What Is a Real Estate Investment Trust and How Do REITs Work?
There are many different relationships you can have with real estate. For some people, their relationship is strictly personal: selling a home, buying a home, and paying a mortgage are sometimes the only experience with real estate a person has. For others, real estate is a way to make money and take advantage of investment opportunities. One of the many ways to do that is to invest in a real estate investment trust (REIT).
Before investing in a REIT, it’s important to understand what it is and how it works. Though there are plenty of perks to REIT investing, it’s also important to understand the drawbacks and carefully consider whether REIT investing would make sense for you.
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What Is a REIT?
A real estate investment trust, also known as a REIT, is a company that owns, operates, or finances real estate that produces income. They operate similarly to a mutual fund in that individual investors can acquire ownership in commercial real estate that pays a dividend, usually by collecting rent from tenants. Some examples of REIT properties include apartment complexes, hospitals, warehouses, hotels, shopping malls, and office buildings.
There are plenty of ways to utilize real estate as an investment opportunity. Having a vacation home that you also rent out, or even purchasing a timeshare are ways to invest in real estate on an individual level. A REIT won’t offer these personal ties to the real estate you’re investing in, but it’s a way to invest in real estate for the financial gains in a fairly risk free way by pooling both risk and investment across a group.
Types of REIT Companies
Not all REIT companies are created equal. There are a few different types that a company can fall under:
- Equity REITs: Equity REITs are the most common. This type of REIT is publicly traded and invests in and owns real estate properties that produce income and give investors the ability to invest in them as well.
- Mortgage REITs: Mortgage REITs are known as mREITs. This type of REIT will invest in property mortgages and make money through interest.
- Public Non-Listed REITs: Public non-listed REITs, or PNLRs, are registered with the U.S. Securities and Exchange Commission (SEC) but don’t trade on national stock exchanges.
- Private REITs: Private REITs are exempt from being registered with the SEC and do not trade on national stock exchanges.
How Do REITs Work?
It’s important to understand how an REIT works if you’re interested in investing. Most REIT companies pay out their taxable income as dividends to shareholders. Those shareholders pay the income taxes on those dividends. Each REIT has certain requirements to qualify and a basic structure that allows it to function.
- Invest in at least 75 percent of its total assets in real estate
- Receive at least 75 percent of its gross income from real estate sales, rents from real property, or from interest on mortgage financing real property
- Pay at least 90 percent of its taxable income in shareholder dividends each year.
- Be a taxable corporation
- Be managed by a board of trustees or directors
- Have at least 100 shareholders
- Have no more than 50 percent of its shares held by five or fewer individuals
The structure of a REIT is created in order to allow individuals to invest in real estate without actually having to buy, manage, and finance a property. Though there are loans and financing options if you decide to purchase real estate, a REIT is a way to invest in real estate on a smaller scale with less risk, while accessing a more diverse portfolio of properties. The structure is simple in that an investor will invest in a REIT, it will collect income on that space, then the REIT will pay shareholders dividends from that income based on a formula.
When investing in a REIT, it’s not only helpful to understand how to invest, but also the benefits and drawbacks.
How To Invest in REITs
To invest in a REIT, you can purchase your shares in an open exchange, or by investing in a mutual fund that specializes in public real estate. Some invest by region, some invest by type of real estate, and some by country. They are listed on major stock exchanges, just like any other public stock. In order to make the best decision for your finances, discuss investing with a broker, investment advisor, or financial planner. They can help to analyze which REIT investments are the best for you.
Benefits of Investing in REITs
The biggest perk of investing in REITs is the benefit of real estate investing without the difficulty. Unlike something like private equity real estate investing, it’s an option that doesn’t require a big investment sum in order to be involved. It’s also relatively easy to buy and sell since they function and behave like a stock. In addition to that, the 90 percent rule in a REIT requirement means that investors can collect a higher amount of income than other stock options that pay dividends.
Drawbacks of Investing in REITs
One of the drawbacks to investing in a REIT is the limit for future growth compared to other investment opportunities. While the 90 percent rule means you can collect a higher amount of income, it also means the REIT has limited leverage to gain more properties. Also, the government will tax your dividends as ordinary income, which they dont do for other types of dividends. Other types are taxed less.
REIT opportunities offer an entirely new relationship with real estate in a relatively simple package. By investing in a company that owns, operates, or finances income-producing properties, you can gain some of the financial perks of real estate ownership without the difficult leg work involved with buying real estate. If you do your research on REIT company categories, requirements, benefits, and drawbacks, and decide you want to invest in a REIT, you may be able to gain some real estate investments to your personal financial portfolio.
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Chelsy is a writer from Montana who now lives in Boise, Idaho. She graduated with her journalism degree from the University of Montana in 2012. She enjoys talk radio, cold coffee, and playing Frisbee with her dog, Titan. Follow Chelsy on Twitter @Chelsy5
This post was updated February 28, 2019. It was originally published November 19, 2018.