What Are REITs?
REITs are a passive way to invest in real estate. Find out how they work, their pros and cons, and how to invest in them here.
Real estate investing can be a smart way to diversify your portfolio and see big returns. But taking the plunge and buying physical properties can be both time-consuming and expensive. This is where passive investments, like real estate investment trusts (REITs), come in.
REITs (sounds like “reets”) allow you to own shares of actual real estate properties but with a much lower barrier to entry. They’ll also pay you dividends, which can serve as a passive income source. In this article, you’ll learn how they work, what types are available, and their pros and cons. We’ll also answer frequently asked questions about the asset.
How REITs Work
REITs are companies that buy, own, and operate revenue-generating property. They pool funds from several different investors to do so, much like a mutual fund does with stocks. Typically, one will own commercial real estate, such as:
- Apartment buildings
- Office buildings
Since they’re publicly traded, you can buy REIT shares through a brokerage account, such as with Fidelity or Vanguard, or with a broker or financial advisor. Once you own shares, you’ll receive any income that its property generates in the form of dividends, or regular payments. Per the SEC, shareholders must receive at least 90% of the trust’s taxable income. Revenue normally comes from rent, mortgage interest, or property sales.
Keep in mind that, while REITs make money from real estate sales, this is generally not their true intention. The goal is for investors to pool their funds together so that the trust can buy and operate properties to create revenue.
Overall, investing in a REIT allows you to enter the real estate industry in a low-maintenance and cost-effective manner. It’ll also grant you an income-generating investment that helps diversify your portfolio.
What Qualifies as One
For a company to become a REIT, it must meet a set of criteria according to the Internal Revenue Code (IRC). Typically, this means a company must:
- Have at least 100 shareholders after the inaugural year
- Receive at least 75% of its income from rental payments, mortgage interest, or property sales.
- Be a taxable corporation.
- Be managed by a board of directors or trustees.
- Have at least 75% of its assets invested in cash, U.S. Treasuries, or real estate.
- Have 50% or less of the total shares be owned by five or fewer investors.
Four Types of REITs
There are four major types of REITs. They vary based on how you can buy and sell them, as well as the type of real estate they invest in. Here’s a breakdown of each:
- Equity REITs. These are publicly traded trusts that allow you to own shares of commercial real estate. Most of the income that it makes from property is distributed to its shareholders in the form of dividends.
- Mortgage REITs (mREITs). These allow investors to come together to finance properties, so that they may earn income from both interest and other sources, such as rent.
- Public non-listed REITS (PNLRs). While this type is registered with the SEC, it’s not listed on national stock exchanges. Because you can’t sell these on major exchanges, liquidity can be a challenge.
- Private REITs. These are both not registered with the SEC or on national stock exchanges. Typically, only institutional investors, such as pension funds or high-net-worth individuals (at least $1M in assets) can buy these.
Pros and Cons
REITs can be a smart investment, especially if you’re looking for diversification opportunities. They’re also a great way to create passive income. However, like with any other type of investment, they don’t come without their drawbacks or risks, such as volatile market conditions or lack of control.
Here’s a look at the pros and cons of investing in REITs:
- Easy to get into. REITs have a low barrier to entry. They can be relatively cheap and require little research or effort before you buy, unlike physical real estate.
- Potentially higher yields. Unlike other securities, you’ll receive regular income in the form of dividends that can boost your yield. This, coupled with a rise in value, could make for some nice returns.
- Allows for diversification. REITs afford you the chance to own shares of various types of property. They also let you own real estate within a larger portfolio that includes other securities, such as stocks or bonds.
- Passive income. Besides needing to do initial research, REITs are a relatively passive income source. They don’t require you to manage or pay money to maintain properties. Rather, you’ll simply receive dividends regularly.
- At the mercy of the market. Just like with typical real estate, investing in REITs subjects you to ever-changing market conditions. If the market goes down, your shares may be worth less.
- Interest rate risks. Changes to interest rates can significantly impact property values in the market. In turn, this could reduce your income or share value.
- Occupancy rate risks. Much of the income you make from REITs is from tenants paying rent. If occupancy rates struggle, so too could your investment.
- Not as much control. When you invest in a REIT, you forfeit the same type of control you’d have over properties you fully own. Fund managers pick the investments and manage the real estate that the company owns. If they make mistakes, the investors bear the weight of that as well.
How Taxes Work for REITs
One of the key benefits of REITs is that you’ll receive regular income via dividends. However, as a shareholder, you’re responsible for paying taxes, including capital gains. The government treats money you make from dividends as ordinary income.
The exceptions to the above tax rules are if you invest in REITs through a Roth IRA. In this case, dividends are not taxed, and you may withdraw your earnings without penalty once you reach age 59.5. 401(k)s and traditional IRAs, however, still require you to pay taxes on your earnings once you finally take funds out.
How to Invest in Them
As briefly mentioned earlier, REITs are typically publicly traded on national stock exchanges. You may purchase them either through a brokerage account or with a financial advisor or broker. This is especially useful if they’re PNLRs.
Working with a financial advisor is also useful because they can work with you to identify investments that fit your goals. You may also get help with the tax implications of REITs. To find a qualified professional, you can use a free matching tool, which will connect you with up to three near you.
How You Can Check One’s Validity
REITs must register with the Securities and Exchange Commission (SEC) for people to invest in them publicly. You can check a company’s validity by using the SEC’s EDGAR tool. Both publicly traded REITs and PNLRs will have annual and quarterly reports on file that you can access and review.
Frequently Asked Questions
Are REITs a good investment?
REITs may be a good investment, depending on what your goals are. If you’re looking for an asset that has minimal maintenance and will provide regular income, you might want to consider buying. However, you’ll also be subject to taxes and market risks. Before investing, you should conduct appropriate research and speak with your financial advisor.
Do they pay dividends?
Yes, REITs will pay regular dividends. Income typically comes from rent payments, mortgage interest, and property sales. By law, it must pay you at least once annually and all shareholders need to receive at least 90% of its taxable income.
How are dividends taxed?
Dividends are taxed as ordinary income by federal and state (if applicable) governments. You’ll also be subject to capital gains taxes, if any, from your REIT earnings.
What is a mortgage REIT?
This is a type of REIT that finances properties to create income via mortgage interest payments. Unlike equity REITs, these typically don’t buy real estate properties to earn revenue from tenants.
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