Getting into real estate doesn’t always mean buying property or becoming a landlord, one of the most accessible ways to invest in real estate today is through vehicles known as REITs — Real Estate Investment Trusts.
These funds let you invest in a range of income-producing properties, like apartment buildings, shopping centers and office spaces without the hassle of ownership. If you’ve ever wondered what are REITs and how they might fit into your investment strategy, this guide will walk you through the basics, how they work, and what to keep in mind before getting started.
Key Takeaways
- REITs are companies that own, manage or finance income-generating real estate.
- Investing in REITs can provide a reliable income stream through dividends.
- You can invest in REITs through public exchanges, non-traded options or private funds.
- Unlike traditional real estate, REITs are generally more liquid and accessible.
- There are various types of REITs, including equity, mortgage and hybrid REITs.
Understanding REITs
Definition of REITs
So, what exactly is a REIT? In everyday terms, a Real Estate Investment Trust is a company that owns, manages or finances properties that generate income, things like apartment buildings, office spaces, shopping centers and even data centers, but instead of having to buy a property yourself, which can be expensive, complicated and time-consuming, REITs offer a way to invest in real estate without all the traditional barriers.
Think of it like this: just as mutual funds let you invest in a basket of stocks, REITs let you invest in a portfolio of real estate assets, you’re buying shares of a company that’s in the business of real estate and in return, you get a piece of the income it generates.
This is one of the simplest ways for everyday investors to gain exposure to the real estate market, without ever having to deal with tenants, toilets, or the paperwork of being a landlord.
Key Characteristics of REITs
REITs have a few defining features that set them apart.
- First, they’re all about generating income, most REITs lease space and collect rent, then pass that income on to shareholders as dividends.
- Second, they invest in a variety of properties, from apartment buildings and shopping malls to data centers and cell towers.
- Third, they’re required to distribute a significant portion of their taxable income to shareholders, which makes them attractive for income-seeking investors.
REITs were created to make real estate investing more accessible. They allow smaller investors to participate in large-scale real estate ventures, something that was previously out of reach for many.
Types of REITs
There are several different types of REITs, each with its own focus. Here’s a quick rundown:
- Equity REITs: These are the most common type. They own and operate income-producing properties.
- Mortgage REITs: Instead of owning properties, these REITs finance them. They earn money from the interest on mortgages and other real estate loans.
- Hybrid REITs: As the name suggests, these REITs combine both equity and mortgage investments.
It’s worth noting that most REITs are publicly traded, meaning you can buy and sell shares on a stock exchange. However, there are also non-traded and private REITs, which are less liquid and may have higher minimum investment requirements.
Benefits of Investing in REITs
REITs can be a pretty interesting way to get into real estate without, you know, actually buying buildings. There are some solid reasons why people put their money into them.
Let’s break down some of the main perks.
Steady Income Stream
One of the biggest draws of REITs is the potential for a consistent income stream. REITs are required to distribute a large chunk of their taxable income (usually around 90%) to shareholders as dividends.
This can be super appealing if you’re looking for investments that pay out regularly, it’s like being a landlord, but without the hassle of fixing leaky faucets or dealing with tenant complaints, of course dividend amounts can fluctuate based on the REIT’s performance and the overall market, but the general idea is a reliable payout.
Portfolio Diversification
Another cool thing about REITs is how they can help diversify your investment portfolio. They don’t always move in sync with stocks and bonds, so adding them to your mix can potentially lower your overall risk.
Think of it like this: if your stock portfolio takes a hit, your REIT investments might hold steady or even increase in value, which can help cushion the blow. It’s all about not putting all your eggs in one basket, REITs invest in real estate portfolios.
Accessibility for Investors
This is a good tool to make real estate investing accessible to pretty much anyone, you don’t need a ton of cash to get started and you don’t have to be a property management guru, you can buy shares of publicly traded REITs just like you would any other stock.
This means you can get exposure to the real estate market with a relatively small investment and without the headaches of direct property ownership plus REITs offer attractive risk-adjusted returns.
Investing in REITs can be a good way to generate income, diversify your investments, and get into the real estate game without a huge upfront investment or the need to manage properties directly. However, like any investment, it’s important to do your homework and understand the risks involved before diving in.
How to Invest in REITs
REITs have opened up real estate investment to pretty much everyone, instead of needing a ton of cash to buy a building, you can invest in REITs with much less. They function a bit like mutual funds, but for real estate, you can earn money through dividends or if the share price goes up.
Publicly Traded REITs
These are the most common and easiest to get into, publicly traded REITs are listed on major stock exchanges, just like regular stocks, you can buy and sell shares through a brokerage account, it’s pretty straightforward, just pick a REIT, do some research and buy shares.
Keep in mind that, like any stock, the price can go up or down based on market conditions.
- They’re regulated by the SEC.
- They’re easy to buy and sell.
- Their prices can be volatile.
Non-Traded REITs
Non-traded REITs are registered with the SEC, but they don’t trade on public exchanges. This means they’re less liquid, you can’t just sell your shares whenever you want.
They tend to be more stable because they aren’t subject to the daily ups and downs of the stock market, you usually buy shares through a broker or financial advisor who’s participating in the offering.
- They’re less liquid than publicly traded REITs.
- They’re not subject to market volatility.
- You buy them through a broker or advisor.
Private REITs
Private REITs aren’t registered with the SEC and aren’t available to the general public. They’re usually only open to accredited investors, people with high incomes or net worth.
However they’re not regulated like public REITs, so they can be riskier, but they also might offer higher potential returns. Accessing these usually requires connections or a specialized financial advisor.
Investing in REITs can be a good way to diversify your portfolio and earn income, but it’s important to do your homework and understand the risks involved. Look at the portfolio, management, debt and dividend history before you invest and remember that REITs are usually best for long-term investing.
What Qualifies As a REIT
Most REITs make money by leasing out space, collecting rent and then passing that income to their shareholders as dividends. There are also mortgage REITs which focus on financing real estate instead of owning it directly, but they’re a smaller part of the REIT world. To actually be a REIT, a company has to meet a bunch of rules set by the IRS.
This is not just about owning property, there are specific requirements they need to follow to get those sweet tax benefits.
Income Requirements
REITs have to meet certain income thresholds to maintain their status. Basically, a big chunk of their income needs to come from real estate-related activities. To be exact, at least 75% of a REIT’s gross income must come from real property rent, interest on mortgages that finance real property or gains from selling real estate.
Also, 95% of a REIT’s gross income must come from the sources described in the 75% test plus earnings from specific types of portfolio income, like interest, dividends and gains from selling securities. For compliance, REITs may create a TRS to hold property or receive income that does not qualify under various tests.
This ensures they’re really in the real estate business, not just dabbling. It’s a way to make sure they’re focused on real estate investments.
Distribution Requirements
There is a requirement to distribute a significant portion of their taxable income to shareholders, specifically they need to pay out at least 90% of their taxable income as dividends each year. This is a key part of the deal in exchange for special tax treatment, they pass the income directly to investors.
This requirement is generally not an issue as long as a REIT has sufficient cash flow. There is a mechanism in the tax code where a lack of adequate cash flow will not cause a failure in the REIT’s status. However, the election does require the shareholders to agree to recognize the income reported on the tax returns.
Ownership Requirements
There are also rules about who can own a REIT and how it’s structured. Here’s a quick rundown:
- It has to be a corporation, trust or association. LLCs can elect to be treated as corporations.
- It needs to be managed by a board of directors or trustees.
- It must have at least 100 shareholders starting with the second taxable year (100 shareholders must exist for at least 335 days each year after the initial year).
- No more than 50% of the REIT’s shares can be owned by five or fewer individuals during the last half of each tax year. This is often called the “5 or fewer” test. Within the provisions of the REIT and related structures, it is a common practice to limit the amount of ownership an individual may maintain to less than 10% of the total shares to ensure a REIT maintains the provisions of the “5 or fewer” test.
These rules are in place to make sure REITs are widely held and not controlled by just a few people. They’re designed to ensure that REITs are accessible to a broad range of investors and operate with a certain level of transparency.
There are also asset tests, under the Section 856(c)(4), 75% of the value of the total assets of a REIT at the close of each quarter of a taxable year must consist of qualifying assets.
The term “total assets” means gross assets of the REIT determined according to U.S. GAAP, qualifying assets of the REIT are represented by one or more real estate assets, government securities, cash and cash items and receivables. A pension-held real estate investment trust is defined as a REIT that would not qualify as such without the involvement of a pension fund.
Differences Between REITs and Traditional Real Estate
Liquidity and Accessibility
One of the biggest differences between REITs and traditional real estate is liquidity, REITs are much easier to buy and sell because many are traded on major stock exchanges.
This means you can convert your investment back into cash relatively quickly, on the other hand, traditional real estate can take weeks or even months to sell.
The work of finding a buyer, negotiating terms and closing the deal all take time plus with REITs, you can invest with significantly less capital than buying a physical property. This accessibility for investors makes them a great option.
Management Responsibilities
When you own traditional real estate, you’re responsible for everything. This includes finding tenants, handling repairs and dealing with property taxes. It can be a lot of work! REITs, however, are professionally managed and you don’t have to worry about the day-to-day hassles of property management.
The REIT’s management team takes care of everything, allowing you to sit back and collect potential dividends.
Investment Minimums
Investing in traditional real estate often requires a significant down payment, closing costs and other expenses. This can be a barrier to entry for many people. REITs, on the other hand, typically have much lower investment minimums. You can often buy shares of a REIT for just a few dollars, making it a more accessible investment option for those with limited capital.
REITs offer a way to invest in real estate without the headaches of direct property ownership. They provide liquidity, professional management and lower investment minimums, making them an attractive option for a wide range of investors. However, it’s important to remember that they also come with their own set of risks, such as market volatility and interest rate sensitivity.
Risks Associated with REIT Investments
Like any investment, REITs aren’t without their downsides, it’s important to understand these risks before jumping in.
While they can offer steady income and diversification, they’re also subject to market conditions and other factors that can impact their performance. Let’s take a look at some of the key risks involved.
Market Volatility
The ones that especially are publicly traded, can be sensitive to overall market swings, if the stock market takes a hit, the REIT prices can fall too, even if the underlying real estate is doing fine.
This volatility can be unnerving for investors, especially in the short term, it’s a good idea to have a long-term perspective when investing in REITs to ride out these ups and downs, market risk could lead to poor performance if the market downturns.
Interest Rate Sensitivity
They often rely on borrowing money to finance their property holdings.
When interest rates rise, their borrowing costs go up, which can squeeze their profits. This can lead to lower dividends for investors and potentially a decrease in the REIT’s share price, rising interest rates can impact a REITs performance, leading to higher borrowing costs and cash flow restraints.
Sector-Specific Risks
REITs often specialize in specific types of real estate, such as office buildings, retail spaces or apartments, if a particular sector faces challenges, the performance can suffer.
For example, a REIT focused in downtown office spaces might struggle if more companies switch to remote work. It’s important to consider the specific sectors a REIT invests in and the potential risks associated with those sectors.
Investing in REITs requires careful consideration of your risk tolerance and investment goals. It’s not a guaranteed path to riches and there are potential downsides to be aware of. Moreover, doing your homework and understanding the risks involved can help you make informed decisions and manage your portfolio effectively.
Here are some risks to keep in mind:
- Economic Downturns: A recession can lead to decreased demand for real estate, impacting rental income and property values.
- Property Management Issues: Poor management of properties within a REIT can lead to lower occupancy rates and reduced profitability.
- Regulatory Changes: Changes in tax laws or real estate regulations can affect the profitability and structure of REITs.
The Future of REITs
It’s interesting to think about where REITs are headed the real estate market is always changing, and technology is playing a bigger role than ever plus regulations can shift, which can really impact how REITs operate. Let’s take a look at some of the things that could shape their future.
Trends in the Real Estate Market
The real estate market is always in motion, right now we’re seeing shifts in what types of properties are popular. For example, with more people shopping online, traditional retail spaces are changing, on the other hand, data centers and warehouses are becoming more important because they support e-commerce.
REITs that can adapt to these trends will likely do well. It’s important to keep an eye on these changes to understand where the opportunities are.
Impact of Technology
Technology is changing everything, and REITs are no exception. Think about how property management is evolving with new software and tools. Also, things like smart buildings and the Internet of Things (IoT) are becoming more common.
These technologies can help REITs operate more efficiently and attract tenants. The rise of online real estate platforms is also making it easier for people to invest in REITs, it’s a pretty big deal.
Regulatory Changes
Regulations can have a big impact on REITs, tax laws, for example, can change how they are structured and how they distribute income to shareholders.
Also, environmental regulations can affect the types of properties that REITs invest in, staying on top of these regulatory changes is important for both REITs and investors. It can be a bit dry, but it’s necessary.
It’s worth noting that the future of REITs isn’t set in stone. There are a lot of factors that could influence how they evolve, but by understanding the trends, technology, and regulations that are shaping the market, investors can make more informed decisions.
Wrapping It Up
In summary, REITs are a solid way to get into real estate without the hassle of buying and managing properties yourself.
They let you invest in a variety of real estate sectors, from apartments to office buildings, all while providing a steady income stream.
Sure, there are risks involved, like market fluctuations, but the potential for dividends and portfolio diversification can make them appealing.
Whether you’re a seasoned investor or just starting out, understanding what are REITs can help you make smarter choices in your investment journey. So, if you’re looking for a way to dip your toes into real estate, consider giving them a shot.
Frequently Asked Questions
What is a REIT?
A REIT or Real Estate Investment Trust is a company that owns, manages or finances properties that make money, like apartments or shopping malls. It lets people invest in real estate without buying properties themselves.
How do REITs make money?
REITs earn money mainly from renting out properties and collecting rent. They can also make money by financing real estate projects.
What are the benefits of investing in REITs?
Investing in REITs can provide a steady income from dividends, help diversify your investment portfolio, and allow you to invest in real estate without needing a lot of money.
How can I invest in a REIT?
You can buy shares of publicly traded REITs on stock exchanges or you can invest in non-traded or private REITs through brokers or financial advisors.
What are the risks of investing in REITs?
REITs can be affected by market changes, interest rates and specific sector issues, which can impact their performance and returns.
Are REITs a good investment for beginners?
Yes, REITs can be a good choice for beginners because they offer a way to invest in real estate without needing large amounts of money or property management experience.
