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Real Estate Investment Trusts (REITs) — Definition, Types, Pros & Cons

For many, real estate represents the ultimate investment. It can generate both passive income and appreciation, boasting a long track record of strong returns. One joint study by the German central bank and several U.S. universities compared real estate returns with other asset classes like stocks and bonds over nearly 150 years, and found real estate combined the highest returns with low volatility and risk.

And let’s be honest, there’s just something satisfying about looking at a building you own, versus staring at shares of stock on a computer screen.

But direct real estate investment comes with several barriers to entry: hefty down payments; financing challenges; the necessary cash reserves for maintenance and repairs; and requirements of substantial knowledge, skills, time, and education in order to succeed. Those barriers to entry are precisely what keeps the returns strong by preventing overcompetition.

Fortunately, today you can invest in real estate indirectly, without owning individual properties. Known as a real estate investment trust (REIT), it allows anyone to invest in real estate without special skills, insider knowledge, or mountains of idle cash.

What Is a REIT?

A REIT is a corporation that invests in real estate, and which raises money from shareholders. They operate much like a mutual fund or exchange-traded fund (ETF), except they invest in properties rather than paper assets. Depending on the type of REIT, they do this directly through the purchase of real estate, or indirectly by providing loans or purchasing preexisting mortgage contracts.

These funds tend to offer exceptionally high dividend yields because publicly traded REITs must disburse at least 90% of their profits to shareholders in order to avoid corporate income tax. Not all REITs trade on public stock exchanges however, and private REITs don’t fall under this restriction.

REITs typically fall into three categories: equity REITs, mortgage REITs, and hybrid REITs.

1. Equity REITs

The most popular and well-known type of REIT, equity REITs focus on acquiring, managing, and developing investment properties. Because REIT restrictions require that properties are held and developed over a long period of time, their main source of revenue is rental income from their holdings. They usually specialize in one specific type of property, such as:

  • Office and Industrial
  • Retail
  • Residential
  • Hotel and Resort
  • Health Care
  • Self-Storage
  • Raw Land

2. Mortgage REITs

Not as popular as equity REITs, mortgage REITs or mREITs don’t own properties directly. Instead, they lend money to real estate investors or buy existing mortgage loans on properties. They primarily earn revenue from interest on the loans they hold.

3. Hybrid REITs

A combination of both equity and mortgage REITs, hybrid REITs diversify by both owning properties and issuing loans to real estate investors. Thus, they generate revenue from both rents and loan interest.

Publicly Traded vs. Private REITs

As touched on above, some REITs trade on public stock exchanges, while others sell shares privately to investors. But the differences don’t end at the way that you buy shares.

Publicly Traded REITs

Publicly traded REITs are registered with the U.S. Securities and Exchange Commission (SEC) and listed on a national stock exchange. You can buy shares through your regular brokerage account (we like SoFi Invest), or through tax-sheltered accounts like an IRA.

That makes them extremely easy and transparent to buy and sell. You can set limit orders or stop-loss orders, trading shares of these REITs just like stocks. It also means instant liquidity, as you can buy and sell shares at a moment’s notice.

These types of REITs tend to be large and diversified, owning a wide range of properties or loans — or both, in the case of hybrid REITs. When market conditions change, share prices respond immediately because they trade like stocks.

And, of course, SEC oversight means strict regulation and transparency.

But public REITs come with their own downsides and limitations. Share price can be heavily influenced by market conditions versus the actual value of the underlying properties. As a result, investors may experience volatility in a publicly traded REIT portfolio, and a higher correlation to stock price swings. That means real estate diversification through public REITs provides less protection than directly owning properties.

Like mutual funds and ETFs, REITs charge investors fees in the form of an expense ratio. The extra expense to run a publicly traded fund can lower your returns.

What I actually find the greatest downside to publicly traded REITs however is the dividend requirement, which mandates that these companies funnel 90% of profits back to investors immediately. That makes it nearly impossible for them to build their portfolios without taking on more debt or investors, because they can’t put their profits toward buying more properties. Which in turn limits public REITs’ growth potential.

Private REITs

Although private REITs are still regulated by the SEC, they fall under different rules. Most operate as crowdfunded real estate investments, which are regulated differently than publicly traded investments listed on stock exchanges.

Some private REITs only allow accredited investors to participate. Although that requirement blocks most Americans from investing, the SEC allows far less regulation for accredited investors. These investors must meet minimum net worth or income requirements to qualify — currently a net worth of $1 million (not including equity in their home) or income of $300,000 per year for married couples ($200,000 for singles).

Shares in private REITs are typically designed to be held long-term — usually five years at minimum, depending on the REIT strategy — and pay a predeclared target dividend. Remember, real estate is inherently a long-term investment given its poor liquidity and daunting entry and exit costs. Unlike their publicly traded counterparts, investors can’t sell shares upon major changes in share value. In turn, that means that “appreciation” exists on paper only until the day you can actually cash out your shares.

This type of REIT sometimes raises money for the first few years and then closes its doors to new investors. There are four common ways the fund may be unwound, either before or after the holding period is over:

  1. The REIT could be acquired by a larger publicly traded REIT with the sale profits passed along to shareholders.
  2. The REIT could sell individual properties and pass a predetermined portion of the profits to the shareholders.
  3. The REIT could go public, in which case the investors would receive new shares that would be sold on an exchange, theoretically for a much higher price.
  4. If the economy dictates that none of these options are profitable, the REIT, by way of shareholder voting, could extend the normal operations until market conditions improve.

The set share price eliminates the daily price fluctuations and volatility associated with publicly traded REITs. Private REITs sometimes pay higher dividends, usually distributed monthly or quarterly. Their lesser regulation allows for lower overhead, which in turn often means lower fees and higher dividends.

It also leaves these REITs more flexibility to reinvest money in new properties and grow share prices.

But share prices and dividends are far from guaranteed, despite being “set.” Private REITs sometimes cut dividends and reduce share values in economic downturns, increased vacancies in their properties, or other weak market conditions.

Because private REITs are not publicly listed, they’re subject to less supervision. That sometimes means less financial transparency of fund operations.

Advantages of REITs

Like all investments, REITs come with advantages and disadvantages that you should weigh before investing a single dollar.

1. Diversification

With a few dollars thrown into a REIT, investors can diversify their asset allocation to include real estate. Rather than investing only in stocks and bonds, investors can add the potentially high returns of real estate without the volatility and risk of stocks. And real estate also enjoys low correlation with stocks, offering true protection from market fluctuations.

Investors can also easily diversify within the real estate market by owning interest in many properties, across multiple sectors. From commercial property to industrial warehouses, retail buildings to apartment complexes, investors can take a small amount of money and spread it across property types. In many cases these funds include large properties like office buildings or hotels that individual investors couldn’t otherwise access.

For that matter, REITs also let you diversify geographically. They allow you to buy fractional ownership of properties in many cities, states, and even countries. Overseas investors, sometimes restricted from owning property directly in another country, can buy ownership interest there via a REIT.

2. Strong Income Yields

As outlined above, REITs tend to pay out high yields in the form of dividends.

For example, Fundrise currently pays around 3% in regular dividends, plus 5% to 6% average appreciation. Commercial REIT Streitwise aims for a dividend between 8% to 9%.

Anyone looking to build passive income and reach financial independence can look to REITs to help supplement their other passive income sources.

3. High Liquidity

When you buy a property directly, it takes months and many thousands of dollars to sell.

When you buy shares of a publicly traded REIT, you can sell them at a moment’s notice.

Even private REITs often allow better liquidity than direct property ownership. Many simply offer to buy shares back at a small discount, if you want to sell within the first few years.

4. No Acquisition or Management Headaches

As a real estate investor myself, I can assure you that buying, managing, and selling properties is a royal pain.

Tenants call you at 3am to complain that a light bulb blew out. Furnaces break down in February. Termites get behind the walls and eat through the framing.

When you buy shares of a REIT, you don’t have to hassle with any of that. A professional team of investors and property managers handle all the acquisition and management headaches, so you can simply sit back and collect the returns.

5. Depreciation Can Offset Dividend Taxes

Typically, investors pay taxes on dividends the year they’re received and as ordinary income. When depreciation expenses are passed down by the REIT, those expenses are viewed as a return of capital to the shareholder and offset an equal portion of shareholder dividends. This delays the payment of taxes on that portion of dividends until REIT shares are sold.

For example, if a shareholder receives a $100 dividend, but can claim $10 of that as a depreciation expense, the shareholder would only pay income tax on $90 that year.

You do pay taxes on the subtracted $10 as a capital gain later. But you pay the lower capital gains tax when you sell shares, as long as you’ve owned them for at least a year. Because ordinary income is taxed at a much higher rate than capital gains, this is a major advantage over the tax treatment of normal REIT dividends.

Disadvantages of REITs

Real estate investment trusts come with their fair share of downsides too.

Make sure you understand the following drawbacks before investing your hard-earned dollars in a REIT.

1. Weak Growth

Publicly traded REITs must pay out 90% of their profits immediately to investors in the form of dividends. That leaves little money for growing the portfolio by buying more properties — the activities that drive appreciation.

If you like the concept of investing in REITs but want appreciation in addition to dividends, look to private REITs.

2. No Control Over Returns or Performance

Direct real estate investors have a great deal of control over their returns. They can cherry-pick properties with strong cash flow, aggressively market vacant rentals to tenants, thoroughly screen all applications, and implement other property management best practices.

But REIT investors can only sell their shares if they don’t like the performance. In the case of some private REITs, they can’t even do that, at least for the first few years.

3. Yield Taxed as Regular Income

Although profits on investments held longer than a year are taxed at the lower capital gains tax rate, dividends are taxed at the (higher) regular income tax rate.

And with much of the returns from REITs coming in the form of dividends, that can leave investors with a higher tax bill than more appreciation-oriented investments.

4. Potential for High Risk and Fees

Just because an investment falls under SEC regulation doesn’t make it low-risk. Do your due diligence before investing and consider all factors in the real estate market — such as property values, interest rates, debt, geography, and changing tax laws.

For that matter, include fees in that due diligence. Some REITs charge high management and transaction fees, leading to lower payouts for shareholders. Often, they bury those fees in the fine print of the investment offering, so prepare to pull out the magnifying glass and hunt down what they pay themselves for property management, for acquisition fees, and so forth.

Tips for Investing in REITs

Real estate investment trusts can provide excellent income and growth opportunities for the right investor. Consider these tips to ensure you come out ahead when investing in REITs.

Understand Exactly What You’re Investing In

What types of properties does a REIT invest in? Where? Does the REIT invest directly or by lending, or both? How and when can you sell your shares, and under what restrictions?

Most REITs specialize in a certain sector which should be easy to find in the fund summary. Understand the risks of each sector. For example, REITs holding undeveloped land or retail shopping centers in a bad economy likely carry more risk than mid-range apartments in a growing metropolis.

Review the Numbers

Yes, you almost certainly checked the income yield before anything else. But are dividends being paid from operations, or is the fund being forced to use additional capital?

A well-run REIT should rely on its operations to pay for expenses and dividends. Also, stay wary of large, one-time real estate sales that might skew the financials upwards.

Research the REIT’s History

When did the REIT start buying properties?

New REITs may have only operated in a growing market, and their strong yields could reflect luck or market strength rather than investing prowess. The true test of any investor lies in their performance during downturns and bear markets.

Besides, if the REIT bought up properties before a market downturn, they could find those properties underwater once the market drops. In such cases, REITs may need to lower dividends or sell additional shares in order to raise cash in the near future. However, if the fund was created after a housing market recession, it could own and be buying valuable properties at bargain prices.

Finally, research the people actually choosing the investments. Read everything you can about their experience, both in years and in actual performance. Look for strong teams with a proven track record of success.

Know Your Time Horizon

Real estate is inherently a long-term investment. If you might need to pull your money out within the next year or two, look elsewhere for shorter-term investments.

Private REITs may not even allow you to sell shares within the first five years. If they do offer to buy back shares within the first few years, they usually do so at a discounted price from what you paid.

Even publicly traded REITs often make poor short-term investments, as they’re subject to similar volatility as stocks. Buy and hold shares of REITs, enjoy the dividends, and check on them periodically to make sure you’re still happy with the returns.

Final Word

Real estate markets grew profoundly over the 2010s, and surged as a rare bright spot during the economic devastation of the COVID-19 pandemic of 2020. But some analysts worry housing markets have burned a little too brightly, and a reckoning could lie ahead.

Regardless of the short-term swings, real estate remains a proven long-term investment opportunity. And REITs offer a simple way to diversify into real estate without the usual headaches and challenges, building passive income despite the low interest rate environment.

If you want to avoid stock market volatility and you meet minimum guidelines, private REITs could play an important role in your personal investment portfolio. As with all investments, make sure you do your homework and understand exactly where you are putting your money and why.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.