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What Is a REIT? A Simple Guide to Real Estate Investing

By Finkerr #how do reits work, #investing in real estate, #real estate investment trust, #reit dividends, #reit explained, #types of reits
An illustration of a stock ticker symbol. The ticker is transparent and contains a portfolio of buildings inside. This symbolizes a Real Estate Investment Trust (REIT), which is a company that owns property but trades on the stock market like a single stock.

Introduction

Investing in real estate has a timeless appeal. It offers the satisfaction of owning tangible, physical assets. It also provides the potential for a steady stream of rental income and long-term appreciation in value. However, for most individual investors, the barriers to direct real estate ownership are incredibly high. It requires a massive down payment. It also involves the ongoing headaches of property management, maintenance, and dealing with tenants. Furthermore, a physical property is a very illiquid asset, meaning it cannot be easily or quickly converted into cash.

What if there was a way to get all the benefits of real estate investing without any of these major drawbacks? Fortunately, there is. It is called a Real Estate Investment Trust, or REIT. A REIT is a special type of company that allows anyone to invest in a large and diversified portfolio of income-producing real estate. You can do this just as easily as buying a share of your favorite stock. This guide will clearly define what a REIT is. We will also explain how they work and the different types that exist. In addition, we will discuss the key benefits and the risks of adding REITs to your investment portfolio.

Defining the REIT: A Landlord in a Stock

First, let’s establish a clear definition. A REIT, which stands for Real Estate Investment Trust, is a company that owns, operates, or finances income-producing real estate properties. REITs are modeled after the concept of mutual funds. They allow individual investors to pool their money together. This allows them to invest in a large-scale portfolio of real estate assets that they could never afford to buy on their own.

The single most important rule that defines a REIT is its dividend requirement. To legally qualify as a REIT and to avoid paying corporate income tax, a company is required by law to pay out at least 90% of its taxable income to its shareholders. This income is paid out in the form of regular dividends. This special tax rule is what makes REITs some of the most powerful and reliable income-generating investments available on the market.

Think of a REIT with this simple analogy.

  • Imagine a mutual fund holds a large basket of different stocks.
  • A REIT is a similar type of company. However, instead of holding a basket of stocks, it holds a basket of large-scale, physical properties. This could include shopping malls, apartment buildings, office towers, and warehouses.
  • When you buy a share of a publicly traded REIT, you become a part-owner of all those properties.
  • You are then entitled to receive your proportional share of the total rent that is collected from all the tenants in all of those buildings. It is like becoming a major commercial landlord, but without ever having to fix a leaky faucet or screen a new tenant.

The Different Types of REITs

The world of REITs is incredibly diverse. They are typically categorized by the types of properties they own or by their business structure.

Equity REITs

This is the most common and well-known type of REIT. Equity REITs are companies that directly own and operate physical real estate properties. Their revenue comes primarily from collecting rent from the tenants who occupy their buildings. Equity REITs are often specialized in a specific property sector. Some of the major sectors include:

  • Retail REITs: These REITs own and manage shopping malls, outlet centers, and neighborhood strip malls.
  • Residential REITs: These companies own and operate large multi-family apartment buildings and manufactured home communities.
  • Office REITs: These REITs own and manage large office buildings, typically in the central business districts of major cities.
  • Industrial REITs: These REITs own warehouses, distribution centers, and logistics facilities. The growth of e-commerce has made this a very important and successful sector.
  • Healthcare REITs: These REITs own a variety of medical-related properties, such as hospitals, senior living facilities, and medical office buildings.
  • Other Specialized REITs: There are also many other types, including REITs that specialize in data centers, cell towers, and self-storage facilities.

Mortgage REITs (mREITs)

Mortgage REITs do not own physical property. Instead, they operate on the financing side of the real estate industry. They provide financing for real estate by originating or purchasing mortgages and mortgage-backed securities. They earn their income from the interest that is paid on these mortgage investments. It is important to know that mREITs are generally considered to be more complex and to carry a higher level of risk than standard Equity REITs.

Publicly Traded vs. Non-Traded REITs

The vast majority of REITs are publicly traded. This means their shares are listed and traded on major stock exchanges, just like any other stock. This makes them a very liquid investment. In contrast, there are also private or non-traded REITs. These are not traded on a public exchange and are very illiquid. They are generally not suitable for beginner investors.

The Key Advantages of Investing in REITs

Including REITs in your portfolio can offer several powerful benefits.

  1. High Dividend Income: As mentioned, the legal requirement to pay out at least 90% of their taxable income makes REITs some of the highest-yielding dividend payers in the entire stock market. This makes them a very attractive option for retirees and other investors who are focused on generating a steady stream of passive income.
  2. Portfolio Diversification: Real estate is a distinct asset class. Its performance is driven by different factors than the broader stock and bond markets. For example, the value of real estate is often tied to local economic conditions and property markets. The stock market, in contrast, is more influenced by corporate profits and global economic trends. Because of this, the prices of REITs often move independently from the prices of other stocks. This can help to reduce the overall volatility of a diversified portfolio.
  3. Liquidity: Direct real estate is a famously illiquid asset. It can take many months to sell a physical property. Publicly traded REITs, however, offer a liquid way to invest in this illiquid asset class. You can buy or sell your shares of a massive real estate portfolio on a stock exchange at any time during market hours, just as easily as you can with any other stock.
  4. Professional Management: The properties that are held within a REIT are selected, managed, and maintained by a team of experienced real estate professionals. This saves you from the considerable time, effort, and stress of being a direct landlord.

The Risks and Considerations

While REITs offer many benefits, they are not without their own unique set of risks.

  • Market Risk: Like all stocks, the share prices of publicly traded REITs can be volatile. Their prices will fall during a broad market downturn or a bear market, regardless of how well their underlying properties are performing.
  • Interest Rate Sensitivity: REITs often use a significant amount of debt to finance the purchase of their properties. When market interest rates rise, their borrowing costs increase. This can reduce their profitability and, in turn, their ability to pay high dividends. In addition, when interest rates on safer assets like bonds are high, the high dividend yields on REITs become less attractive to investors by comparison.
  • Economic and Sector-Specific Risks: The performance of a REIT is directly tied to the health of the economy and, more specifically, to the health of its particular real estate sector. For example, a major economic recession can lead to higher vacancy rates in office buildings and shopping malls. The long-term rise of remote work has also created specific and ongoing challenges for Office REITs.
  • Taxation of Dividends: It is important to know that the dividends paid by REITs are typically not considered “qualified dividends.” As a result, they are usually taxed at the investor’s higher, ordinary income tax rate. This can make REITs a more suitable investment to hold within a tax-advantaged retirement account, such as an IRA.

Conclusion

In conclusion, Real Estate Investment Trusts are a powerful and accessible tool for the modern investor. They have successfully democratized real estate investing. They allow anyone to own a piece of a large, professionally managed portfolio of income-producing properties with the same ease and convenience as buying a stock.

REITs can be an excellent addition to a well-diversified portfolio. They offer the potential for high and consistent dividend income. They can also provide long-term capital appreciation and valuable diversification benefits. However, like all investments, they also come with their own unique set of risks that you must be aware of, particularly their sensitivity to interest rates and the health of the broader economy. By understanding how REITs work and the different types that are available, you can make an informed decision about whether this unique asset class has a place in your long-term investment strategy.