Real Estate Investing
What's a REIT? How does it work?
So you want to invest in real estate, but there is no way you can swing the down payment on an investment property. There’s a way to invest in real estate while not owning property directly. The answer is through a real estate investment trust, or REIT.
REITs take a play from a traditional stock’s playbook. You own a share of a real estate investing portfolio. But there are some differences that we’ll look at as well. We’ll explain what a REIT is, if it’s suitable for your portfolio, and how to invest in REITs today.
What’s a REIT (Real Estate Investment Trust)?
Real estate investment trusts, known as REITs, are companies that own, operate, or earn money from real estate. You can invest in a REIT as a way to invest in the real estate market without the hassle of directly owning property and managing it from day to day.
Similar to mutual funds, REITs often function as a collection of income-producing assets that are specific to the real estate sector. These trusts allow everyday investors to buy shares in real estate. Most REIT shares can be purchased in the same manner as you would buy stocks (more on that below), and are as liquid as a traditional stock.
How does a REIT work?
There are real estate companies that specifically buy properties to generate profit. They are not buying properties intending to sell but instead leasing properties for profit. These companies own malls, hospitals, apartment buildings, warehouses, and more. They classify themselves as a REIT.
Most real estate investment trusts are traded on the stock exchange, and you can buy and sell your shares with a broker. You can own equity in these real estate companies, similar to how you would buy a stock for Apple or Tesla. But some key differences make REITs unique:
- REITs are required to meet specific criteria by the IRS. Following these criteria, REITs get a tax break to finance additional real estate holdings.
- REITs must pay their investor dividends– 90% of taxable income goes to shareholders!
What are the different types of REITs?
Not all REITs are the same. There are three general types of REITs.
Equity REITs own properties that produce income. Examples of these include:
- Medical facilities
- Multi-family housing
- Cell towers
- Office buildings
- Retail centers
Equity REITs are the most prevalent form of REITs, and they typically earn money through rent.
Mortgage REITs profit from loaning money through mortgage loans or indirectly through mortgage-backed securities. A mortgage-backed security is a group of mortgages purchased from a lender by an investor.
Often the mortgage company you initially purchase a mortgage from will sell your mortgage to another company. This is where mortgage REITs usually buy their investments. From there, a mortgage REIT company earns money from financing the mortgage.
Mortgage REITs are far less popular than equity REITs because they are more volatile. Mortgage REITs are profitable when interest rates are low. They earn money from the margin between the cost of financing and the interest rate.
Some REITs use a hybrid of equity and mortgage REITs. Often this is a collection of holdings with income-producing properties and mortgages.
How do you make money on a REIT?
REITs are publicly traded on an exchange function much like company stock. You can buy and sell them in the same way. So the first way you can make money on a REIT is by buying low and selling high.
You can also make money with your share of a REIT through dividends. According to law, REITs must pay their shareholders 90% (or more) of their taxable profits. The exchange for REIT companies is that they have more exemptions on their corporate income tax. The shareholders, however, pay taxes on these dividends.
What are the advantages of a REIT?
Here are a few of the pros of investing in a REIT. Many of these advantages come from investing in publicly traded REITs.
Many people look to real estate when they want to diversify their portfolio. The problem they run into is that few can afford an investment property. REITs help you to diversify your portfolio, invest in real estate, and avoid the hassles of property management.
Stable cash flow
REITs have a stable cash flow, especially when they are equity REITs. This type of REIT will constantly generate income from its real estate portfolio. And while no investment is a sure thing, you can count on that cash flow being passed on to you via a dividend. You can expect your REIT to pay 90% (or more) of its annual income in dividends.
Unlike traditional real estate investments, REITs are highly liquid. You can sell your share in a REIT and get your money out quickly. If you want the most liquid option, opt for a REIT that is publicly traded.
A real estate investment trust must meet qualifications to be classified as a REIT, which leads to financial reporting. Further financial reporting is required for a REIT to be publicly traded. So there is a certain amount of transparency that comes with your investment.
Strong long-term return
Historically, REITs have outperformed the S&P 500 Index. So they should be a part of a long-term investment plan. With their long-term solid return and steady dividend payments, they work well in various investing situations.
What are the disadvantages of a REIT?
No investment is a sure thing. There are risks to even the best-performing REITs. Here are some of the major disadvantages of investing in REITs.
Not all REITs are liquid
Earlier, we listed REITs as highly liquid, but not all REITs are quick and easy to sell. It can be challenging to buy and sell if you are buying a REIT that isn’t listed on a public exchange. So start with REITs on an exchange, so you are choosing one that is liquid.
Business model built on debt
Investing in real estate comes with a lot of debt. If your entire company structure is investing in real estate, you have a business model built on debt. Many people reason that this risk is balanced by real estate generating income.
REITs are required to pay at least 90% of their income as dividends. This doesn’t leave very much money for growth. A REIT must issue new stocks or bonds if it wants to expand. There is no guarantee that investors will buy these, and the REIT does not have the cash flow to grow.
You pay the taxes
REITs get a lot of tax breaks because they pass their dividends on to their investors, but the investor will shoulder this tax burden. If you invest in a REIT, be prepared to pay taxes on the dividends you receive. (One exception is putting the dividend payments into a tax-advantaged account like an IRA.)
How to invest in REITs
Many REITs are listed on the stock exchange. So you can purchase shares of the REITs in the same manner you would buy stocks. Your preferred broker can help.
But not all REITs are on an exchange. You can purchase non-traded REITs from a broker who specializes in selling REITs that are not on an exchange.
Lastly, you may already invest in REITs through mutual funds or ETFs. Be sure to ask your financial planner because you may already benefit from the diversification of your portfolio due to REITs (145 million Americans own a REIT in some way).
What are the average returns of a REIT?
One of the most significant advantages of investing in REITs is that they are liquid– meaning you can buy and sell them quickly. But that doesn’t mean you always should.
Many investors consider REITs to be part of a long-term strategy. REITs outperform traditional stocks 56% of the time. No investment strategy is guaranteed, but historical trends show that REITs typically recover from economic downturns.
Why invest in REITs?
No investment strategy is one size fits all. Here are some questions to ask before investing in REITs:
- Do you want to diversify your portfolio with real estate? REITs are one way to do this without directly buying property.
- Do you want to pick an investment that has historically performed well? We’re not fortune tellers, but we can look back at how REITs have performed in the past. Keep in mind that REITs do tend to be slow to grow.
- Do you want to invest in liquid assets? Choose a publicly traded REIT so you can easily buy and sell your REIT.
Do you want to receive dividend payments? REITs are required to pay out 90% of their income in dividends.
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