When it comes to building a well-diversified investment portfolio, there’s so much more to consider than just stocks and bonds. There are many additional asset classes that may also have a role to play in your portfolio — as potential diversifiers, income generators, growth drivers and more.
Real estate is one such asset class that can fulfill many of these needs. Unfortunately, not everyone has the capital available to purchase an investment property outright; and even those that do might not want to lock away so much of their wealth in an asset as non-liquid as physical property.
The good news is that there are ways to invest in real estate that don’t involve purchasing physical property. Buying shares of real estate investment trusts (REITs) is one such option.
Below, we take a closer look at real estate investment trusts, explain how they work and how to invest in them, and answer other common questions that investors often ask about REITs.
What is a REIT or real estate investment trust?
A real estate investment trust (REIT) is a type of company that either owns, operates or finances income-generating real estate. REITs can be privately held or publicly traded companies.
REITs can be specialized, focusing on just one or two types of real estate, or diversified, owning, operating or financing many different types of real estate. Virtually any type of real estate capable of generating income, typically in the form of rent, can be owned, operated or financed by a REIT. Popular real estate categories owned by REITs include:
- Apartment complexes
- Single-family and multi-family homes
- Hotels and motels
- Health care facilities
- Data centers
- Office buildings
- Retail centers
By law, a REIT must pass on (distribute) at least 90 percent of its income in the form of dividends, or else risk losing its status as a REIT and, by extension, the preferable tax treatment that makes the business model possible. For this reason, REITs are extremely popular among investors looking for income generation in their portfolios.
Types of REITs
There are three varieties of REITs that investors should be aware of, each with its own unique benefits, risks and means of operating: equity REITs, mortgage REITs and hybrid REITS.
An equity REIT is a business that directly owns and operates income-generating real estate. Income is typically generated through rent payments. Equity REITs are the most common type of REIT.
A mortgage REIT (also called an MREIT), by comparison, does not directly own real estate. Instead, it finances real estate. It can do this in multiple ways. For example, it can lend money directly to real estate owners and developers, or purchase mortgage-backed securities originated by other lenders. Instead of rent, MREITs generate income from interest payments on the debt that they own.
A hybrid REIT takes a page out of both playbooks, directly owning some real estate (like equity REITs) while also financing other real estate (like mortgage REITs).
How does a REIT work?
As mentioned above, a REIT is a business that either directly owns and manages real estate, or else finances it. REITs generate income either by collecting rent payments or by collecting interest payments on debt.
In order to qualify as a REIT, a business must meet a number of requirements. The most important requirements for investors to understand include:
- At least 90 percent of the company’s taxable income must be paid to shareholders each year in the form of dividends.
- At least 75 percent of the REIT’s assets must be in real estate assets and cash.
- The company must be managed by a board of trustees or directors.
- No more than 50 percent of the company can be owned by five (or fewer) shareholders.
- Shares of the company must be held by at least 100 investors after its first year.
REIT vs. real estate fund
A REIT is an individual business that owns, operates or finances real estate in order to generate income for investors.
A real estate fund, by comparison, is a type of mutual fund that specifically invests in a variety of REITs and other businesses related to real estate. Some real estate funds may also invest directly in real estate. This makes investing in real estate funds a more diversified option compared with investing in individual REITs.
While real estate funds may provide investors with dividend payments, they are not required to do so by law, and yields tend to be lower than investing directly in REITs. Real estate funds instead aim to provide value to investors through price appreciation.
How to invest in a REIT
Shares of publicly traded REITs can be bought and sold on an exchange, just like stocks and bonds. That means that all you need to do to invest in REITs is open a brokerage account. In addition to holding REITs in a taxable investment account, REITs can also be held in an IRA and, increasingly, in many 401(k)s.
Of course, investors must perform their own due diligence before making any investment decision, whether that includes investing in stocks, bonds or REITs. When evaluating REITs, you’ll want to consider their cash flow, debt levels, dividend payout history and other factors to ensure that the business is healthy.
While a REIT is itself a great way to invest in a diversified portfolio of real estate, it’s important to recognize that, at the end of the day, a REIT is a single company. Therefore, it’s typically advised that investors select multiple REITs when building their portfolio in order to properly diversify their holdings.
It’s possible to diversify by sector (buying shares of REITs which specialize in different types of real estate) as well as by REIT type (buying shares of equity REITs, mortgage REITs and hybrid REITs).
If you’re unsure about your ability to evaluate individual REITs and ensure that your portfolio is properly diversified, a financial advisor can help you build a portfolio.
REIT pros and cons
Real estate investment trusts offer investors several potential benefits, including:
- An easy and convenient way of investing in real estate without having to purchase physical property.
- You can invest in real estate without a significant amount of upfront capital.
- Diversification for a portfolio, as REITs are not highly correlated with other asset classes like stocks and bonds.
- A more diversified means of investing in real estate as opposed to purchasing a single piece of property.
- The ability to buy and sell shares just like stocks and bonds, making them a much more liquid asset than physical real estate, which may take significant time and effort to sell.
- An excellent means of income generation due to distribution requirements that they must meet.
But just like other asset classes, REITs also come with certain drawbacks that may make them less than ideal for certain investors or for certain investment scenarios. These include:
- REITs are designed to return value to shareholders through dividend payments. Because only 10 percent of taxable income can be reinvested back into the business, this limits how much the business can grow and, by extension, how much share prices can appreciate.
- Dividends that an investor receives from their REIT investments will typically be taxed at the investor’s ordinary income tax rate, which will usually be higher than the rate qualified dividends are taxed at.
- Due to the nature of how they do business, REITs tend to carry significant levels of debt, which may make some investors nervous.
- REITs are sensitive to changes in interest rates, like the broader equities market. That’s because rising rates can make it more expensive for REITs to operate.
Real estate investment trusts and your financial strategy
Real estate investment trusts can offer investors an easy and convenient means of investing in real estate. By doing so, REITs can play several important roles in an investment portfolio — most notably, as a diversifier and income generator.
Of course, REITs are only one asset class and are typically paired with others like stocks, bonds and commodities in a well-diversified portfolio. If you’re interested in REITs, a financial advisor can help you see how they can fit into your larger financial picture.
This information is for educational purposes only and is not a recommendation for any particular investment. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future performance. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.