When we think of investing in real estate, the first thing that often comes to mind is ownership of residential and commercial properties. However, there are more practical and accessible alternatives that investors can tap into.
A real estate investment trust (REIT) has emerged as one of the most popular options.
But what are real estate investment trusts and how do they work? How can you find the best REITs to invest in? Are REITs a good investment option in the current economic climate?
InvestmentNews answers these questions and more in this client education guide. This article can be useful for new and aspiring investors who want exposure to the real estate market, but don’t have enough capital to buy actual property.
We encourage financial and investment advisors, who frequently visit our website, to share this guide with their clients who may be considering REITs to diversify their portfolios.
A real estate investment trust is a company that holds real estate assets in its portfolio. As an investment vehicle, a REIT works almost exactly like mutual funds. However, instead of buying and selling shares of stocks, you trade shares of income-producing properties.
To be classified as a REIT, a company must meet several criteria set by the Internal Revenue Service (IRS). These include:
The industry body National Association of Real Estate Investment Trusts (Nareit) categorizes REITs into two general categories:
Let’s delve deeper into these categories:
These companies own or operate income-producing real estate. They earn revenue mostly through rent. This rental income is then passed to investors in the form of dividends.
Most equity REITs focus on a specific property type. But there are also some that hold multiple types of properties in their portfolios.
These are the common types of equity real estate investment trusts, according to Nareit:
Office REITs: own and manage office properties, including office parks and skyscrapers; some focus on specific markets like central business districts, while others prioritize tenant classes such as government agencies or private firms
Industrial REITs: buy or invest in industrial facilities, including warehouses and distribution centers
Residential REITs: own and manage different types of housing, including single-family homes, apartment buildings, student housing, and manufactured dwellings; some focus on a particular geographic market or property type
Retail REITs: own and operate retail spaces, including malls, shopping centers, and grocery stores
Resorts/lodging REITs: buy and invest in hotels and resorts that cater to a range of clients, from vacationers to business travelers
Healthcare REITs: own and manage healthcare-related properties, including hospitals, medical office buildings, and senior living facilities
Gaming REITs: focus on experiential real estate assets such as casinos and entertainment properties
Self-storage REITs: specialize in storage facilities for personal or business use
Telecommunications REITs: own and operate infrastructure real estate such as telecommunications towers, wireless infrastructure, energy pipelines, and fiber cables
Data center REITs: buy and invest in facilities where clients can store data safely; they may also provide products and services to help keep servers and data secure such as uninterruptable power supplies (UPS), air-cooled chillers, and physical security
Timberland REITs: focus on facilities for harvesting and selling timber
Specialty REITs: own and manage real estate that doesn’t fit within a specific sector; some examples are outdoor advertising sites, movie theaters, and farmland
Diversified REITs: own and operate a mix of property types; some, for example, hold portfolios consisting of office and healthcare properties; diversified REITs are ideal for investors looking to gain exposure to different real estate asset types
These companies lend money to property owners through loans or mortgage-backed securities. They earn revenue primarily through what is called the net interest margin. This is the difference between the mortgage interest and the cost of funding these loans. Net interest margin can show how successful a company’s investment decisions are relative to its debt situation.
Mortgage real estate investment trusts are sensitive to interest rate fluctuations.
Both types of REITs can be classified further into:
These REITs are registered with the Securities and Exchange Commission (SEC). Their shares are listed on a public exchange, where investors can buy and sell them.
These real estate investment trusts are also registered with the SEC, but don’t trade on exchanges. This makes them less liquid than publicly traded REITs, but more stable because they’re not usually impacted by market volatility.
Investors can buy shares of non-traded REITs from a broker or financial advisor.
These companies aren’t registered with the SEC. They also don’t trade on public exchanges. Private REITs can be sold only to institutional investors.
Because of the unregulated nature of the market, private REITs are also more at risk of investment fraud compared to their publicly traded and non-traded counterparts.
Check out this guide if you want to learn more about the basics of real estate investing.
Investing in a real estate investment trust shares several similarities with investing in mutual funds in that:
Most real estate investment trusts earn income by leasing properties and collecting rent. For mortgage REITs, revenue comes from loan interests. The income is then paid out to shareholders in the form of dividends.
As a rule, REITs must pay out at least 90% of their taxable income to shareholders. Many trusts even pay out their entire taxable income. Dividends are considered taxable income for the shareholders.
REITs can be a sound investment option for investors who want exposure to the real estate market but don’t have sufficient funds to purchase property. Investing in REITs also suits those who don’t have the time or patience to deal with the troubles of owning and maintaining real estate property.
Check out our picks for the best books on real estate investing if you want to find useful resources about REITs.
Generally, REIT investing follows a straightforward process. Here are some of the ways to invest in real estate investment trusts:
One of the simplest methods is to buy shares in REIT, which you can find on major stock exchanges. This works just like purchasing any other public stock. If you’re looking for options, this article lists the 10 best REIT stocks to invest in.
You may also choose to buy shares in a REIT mutual fund or exchange-traded fund (ETF). Recent data from Nareit shows that around 170 million Americans live in households invested in REITs. Many have gained access through mutual funds and ETFs in their 401(k), IRAs, and pension plans.
If you’re not yet comfortable picking investments on your own, you can consult with a broker, investment advisor, or financial planner. These experts can help guide you in choosing REIT investments that best suit your financial goals.
If you’re looking for a financial professional to assist you in your investment journey, our Best in Wealth Special Reports Page is the place to go. Our special reports feature only vetted financial experts who are considered reliable and respected leaders in the industry.
Because each investor comes with their own investment goals and financial circumstances, there is no one-size-fits-all answer to this question. However, a few studies recommend having a portfolio consisting of between 4% and 18% real estate investment trusts:
In his book Unconventional Success: A Fundamental Approach to Personal Investment, the late David F. Swensen recommended a 15% allocation to REITs for most investors. Swensen was the chief investment officer at Yale University from 1985 until his death in 2021.
A poll conducted by Chatham Partners, meanwhile, has found that financial advisors see between 4% and 12% REIT allocation as ideal. This is regardless of an investor’s age.
Another analysis from Morningstar suggested around 5% to 18% of an investment portfolio consisting of REITs. The allocation, however, must be based on the investor's risk tolerance and time horizon.
If you’re interested in investing but don’t know where to start, this primer on how to invest for beginners can help kickstart your investment journey.
Apart from the simplicity and ease of the investment process, adding REITs to your portfolio comes with several advantages. These include:
Higher dividends: REITs often pay higher dividends than other types of equities because of how they’re structured. IRS rules require REITs to return 90% of their taxable income to investors. This helps keep the trusts’ taxes lower, leaving more earnings available for dividends.
Liquidity: Unlike traditional real estate investments, most REITs are publicly traded like stocks. This makes them highly liquid.
Portfolio diversification: REITs, however, follow a different cycle than stocks. The real estate cycle usually lasts around 18 years. This is longer than the regular economic business cycle of about four to five years. That’s why when stocks lose value due to a recession, there’s a good chance that REITs will outperform them.
Hedge against inflation: Real estate investment trusts provide natural protection against inflation. This is because lease and rental payments tend to increase in line with price increases. This built-in REIT feature also supports dividend growth.
Investing in RIETs also has its share of disadvantages, including:
Dividend taxes: As mentioned, REITs are able to pay higher dividends because they don’t have to pay corporate taxes. The downside to this is that REIT dividends are often taxed at the same rate as ordinary income. Depending on your tax bracket, the amount can be significant.
Sensitivity to interest rates: Real estate investment trusts, especially mortgage REITs, are sensitive to changes in interest rates. A rise in interest rates can negatively impact the price of REIT stock.
Little control over investments: If you choose to invest in a REIT mutual fund or ETF, you don’t have any say in where the trust invests your money. And since you don’t own real estate, you also don’t have control over the properties.
High fees: While publicly traded REITs don't often have fees beyond trading commissions – which many online brokers no longer charge – non-listed and private REITs are different. These types of real estate investment trusts can charge as high as 11% in upfront costs. Private REITs may also charge 2% in annual management fees.
To learn more about whether REITs are a good investment option in today's economy, listen to this podcast hosted by our very own Bruce Kelly:
With the potential to provide high, regular returns, REITs can be a great addition to your investment portfolio. The instant diversification that real estate investment trusts provide serves as good protection against potential losses.
But just like other types of investment, investing in REITs comes with risks. Some types of investments can be sensitive to changes in interest rates and may charge fees that could eat into your returns. You are also required to pay income taxes on any dividends you receive, unless the investments are held in a tax-advantaged account like an IRA.
Before investing in REITs, it’s crucial that you first weigh the benefits and disadvantages of doing so. It’s also important to determine how a real estate investment trust fits your financial goals.
Visit our Investing News Section for more information on REIT investing and other types of investment strategies. Be sure to bookmark this page for easy access to breaking news and the latest industry updates.
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