look at include current dividend yields and anticipated growth in earnings.

Seeking the help of a financial professional is also useful, as well as checking out Nareit, one of the leaders in the REIT industry.

Investing In REIT Mutual Funds

Investors can get started investing in REIT mutual funds by opening a brokerage account. It’s important to do your research on the best types of brokerages — look at features such as commission or trading fees and the types of REITs on offer. From there, consider your risk tolerance and other factors such as preferred geographical area and even the types of properties you’re interested in investing in.

Once you have a list of mutual funds you’re interested in, compare performance, expense ratio and management fees. Ideally, you’ll choose ones with the lowest fees. Some mutual funds have load funds, meaning you’ll pay fees upfront, which can be in the form of commissions or sales fees.

Investing In REIT Exchange-Traded Funds

Investing in REIT exchange-traded funds (ETFs) happens in the same way as investing in REIT mutual funds — by doing so through a brokerage account. If you’ve already opened a brokerage account, you can look at their list of offerings and choose from ones you believe will work best for your investment goals. Much like REIT mutual funds, compare REIT ETFs by their historical performance, expense ratios and management fees.

The Bottom Line

Investing in REITs is a great way to invest in real estate in a way that’s similar to passive income, since you don’t need to purchase and manage properties directly. Plus, if you invest in REIT mutual funds or ETFs, brokerages have done much of legwork for you in terms of vetting their historical performance and expense ratios. Combined with investing in other types of securities, REITs can offer you diversification in your portfolio, helping you to mitigate risk that inherently comes with investing.

For more information on investing, be sure to check out the Rocket HQSM Personal Finance Learning Center.

Sarah Li Cain

Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.