Key points
- REIT stands for real estate investment trust.
- REITs provide diversification and a recurring income source.
- REITs can carry risks and downsides.
If you’re ready to expand your investment portfolio beyond basic stocks and bonds, real estate can be an excellent option. But buying an investment property comes with a high upfront cost that makes it difficult for many people to get started.
That’s where real estate investment trusts come in. REITs combine many of the benefits of owning stocks and real estate. You can easily trade them on a stock exchange and can enjoy the regular income that investment properties produce.
What is a REIT? And how does it work?
A REIT is a company that owns and operates income-producing real estate using the money of individual investors. REITs were created through legislation passed in 1960 with the goal of creating a mutual fund-like investment structure for real estate.
These investment vehicles offer exposure to commercial and residential properties, including apartments, mortgages, hotels, office buildings, shopping malls, self-storage facilities and warehouses.
Many REITs must be registered with the Securities and Exchange Commission (SEC). For that reason, they are subject to various regulations, including the requirement to pay 90% of the company’s taxable income in the form of shareholder dividends each year.
They must also meet the following requirements:
- Derive at least 75% of their income from real estate sources.
- Have at least 100 shareholders.
- Have no more than half their shares held by five or fewer people.
Example: If you invest in a REIT that manages apartment buildings, the REIT will combine the money from its many investors to own and manage the units and then collect rent from the tenants. Throughout the year, the REIT will pass along the majority of the profits (meaning what’s left after expenses) to shareholders. In return, the REIT will be allowed to deduct those shareholder payments from its corporate taxable income.
Different types of REITs
Deciding whether you want to invest in REITs is just the first step. From there, you’ll also have to decide which REIT types to invest in.
Most REITs are publicly traded and available to all investors. But that’s not always the case. Different REITs invest in different underlying investments, exposing you to different risks.
1. Equity REITs
Equity REITs are the most popular REITs. These companies are publicly traded, meaning you can buy and sell shares on major stock exchanges like you would any other stock.
Because they are publicly traded, equity REITs must be registered with the SEC and are subject to its regulations.
2. mREITs
Rather than making their money primarily from properties like equity REITs do, mREITs make most of their money from mortgage products.
“They typically hold an income-producing mortgage portfolio, mortgage-backed securities, or other real estate-backed loans,” says Kris Lippi, a real estate broker and the founder of ISoldMyHouse.com.
Most mREITs are publicly traded, but they can also be classified as PNLRs or private REITs.
3. PNLRs
Public nonlisted REITs (PNLRs) are technically public like equity REITs and mREITs are. As a result, they must register with the SEC and can be purchased by any investor. But there is an important distinction.
While public nonlisted REITs are also open to any investor, their shares are not listed on the exchanges.
To take advantage of these investments, you can go directly through a REIT management company. You can also purchase PNLRs through a broker-dealer.
It’s worth noting that PNLRs have some risks that other public REITs don’t. Because they don’t trade on stock exchanges, they are more difficult to sell off once you own them. This lack of liquidity could become a problem if you need money quickly. PNLRs also tend to have significantly higher fees.
4. Private REITs
Similar to PNLRs, private REITs aren’t traded on a stock exchange. But the major difference is they aren’t public securities at all. They aren’t registered with the SEC, nor are they subject to SEC regulations.
“Big-time investors who are typically high-income earners or high-net-worth individuals can also invest in REITs through private nontraded REITs,” Lippi says. “These aren’t available to the public and welcome higher investments for higher returns.”
Private REITs are often limited to accredited investors, who typically must meet one of the following requirements:
- Earn at least $200,000 per year, or $300,000 together with a spouse.
- Have a net worth of at least $1 million, either alone or together with a spouse.
- Hold a Series 7, 65 or 82 license in good standing.
- Be a trust with assets of more than $5 million.
- Be an entity with total investments of more than $5 million.
- Be an entity owned solely by accredited investors.
How to invest in a REIT
The process of investing in REITs depends largely on the type. Investing in equity REITs or mREITs is similar to investing in any other stock.
First, you must open a brokerage account. Then, you place a buy order for the REIT of your choice.
But rather than investing in individual REITs, many investors opt for REIT mutual funds or exchange-traded funds. These funds allow you to own many different REITs with a single investment, diversifying your portfolio and your risk.
To invest in PNLRs and private REITs, you have to go through a broker or a REIT company. Depending on the company, you may need to be an accredited investor.
Pros and cons of investing in REITs
REITs can be an excellent addition to many investment portfolios thanks to their benefits. But they also have some downsides and risks, just like any other investment.
Pros of REITs
Investing in REITs offers several benefits:
- Accessibility: Most people can’t afford the upfront cost of purchasing an office building or apartment complex, meaning these investments provide a stream of income that’s often available only to wealthy investors. REIT investing basically affords you ownership of commercial real estate on paper, saving you the expense of buying one outright.
- Liquidity: REITs are far more liquid than traditional real estate investments. If you purchased a rental home and suddenly needed quick cash, you likely wouldn’t be able to sell that property in just a few days. But if you own public REITs, you can quickly sell them for cash.
- Diversification: Investing in REITs helps you diversify your portfolio. Most people start building their investment portfolios with stocks and bonds. REIT investing allows you to add real estate to your portfolio, and with it comes the unique income opportunity it provides.
Cons of REITs
Despite their advantages, REITs also have some downsides for investors:
- Interest rate sensitivity: Because REITs leverage debt — either by borrowing money to buy properties or by investing in mortgages — they are sensitive to interest rate fluctuations. “REIT stock prices often decline as interest rates rise because higher rates can increase borrowing costs and reduce the properties’ profitability,” Lippi says.
- Real estate market sensitivity: REITs are subject to changes in the real estate market. Their profits are dependent on the rental income the properties provide. If a property loses tenants, it also loses income. Imagine a recession where businesses are forced to close their doors. The owners or investors in the buildings where the businesses lived would suddenly have no rental income.
- Tax liability: REITs pass along 90% of profits to their shareholders. While income is a good thing, it also comes with a tax bill. REIT dividends are taxed at your ordinary income tax rate rather than at the long-term capital gains tax rate.
- Additional downsides for certain REIT types: Many private REITs and PNLRs are accessible only to accredited investors. And while those REITs often come with higher profits, they’re also less liquid, often requiring you to keep your money invested for years.
Is a REIT a good investment?
REITs can be an excellent addition to an investment portfolio, but they may not be right for everyone.
“As with any investment, deciding between REITs or a more direct approach is ultimately a matter of means and preference,” says Mitch Rosen, the managing director and head of real estate at Yieldstreet.
First, you must decide whether you want to add real estate to your portfolio in the first place. There’s no doubt that real estate is a popular investment. It can provide diversification and an additional source of income. But you may decide you’re uncomfortable exposing yourself to the risks of the real estate market.
Even if you feel confident you want to add real estate to your portfolio, you’ll have to decide if REITs are the right way to go about it.
Those with adequate real estate experience and a desire to get their hands dirty might want to dive into the direct investment of their choice.
“On the other hand, those looking to invest alongside established professionals, as well as avoid the complex responsibilities and tax requirements associated with development, may find REITs the more attractive choice,” Rosen says.
REITs might be a good investment for you if:
- You have a portfolio of stocks and bonds and want to expand them to include real estate but don’t have the financial means to purchase a property on your own. You’ll be able to purchase a small piece of a property and earn your share of its income.
- You may want to add a recurring source of income to your investment portfolio. While many stocks result primarily in capital gains — and possibly dividends — REITs must pay out 90% of their profits to their shareholders. Because of that, you can add an additional source of income to your budget.
If you decide to invest in REITs, it’s important to consider how they fit into your overall investment strategy. Diversification is one of the most important facets of long-term investing, so keep that in mind when balancing your REIT investments with the other assets in your portfolio.
Frequently asked questions (FAQs)
REITs make money through rental income on the properties they own. Most of that money is either reinvested in the business or passed along to shareholders.
REITs can be an excellent way to make money from real estate without having to purchase it directly, but it’s not exactly the same as owning real estate.
Some investors may prefer REITs, as they have lower upfront costs and require less hands-on work. But others may prefer owning properties themselves, giving them more control over the investments and the profits.
Depending on the amount you invest and how your investment performs, you can make a lot of money investing in REITs.
Unlike many stocks, REITs pay annual dividends to their shareholders from the rental income they collect. However, earning a high income from a REIT generally requires a large initial investment.
