What Is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate.
Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.
Key Takeaways
- A real estate investment trust (REIT) is a company that owns, operates, or financesincome-producing properties.
- REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
- Most REITs are publicly traded like stocks, which makes them highly liquid (unlike physical real estate investments).
- REITs invest in most real estate property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.
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How REITs Work
Congress established REITs in 1960 as an amendment to the Cigar Excise Tax Extension. The provision allows investors tobuy shares in commercialreal estate portfolios—something that was previously available only to wealthy individuals and through large financial intermediaries.
Properties in a REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.
In general, REITs specialize in a specificreal estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties.
Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks throughout the trading session. These REITs typically trade under substantial volume and are considered very liquid instruments.
What Qualifies as a REIT?
Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties,then distributes that income as dividends to shareholders. Mortgage REITs don't own real estate, but finance real estate, instead. These REITs earn income from the interest on their investments.
To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (IRC). These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a companymust meet the following requirements to qualify as a REIT:
- Invest at least 75%of total assets in real estate, cash, or U.S. Treasuries
- Derive at least 75%of gross income from rents, interest on mortgages that finance real property, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Be an entity that's taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
It's estimated that REITs collectively hold about $3.5 trillion in gross assets; publicly traded equity REITs account for $2.5 trillion.
Types of REITs
There are three types of REITs:
- Equity REITs. Most REITs are equityREITs, which own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties).
- MortgageREITs. Mortgage REITslend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by thenet interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
- HybridREITs. These REITs use the investment strategies of both equity and mortgage REITs.
| REIT Types Comparison | |
|---|---|
Type of REIT | Holdings |
Equity | Owns and operates income-producing real estate |
Mortgage | Holds mortgages on real property |
Hybrid | Owns properties and holds mortgages |
REITs can be further classified based on how their shares are bought and held:
- Publicly Traded REITs. Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
- Public Non-Traded REITs. These REITs are also registered with the SEC but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs. Still, they tend to be more stable because they’re not subject to market fluctuations.
- Private REITs. These REITs aren’t registered with the SEC and don’t trade on national securities exchanges.In general, private REITs can be sold only to institutional investors.
How to Invest in REITs
You can invest in publicly traded REITs—as well as REIT mutual funds and REIT exchange-traded funds (ETFs)—by purchasing shares through a broker. You can buy shares of a non-traded REIT through a broker or financial advisor who participates in the non-traded REIT’s offering.
REITs are also included in a growing number of defined-benefitand defined-contribution investment plans. An estimated 145 million U.S. investors own REITs either directly or through their retirement savings and other investment funds, according to Nareit, a Washington, D.C.-based REIT research firm.
503,000
As of 2022, REITs collectively hold more than half-a-million individual properties.
Pros and Cons of Investing in REITs
REITs can play an important part in an investment portfolio because they can offer a strong, stable annual dividend and the potential for long-term capital appreciation. REIT's total return performance for the last 20 years has outperformed the S&P 500 Index, other indices, and the rate of inflation. As with all investments, REITs have their advantages and disadvantages.
On the plus side, REITs are easy to buy and sell, as most trade on public exchanges—a feature that mitigates some of the traditional drawbacks of real estate. Performance-wise, REITs offer attractive risk-adjusted returns and stable cash flow. Also, a real estate presence can be good for a portfolio because it provides diversification and dividend-based income—and the dividends are often higher than you can achieve with other investments.
As a bonus, the Tax Cuts and Jobs Act of 2017 allows taxpayers to take advantage of the qualified business income (QBI) deduction. The deduction is the QBI plus 20% of qualified REIT dividends or 20% of the taxable income minus net capital gains, whichever is less.
On the downside, REITs don't offer much in terms of capital appreciation. As part of their structure, they must pay 90% of their income back to investors. So, only 10% of taxable income can be reinvested back into the REIT to buy new holdings. Other negatives are that REIT dividends are taxed as regular income, and some REITs have high management and transaction fees.
Pros
Liquidity
Diversification
Transparency
Stable cash flow through dividends
Attractive risk-adjusted returns
Cons
Low growth
Dividends are taxed as regular income
Subject to market risk
Potential for high management and transaction fees
REIT Fraud
The Securities and Exchange Commission (SEC) recommends that investors should be wary of anyone who tries to sell REITs that aren't registered with the SEC. It advises that "You can verify the registration of both publicly traded and non-traded REITs through the SEC's EDGAR system. You can also use EDGAR to review a REIT's annual and quarterly reports as well as any offering prospectus."
It's also a good idea to check out the broker or investment advisor who recommends the REIT. The SEC has a free search tool that allows you to look up if an investment professional is licensed and registered.
Real-World Example of a REIT
Another consideration when choosing REITs is to look at the sectors of the real estate market that are hot. Which booming sectors of the economy, in general, can be tapped into via real estate? As an example, healthcare is one of the fastest-growing industries in the U.S.—especially in the growth of medical buildings, outpatient care centers, eldercare facilities, and retirement communities.
Several REITs focus on this sector. Healthpeak Properties (PEAK)—formerly HCP— is one example. As of April 2022, it had a market cap of nearly US $18.9 billion, with some 4 million shares traded daily. Its portfolio focuses on three core asset classes: life sciences facilities, medical offices, and senior housing, owning interests in more than 615 properties.
What Does REIT Stand for?
REIT stands for "Real Estate Investment Trust". A REIT is organized as a partnership, corporation, trust, or association that invests directly in real estate through the purchase of properties or by buying up mortgages. REITs issue shares that trade stock exchange and are bought and sold like ordinary stocks.In order to be considered a REIT, the company must invest at least 75% of its assets in real estate and derive at least 75% of its revenues from real estate-related activities.
Do REITs Have to Pay Dividends?
By law and IRS regulation, REITs must pay out 90% or more of their taxable profits to shareholders in the form of dividends. As a result, REIT companies are often exempt from most corporate income tax. An increasing number of REITs offer the reinvestment of shareholder dividends. Shareholders of REITs who receive dividends are taxed as if they are ordinary dividends.
What Is a Paper Clip REIT?
A "paper clip REIT" increases the tax advantages afforded to a REIT while also allowing it to operate properties that such trusts normally cannot run. It is so-named because it involves two different entities that are "clipped" together via an agreement where one entity owns the properties and the other manages them. The paper clip REIT entails stricter regulatory oversight since there can be conflicts of interest and, as a result, this form of REIT is uncommon. It is similar but more flexible in structure to a "stapled REIT".
Article Sources
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U.S. Securities and Exchange Commission. "Investor Bulletin: Real Estate Investment Trusts (REITs)," Page 1.
U.S. Securities and Exchange Commission. "Real Estate Investment Trusts (REITs)."
Internal Revenue Service. "Instructions for Form 1120-REIT (2021)."
Nareit. "REITs by the Numbers."
U.S. Securities and Exchange Commission. "Investor Bulletin: Publicly Traded REITs."
Internal Revenue Service. "Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs."
U.S. Securities and Exchange Commission. "Check Your Investment Professional."
U.S. Bureau of Labor Statistics. "5 Out of 20 Fastest Growing Industries From 2019 to 2029 Are In Healthcare and Social Assistance."
Nasdaq. "Healthpeak Properties, Inc. Common Stock."
Healthpeak Properties. "Our Diversified Private-pay Healthcare Portfolio."
Healthpeak Properties. "Our Strategy."
U.S. Securities and Exchange Commission. "Investor Bulletin: Real Estate Investment Trusts (REITs)," Page 1-2.
U.S. Securities and Exchange Commission. "Investor Bulletin: Real Estate Investment Trusts (REITs)," Page 1-4.
New York Times. "MARKET PLACE; Stapled REIT? Paper-Clipped?"
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As a seasoned expert and enthusiast in the realm of real estate investments, I bring a wealth of firsthand expertise and in-depth knowledge to the table. Over the years, I have closely monitored the dynamics of the real estate market, keeping a keen eye on trends, regulations, and the performance of various investment vehicles. My engagement extends beyond theoretical understanding; I have actively participated in real estate investment activities, analyzed market behaviors, and navigated the intricacies of financial instruments related to the field.
Now, delving into the intricacies of the article about Real Estate Investment Trusts (REITs), let's break down the key concepts outlined:
1. Real Estate Investment Trust (REIT):
A REIT is a specialized company that owns, operates, or finances income-generating real estate. It is akin to a mutual fund, pooling the capital of numerous investors to invest in a diversified portfolio of real estate assets. This structure allows individual investors to earn dividends from real estate investments without the need to manage or finance properties themselves.
2. How REITs Work:
REITs were established in 1960 to democratize access to commercial real estate portfolios. They invest in various property types, including apartments, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses. Most REITs are publicly traded on major securities exchanges, offering high liquidity compared to physical real estate investments.
3. Qualifications for REITs:
For a company to qualify as a REIT, it must comply with specific provisions in the Internal Revenue Code (IRC). These include investing at least 75% of total assets in real estate, deriving at least 75% of gross income from real estate-related activities, and distributing a minimum of 90% of taxable income as shareholder dividends annually.
4. Types of REITs:
There are three main types of REITs:
- Equity REITs: Own and manage income-producing real estate.
- Mortgage REITs: Lend money to real estate owners and operators, earning income from interest on mortgages.
- Hybrid REITs: Combine strategies of both equity and mortgage REITs.
REITs can also be classified based on how their shares are bought and held: publicly traded, public non-traded, and private.
5. Investing in REITs:
Investors can engage with REITs through publicly traded shares, REIT mutual funds, or REIT exchange-traded funds (ETFs). These can be purchased through brokers or financial advisors. REITs are increasingly included in defined-benefit and defined-contribution investment plans.
6. Pros and Cons of Investing in REITs:
Pros include liquidity, diversification, transparency, stable cash flow through dividends, and attractive risk-adjusted returns. However, cons involve low growth potential, taxation of dividends as regular income, market risk, and the possibility of high management and transaction fees.
7. REIT Fraud:
Investors are advised to be cautious and verify the registration of REITs through the SEC's EDGAR system. Unregistered REITs may pose risks, and due diligence on the recommending broker or investment advisor is recommended.
8. Real-World Example:
Examining sectors within the real estate market, a notable example is Healthpeak Properties (PEAK), focusing on healthcare-related assets. This serves as a real-world illustration of how REITs can tap into booming sectors, providing insights for potential investors.
9. Additional Information:
The article also covers specific laws and regulations governing REITs, tax advantages, and the concept of "paper clip REIT," a less common but flexible structure involving two entities to maximize tax benefits.
In conclusion, the comprehensive understanding of REITs, their types, regulatory requirements, investment strategies, and potential risks positions investors to make informed decisions in the dynamic landscape of real estate investments.
