What Is a REIT? How to Invest in REITs

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A real estate investment trust (REIT) is a company that owns, operates or finances income-producing real estate and that qualifies for special tax treatment by paying out most of its taxable income to shareholders as dividends. Buying a REIT share gives you a slice of a portfolio of properties or real estate loans without having to buy, manage or finance a building yourself. Most REITs trade on stock exchanges, so you can buy and sell them through an ordinary brokerage account the same way you trade a stock.

The tax status is the main difference between a REIT and any other company that happens to hold property. A REIT that meets the qualification rules generally avoids corporate income tax on the income it distributes, so rent or interest reaches shareholders after only one layer of tax. That structure explains how REITs pay out cash, why they carry the debt they do and how their dividends are taxed.

How a REIT Works

Congress created the REIT structure in 1960 to give ordinary investors access to large commercial property portfolios in roughly the way a mutual fund gives them access to a basket of stocks and bonds.

The flow of money is straightforward:

1. Investors buy shares, and the REIT also borrows, usually through bonds, bank loans or mortgages.
2. The REIT uses that capital to buy or develop properties, or to make or buy real estate loans.
3. Tenants pay rent, or borrowers pay interest.
4. The REIT pays operating costs, interest on its own debt and management expenses.
5. At least 90% of what remains as taxable income goes out to shareholders as dividends.

Because only a small share of taxable income can be retained, REITs grow mainly by raising new capital, either by issuing more shares or by borrowing, rather than by reinvesting their own earnings the way a typical corporation does.

REITs hold a wide range of property types: apartment complexes, office buildings, retail centers, warehouses, hotels, healthcare facilities, self-storage units, data centers, timberland and infrastructure such as cell towers, fiber cables and energy pipelines. Many specialize in a single sector, while others hold diversified portfolios across several.

The structure also converts an illiquid asset into a liquid one. Selling a warehouse can take months. Selling shares of a listed REIT that owns hundreds of warehouses can take seconds during market hours. The trade-off is that the share price moves with the stock market every day, so a REIT investor sees volatility that a direct property owner, who rarely gets a fresh valuation, does not see on paper.

REIT Qualification Rules

A company cannot simply call itself a REIT. Under U.S. tax law it must meet a set of tests, including:

• Asset test: at least 75% of total assets invested in real estate, cash or U.S. Treasurys.
• Income test: at least 75% of gross income from rents, interest on mortgages that finance real estate, or real estate sales.
• Distribution requirement: at least 90% of taxable income paid to shareholders as dividends.
• Corporate form: organized as an entity taxable as a corporation.
• Governance: managed by a board of directors or trustees.
• Ownership breadth: at least 100 shareholders.
• Concentration limit: no more than 50% of shares held by five or fewer individuals.

The asset and income tests keep a REIT focused on real estate rather than operating businesses, and the ownership rules prevent a handful of wealthy individuals from using the structure as a private tax shelter.

The 90% figure applies to taxable income, not cash flow. Depreciation reduces taxable income without using cash, so a REIT can pay the required amount and still hold back meaningful cash, or it can distribute more than the minimum.

Types of REITs: How They Make Money

Equity REITs

Equity REITs own and manage income-generating property. Revenue comes primarily from rent, not from buying and reselling buildings. Their results depend on occupancy, rent levels, lease terms, tenant quality and property values. An apartment REIT with short leases can reprice rents relatively quickly, while an office REIT with long leases has more predictable income but adjusts more slowly when markets change.

Mortgage REITs

Mortgage REITs (often called mREITs) do not own buildings. They originate or buy mortgages and other real estate loans, or invest in mortgage-backed securities. Most of their earnings come from the net interest margin: the spread between the interest earned on their assets and the cost of the money they borrow to fund them. Because that spread is narrow, mortgage REITs typically use leverage, which makes them especially sensitive to interest rates. When short-term funding costs rise faster than asset yields, the margin shrinks. Equity REITs feel rates less directly, through borrowing costs and property valuations.

Hybrid REITs

Hybrid REITs combine owning property with holding real estate debt. They were already declining before the 2008 financial crisis and largely disappeared afterward as the industry became more specialized.

Publicly Traded, Non-Traded and Private REITs

How a REIT raises and returns money matters as much as what it owns.

• Publicly traded REITs are registered with the SEC and listed on a stock exchange. Shares trade whenever the market is open at continuously quoted prices, and the company files regular public reports. REITs are part of broad stock indexes such as the S&P 500, where they make up much of the real estate sector.
• Public non-traded REITs are registered with the SEC and file reports, but their shares do not trade on an exchange. You buy them through a broker or financial advisor participating in the offering. Their reported value does not swing daily, but that reflects how they are valued, not lower risk. Selling usually depends on the REIT’s own redemption program, which can be limited or suspended, or on an eventual listing or liquidation. They have carried substantial upfront commissions and offering costs, and distributions can be funded partly from borrowing or new investor money rather than operations.
• Private REITs are not registered with the SEC and do not trade on exchanges. They are generally limited to institutional and accredited investors, with minimums that start in the low thousands of dollars and often run much higher. Disclosure is lighter, and this is the segment where REIT-related fraud is easiest to carry out.

REITs also reach many investors indirectly. Mutual funds and exchange-traded funds (ETFs) hold REIT shares, and those funds appear in many 401(k) plans and pension portfolios, so a large number of U.S. savers own REITs without having bought one directly.

Worked Example: From Rent to Dividend

The following is a hypothetical example built to show the mechanics. It does not describe any real company’s figures.

Imagine an equity REIT that owns a portfolio of warehouses. For one year:

• Rental revenue: $100 million
• Property operating expenses: $30 million
• Interest on debt: $20 million
• General and administrative costs: $5 million
• Depreciation: $25 million

Net income is $100M − $30M − $20M − $5M − $25M = $20 million. Assume for simplicity that taxable income equals net income. The REIT must distribute at least 90% of that, or $18 million, to keep its status.

Depreciation, though, is an accounting charge, not a cash payment. Analysts therefore look at funds from operations (FFO), which adds depreciation and amortization back to net income and removes gains or losses from property sales:

FFO = net income + depreciation and amortization − gains on property sales

Here, with no property sales, FFO = $20M + $25M = $45 million. With 100 million shares outstanding, FFO is $0.45 per share and the minimum required dividend is $0.18 per share. Suppose the board pays $0.36 per share. That is double the legal minimum but only 80% of FFO, leaving $9 million for property improvements or debt reduction. This is why REIT investors compare dividends with FFO rather than with earnings per share.

What a dividend yield means for a small investment

The income from a modest stake is:

Quarterly income = amount invested × annual dividend yield ÷ 4

As a hypothetical illustration, $500 invested in a REIT yielding 4% a year would produce about $20 a year, or roughly $5 a quarter, before taxes, assuming the dividend stays constant and is paid quarterly. Yields and dividends change, and dividends are not guaranteed. Total return also includes any rise or fall in the share price, which can easily outweigh a year of dividends, so return on investment (ROI) gives a fuller picture than yield alone.

How to Analyze a REIT

Ordinary stock metrics fit REITs poorly because depreciation depresses reported earnings. The figures analysts lean on instead:

• FFO and AFFO. FFO is the standard measure of operating cash flow for REITs. Adjusted FFO (AFFO) goes further by subtracting recurring capital spending needed to maintain properties, which gives a closer view of the cash actually available for dividends. Definitions of AFFO vary between companies.
• Payout ratio. Dividends divided by FFO or AFFO. A ratio near or above 100% leaves little room if income falls.
• Price to FFO. The REIT equivalent of a price-to-earnings ratio, used to compare valuations within a sector.
• Net asset value. An estimate of the market value of the properties minus debt, per share. Comparing the share price with net asset value (NAV) shows whether the market prices the REIT above or below its estimated property value.
• Leverage. Debt-to-equity, debt relative to earnings before interest, taxes, depreciation and amortization, and the maturity schedule of the debt. Because a REIT retains so little income, debt is one of its main sources of growth capital. Many REITs prefer long-term, fixed-rate debt to match the long life of their buildings, since a heavy load of debt coming due during a period of high rates can force asset sales or dividend cuts.
• Property fundamentals. Occupancy, lease length, tenant concentration and rent growth in the specific sector.

Sectors that look alike can behave very differently. Malls and neighborhood shopping centers both hold retail tenants but depend on different consumer habits. Office demand responds to how people work, while apartment and self-storage demand responds to household formation and moving patterns.

How to Invest in REITs

1. Choose the vehicle

For most individual investors, publicly traded REITs are the simplest entry point. The cost of entry is the price of one share, or less with fractional shares, and there are no special fees beyond normal trading costs. Management expenses are built into the REIT’s operating costs, so comparing general and administrative costs across similar REITs shows how efficiently each one runs.

If you prefer not to pick individual companies, REIT funds spread the risk further:

• REIT mutual funds offer professional, often active management. Some are available inside employer 401(k) plans, which allows automatic investing through payroll deductions.
• REIT ETFs trade on exchanges throughout the day. Some are actively managed and some focus on a single sector, such as industrial property.
• Real estate index funds passively track a broad real estate index, usually at lower fees than actively managed funds. Global REIT index funds add exposure to property companies in developed and emerging markets outside the United States.

2. Open or use a brokerage account

You buy listed REITs and REIT ETFs through any standard brokerage account, a traditional or Roth IRA, or a workplace plan that offers a real estate fund. Non-traded REITs are sold through participating brokers or advisors, and private REITs through their own offering process.

3. Size the position

One approach is to begin with perhaps 2% to 5% of a portfolio in a broadly diversified REIT or REIT fund and watch how it behaves relative to your stocks and bonds before adding more. Some financial advisors suggest a well-diversified portfolio might hold 5% to 10% in real estate, depending on goals, risk tolerance and time horizon. Because real estate moves in cycles, building gradually reduces the chance of concentrating just before a downturn.

4. Diversify across property types

Holding REITs in several sectors, such as residential, industrial, healthcare and retail, reduces dependence on any one part of the property market. A broad fund does this automatically.

5. Think about account location

Because most REIT dividends are taxed as ordinary income, many investors hold REITs in tax-advantaged accounts. In a traditional IRA or 401(k), dividends grow tax deferred; in a Roth account, qualified withdrawals are tax free. A tax professional can tell you how this applies to you.

How REIT Dividends Are Taxed

The pass-through structure removes corporate tax at the REIT level but changes how shareholders are taxed. Dividends from most ordinary corporations can qualify for lower long-term capital gains rates. Most REIT dividends do not, because the REIT has not paid corporate tax on that income, so they are taxed at your ordinary income rate.

A REIT’s distribution can also include other components, reported separately on the year-end tax form:

• Ordinary dividends, the largest part for most REITs.
• Capital gain distributions, when the REIT passes through gains from selling property, generally taxed at capital gains rates.
• Return of capital, which is not taxed when received but reduces your cost basis in the shares, increasing the taxable gain when you eventually sell.

Benefits and Limitations

Benefits

• Liquidity. Listed REIT shares sell quickly at a quoted price, unlike a building.
• Access and diversification. A single share or fund unit provides exposure to large commercial portfolios across many properties and sectors.
• Income. The 90% distribution requirement channels most taxable income to shareholders.
• No landlord duties. Management handles tenants, maintenance, financing and leasing.
• Potential inflation link. Rents and property values can rise with inflation over time, although not reliably over every period.
• Transparency for SEC-registered REITs, which file annual and quarterly reports.

Limitations

• Limited internal growth. With most taxable income paid out, growth slows when shares are depressed or borrowing is expensive.
• Interest rate sensitivity. Higher rates raise borrowing costs, can lower property values and make bonds a stronger competitor for income investors.
• Market risk. The share price can fall sharply in a broad selloff even if the properties keep collecting rent.
• Sector risk. Structural changes, such as shifts in office use or retail shopping, can hit a specialized REIT hard.
• Tax and fees. Ordinary income rates on most dividends reduce after-tax returns in taxable accounts, and non-traded and private REITs can carry high management and transaction costs.
• Dividend cuts. If taxable income falls, so can the dividend.

REITs Compared With Similar Investments

REIT vs. a stock of a real estate company. A listed REIT is a stock, but not every real estate company is a REIT. A homebuilder, a real estate brokerage or a property developer that sells what it builds is an ordinary corporation: it pays corporate income tax, can retain as much profit as it wants and has no obligation to pay dividends. A REIT must pass the asset, income and distribution tests, and in exchange it generally avoids corporate tax on distributed income. The tax status, not the industry, defines a REIT.

REIT vs. a real estate fund. A REIT owns or finances property directly. A real estate mutual fund or ETF usually owns shares of many REITs and other real estate companies. The fund adds diversification and a management fee layer; the REIT is the underlying operating business.

REIT vs. owning rental property. Direct ownership gives you control, the ability to use mortgage leverage on a single asset and the full set of property tax deductions, including depreciation against your own rental income. It also brings concentration, illiquidity and landlord work. A REIT gives up control and the personal depreciation benefits in exchange for liquidity, diversification and passive income.

REITs and structured products. A REIT share is equity in an operating company or trust, not a structured product. Mortgage REITs invest in mortgage-backed securities, but the share itself has no built-in payoff formula.

REIT vs. venture or private equity real estate. Private real estate funds lock up capital for years and target returns from development or repositioning, while even a private REIT must follow distribution rules that push it toward income-producing property.

How to Avoid REIT Fraud

FINRA has repeatedly warned about schemes falsely labeled as REITs that own no real estate at all, and the SEC advises caution with anyone selling a REIT that is not registered with U.S. regulators. You can verify registration of publicly traded and non-traded REITs through the SEC’s EDGAR system, which also holds their reports and any offering prospectus. Guaranteed returns, pressure to decide quickly or an offering you cannot find in EDGAR are reasons to walk away.

FAQs

The Bottom Line

REITs suit investors who want real estate income and diversification without buying or managing property themselves. Publicly traded REITs and REIT funds offer the simplest, most liquid entry, while non-traded and private REITs bring higher costs, limited exits and more fraud risk. Judge a REIT by its FFO, payout ratio and debt rather than reported earnings, and verify any offering in the SEC's EDGAR system before investing.