How REITs work and how to invest

So-called REITs allow everyday investors to own and profit from real estate, an asset that experts say rounds out a portfolio of stocks, bonds, and cash.

“REITs represent a very low-cost, effective, and liquid means of investing in commercial real estate that’s actually available to the broad public,” says Abby McCarthy, senior vice president of investment affairs at the National Association of Real Estate Investment Trusts (Nareit), an advocacy group. 

What is a REIT?

A REIT is a company that owns, operates, or finances income-producing real estate, such as retail centers, malls, hotels, medical facilities, apartment buildings, and office complexes. More than half a million properties in the U.S. are owned by REITs, according to Nareit.

Buying stock in a REIT is like buying stock in any other company, except a REIT generates revenue exclusively from real estate. 

McCarthy says commercial real estate has historically been in the hands of wealthy and institutional investors, but REITs give everyday investors a slice of the pie. “REITs are total return investments, so they typically provide high dividends plus the potential for moderate long-term capital appreciation,” she says.

How REITs work

A REIT collects rent, operating expenses, or interest payments from the properties in its portfolio. Then it turns around and gives the majority of that income to its shareholders in the form of dividends. According to Nareit data, REITs listed on major stock exchanges paid out more than $51 billion in dividends to investors in 2020.

The properties in a REIT typically share an overarching theme. A healthcare REIT, for example, might own or finance hospitals, senior-living facilities, and medical office buildings; a residential REIT would have apartment buildings and student housing; and a self-storage REIT would own and manage storage facilities. Diversified REITs include a mix of property types.

The IRS requires a company to meet these requirements to qualify as a REIT:

• It must distribute at least 90% of its annual taxable income to its shareholders
• It must be managed by a board of directors or trustees
• It has to be registered as a corporation
• It must have at least 100 shareholders
• It should derive at least 95% of its gross income from real estate, with at least 75% coming from specific sources
• It has to invest at least 75% of the value of its total assets in real estate assets, cash or cash-like vehicles, and Treasuries

The 3 types of REITs

REITs can be separated into three broad categories, the main difference between them being whether they own/manage or finance real estate. Some do both.

• Equity REITs: This type of REIT owns several properties that are typically concentrated in one sector, McCarthy says. Tenants pay rent to the REIT, which turns around and pays dividends to its shareholders. 
• Mortgage REITs: REITs that finance, rather than own, properties are called mortgage REITs or mREITs. Income is earned from interest on primary mortgages or mortgage-backed securities, and paid to investors as dividends.  
• Hybrid REITs: These REITs own and finance properties, using both strategies to generate income. 

REITs are also categorized by how they are available to investors: either on or off major stock exchanges. Here’s more about the three types of trading statuses:

• Publicly traded REITs: Equity REITs are publicly traded, meaning they’re listed on major stock exchanges like the New York Stock Exchange (NYSE). Because they’re regulated by the Securities and Exchange Commission (SEC), they tend to be more transparent than REITs that aren’t publicly traded. REITs can be listed directly on an exchange—there are 209 publicly listed REITs as of October 2022, according to Nareit—or they can be part of a mutual fund or exchange-traded fund (ETF) made up of several REITs. Like any publicly traded security, REITs come with risks, McCarthy says. Factors as varied as the current political climate, interest rate environment, geography, and tax laws can affect how an equity REIT performs. 
• Public, non-traded REITs: Non-listed REITs don’t trade on national stock exchanges, but they’re still regulated by the SEC. They tend to have higher minimum investment requirements and longer holding periods, which make them more difficult to sell (i.e., less liquid) than publicly traded REITs and therefore riskier.
• Private REITs: This non-regulated class of REITs is reserved for high net worth investors and financial firms that manage pension plans. Returns may be higher, but performance is often harder to track.

REITs that generate high dividends are particularly attractive to investors when prices of everyday goods and services—like rent—are going up. “It has inflation protection that some assets don’t,” says Michael Becker, an associate wealth advisor and investment analyst at Hightower Wealth Advisors in St. Louis. However, he adds, impacts from COVID-19 have shaken up commercial real estate. Shoppers are leaning more heavily on e-commerce and many businesses have not returned to offices. 

“Not all real estate trends for the past 10 years can be counted on for the next 10 years,” he says—a reminder for investors to be judicious about choosing REITs to invest in.

How to invest in REITs

Nareit’s online database shows the current stock price, annual returns, and dividend yields of more than 180 publicly traded REITs. You can buy shares using a taxable brokerage account or a tax-advantaged retirement account, like your workplace 401(k) or an IRA. 

“REITs are publicly traded securities, so investors can access them by picking direct stocks,” McCarthy says. “But really the majority of investors invest in REITs through either actively managed mutual funds, index funds, or ETF products.” 

A fund is a basket of multiple companies. It does the work of researching, vetting, and selecting REITs that align with a certain goal or value. By owning stock of multiple companies, McCarthy says investors are able to increase their returns without taking on more risk.

Keep in mind that index funds and ETFs may be subject to investment minimums, though they’re usually under $1,000, and you’ll have to pay a fee, known as an expense ratio, to cover management costs.

If you’re interested in non-traded REITs, check out platforms like Fundrise or DiversyFund. If you qualify as an accredited investor, consider a platform like Yieldstreet or talk to a financial advisor directly. 

But remember: Any investments you buy and sell through a retirement account usually can’t be accessed without penalty until retirement age. If you’re looking for a current stream of income from dividends, a brokerage account may be a better fit, though there are tax rules to consider.

How REITs are taxed

A REIT has to be registered as a corporation, but it typically doesn’t pay corporate taxes. Instead, the business’ income flows through as dividends to shareholders, who are responsible for paying income taxes.

In general, dividends paid via REITs are considered “non-qualified” for tax purposes. That means an investor’s ordinary income tax rate applies, not the lower capital gains tax rate that applies to long-term stock gains.

“For high income earners, that [rate] can be close to 40% depending on what state you’re in,” Becker says. “For lower income earners, it can be in the mid-to-high teens.”

Some dividends are a mixture of ordinary income and capital gains. This happens, for example, when a REIT sells a property that it has owned for more than a year and gives some of the proceeds to shareholders.

Ultimately though, the account you use to invest in REITs determines the tax treatment of your dividends. In a tax-deferred account like an IRA, you avoid paying taxes on dividends each year, in part because you aren’t pocketing the money yet. Dividends get reinvested and lumped together with your other investment principal and gains, and are taxed as ordinary income when you make withdrawals in retirement. In a brokerage account, REIT dividends are taxed annually. 

The takeaway 

Real estate investment performance tends not to follow that of stocks or bonds, making it a great diversification tool. For investors with liquidity needs, a REIT can be a smart alternative to owning physical real estate.

REITs offer a way for investors to benefit from some of the more stable aspects of the real estate market, even while its trajectory is largely unpredictable. As long as people need a place to conduct business, whether a retail shop, office, or healthcare facility, they’ll pay rent. And as long as a REIT collects rent payments, it’s required to share at least 90% of that income with investors.