What are REITs and how do they work?

Want to invest in commercial real estate without actually having to go out and buy commercial real estate. Consider REITs, or real estate investment trusts. A REIT is an investment arrangement that finances, operates, or owns real estate that produces income for its investors.

REITs were created by congress in 1960. Today more than 80 million Americans invest in REITs either directly, through mutual funds or directly through exchange-traded funds.¹ Institutional investors — pension funds, foundations, insurance companies, as well as banks — also own a piece of the REIT action.

Types of REITs

The most common publicly traded REITs are equity REITs. Equity REITs either own or operate real estate that produces income for investors. Next, there are mortgage REITs that finance income-producing real estate by originating or actually purchasing mortgages. Mortgage REITs earn income from the interest on those investments.

Then there are public non-listed and private REITs. Public REITs do not trade on the stock exchange but are registered with the SEC. Private REITs are exempt from SEC registration, and their shares do not trade on the stock exchange.

Regardless of type, most REITs will pay out all — or at least 90 percent — of their taxable income as dividends to their stockholders. REIT shareholders must pay the income taxes on those dividends.

How to Qualify as a REIT

The criteria for a company to be designated as a REIT are as follows:¹

The company must be an entity taxed as a corporation and managed by a board of directors/trustees.
The company must have at least 100 shareholders with no more than 50 percent of its shares held by five or fewer investors.
At least 75 percent of the company’s assets must be invested in real estate.
At least 75 percent of the company’s income must come from rents, mortgage interest financing real property, or from real estate sales.
Shareholders must receive at least 90 percent of the company’s taxable income in the form of annual dividends.

Advantages of Investing in a REIT

REITs have a historically competitive return on investments. Those returns are based on a consistent, high dividend income as well as long-term capital appreciation.² Those returns have a relatively low-performance correlation with other standard portfolio assets, which could be based on volatile stock market performance. So, REIT investment can add stability as well as diversity to investment portfolios.

Liquidity and Transparency

In addition to substantial and stable dividend yields, REITs offer investors liquidity in trading on the stock exchange (for publicly traded REITs). Non-listed and Private REITs can have limited liquidity, so investors always need to be aware of the terms. Investors will also enjoy transparency as independent fund directors, auditors and analysts — along with financial media gurus — monitor REIT performance.

REIT for the Average Investor

So, REITs allow anyone to invest in commercial real estate using the same tools that they invest in other financial sectors. Investors can purchase stock of individual companies or through a mutual fund. Without actually having to go out and buy, manage, or engage in complicated financing deals, REIT investors can earn a share of the income produced in the high-value commercial real estate market.

REIT as an Investment Equalizer/Stabilizer

If you’re looking for strong dividend returns when everything else in your portfolio is sliding, REITs can be an equalizer. A stable stream of contracted commercial real estate rents from commercial property tenants means consistent and high income. This income can help lower volatility and provide consistent returns. Non-listed and private REITs take this to the next step for being non-correlated to stock and bond investments. REITs are also a great way to keep pace with inflation. As new leases are signed in the properties owned, those rising prices are passed along to investors.

Finally, REITs can be concentrated in certain sectors or be highly diversified across property types. REIT portfolios span a variety of real estate properties across the geographic spectrum. The investments can go where the market is hot or heating up.

It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.