What is a REIT? A guide to real estate investment trusts

If you, like so many, believe that real estate is a great investment, but don’t have the resources or time to buy and rent out houses, real estate investment trusts (REITs) might be an attractive investment option.

REITs are a popular, hands-off way to invest in property. They allow you to earn passive income from real estate, without the labor and time involved in owning and managing a rental property. Even if you have a property manager, real estate ownership can be time consuming and costly.

REITs are an alternative way of investing in real estate. Here’s how they work: Companies invest in property and form a REIT that you can buy shares in, along with other investors. Think of these as sort of mutual funds or stocks which have real estate as the underlying asset.

Defining qualities of a REIT

REITs own, operate, or provide funds for income-generating properties, like office buildings, shopping centers, apartments, hotels, and warehouses. Unlike traditional real estate businesses, REITs focus on managing and maintaining a property portfolio rather than building properties for sale.

To be a REIT:

• At least 75% of its assets must be in real estate, cash, or government securities.
• At least 75% of its income must come from renting properties, mortgage interest, or property sales.
• At least 95% of total income must come from these real estate sources, along with dividends and interest.
• It needs at least 100 shareholders for at least 335 days of a 12-month tax year, and shares should be freely transferable like regular stocks.
• Five or fewer people can own no more than 50% of the REIT's shares during the last half of the tax year.

Note that REITs are required to pay out at least 90% of their taxable income as dividends to investors each year.

What properties do REITs invest in?

Let’s explore some common REIT categories:

• Residential REITs: These are REITs with properties used by residential tenants, such as apartment complexes, single-family residential, and townhouses. They could include student housing and manufactured homes.
• Commercial REITs: These companies buy and run properties where businesses operate. Think about office buildings, coworking spaces, medical buildings, shopping malls, and retail centers. These properties typically generate income through long-term leasing arrangements.
• Health care REITs: These focus on real estate related to medical facilities. They invest in hospitals, nursing homes, retirement communities, and medical centers. Their income depends greatly on changes in health care costs and how full their properties are.
• Industrial REITs: These own and oversee industrial properties like warehouses and distribution centers. They benefit from the increase in online shopping and global supply chains. They usually sign long-term leases with reliable tenants, which helps them stay strong during tough economic times.

How do REITs work?

REITs allow you to invest in real estate and potentially profit from it without actually buying, owning, and maintaining property. There is more than one kind of REIT. Here are three main types:

• Publicly traded REITs are traded on major stock exchanges, and you can buy and sell them like stocks. You can also get information about them easily.
• Public non-traded REITs aren’t on exchanges but, like publicly traded REITs, are regulated by the Securities and Exchange Commission (SEC). These are sold by brokers and can be more difficult to sell.
• Private REITs aren’t registered with the SEC, are not traded on exchanges, and are usually available only to high-net-worth investors or those who meet certain criteria.

REITs are often also categorized by the types of real estate they invest in.

REIT categories

As mentioned, REITs are often defined by the types of real estate investments they contain. Here are common types of REITs.

• Equity REITs: These own and manage properties that generate rental income, such as apartments and office buildings. After covering expenses, they send most profits to investors as dividends.
• Mortgage REITs (aka mREITs): Mortgage REITs hold mortgages and make money from the interest on them. They create new loans or buy mortgage-backed securities.
• Hybrid REITs: These combine equity and mortgage REITs. By generating income from both rents and mortgage interest they mitigate risk if one part of the real estate market takes a hit.
• Specialty REITs: These REITs focus on unique properties that don’t fit the other categories, such as amusement parks, movie theaters, or farms. If you want something different from the typical property investment options, this is your area.

How to invest in REITs

Before investing in REITs, you should seriously consider your risk tolerance. Although they will be less risky the more you diversify your portfolio, and are generally less risky than any one stock, REITs are still riskier than high-yield savings accounts and some other more stable investments.

As with any investment, you need to carefully research any REIT you consider. Look at previous returns, management fees, and other key metrics. It’s wisest to seek the help of a trusted financial adviser who can fit REIT investments into your overall portfolio and investment strategy.

Pros of REIT investing

Putting money into REITs can help you tap into the benefits of passive real estate investing and create new financial opportunities.

• Liquidity: Selling REIT shares is easier than selling a property. If they’re publicly traded, you can sell fast – often within minutes – instead of waiting weeks or months to sell a property.
• Investment diversification: REITs let you add real estate to your investments without owning physical property. If you have stocks or bonds, this helps balance your investment assets.
• Dividend income: REITs must give out most of their profits as dividends to keep their tax perks. This means a steady flow of passive income for you.

Cons of REIT investing

Even though REITs offer some great investment opportunities, they have potential downsides.

• Market risk: When investing in REITs, you face the ups and downs of the real estate market. Things like economic hits, dropping property values, or more foreclosures can hurt your investment.
• Sensitivity to interest rates: Interest rates affect the real estate market a lot. When rates go up, it can make buying or renting harder. While fixed-rate REITs might offer some shield, rising rates still have a big impact.
• Management fees: Trustees and fund managers handle REITs, which means they charge fees that can reduce your returns. So think about these costs when looking at possible investments.

Tax implications of REIT real estate investing

One of the big perks of investing in REITs is that they don't pay income tax if they give back 90% of their revenue to investors after covering costs. This rule makes them a tax-smart choice for investors.

For individual investors, the dividends are taxable. They usually get taxed as your normal income, so the rate varies depending on your tax bracket.

If a REIT decides to sell a property, it must pay a capital gains tax, which can hit up to 20%. Plus, if your modified adjusted gross income crosses certain limits, you'll owe an extra 3.8% on your net investment income.

Here’s the breakdown:

Investing in REITs through a retirement account works a little differently. You won't pay taxes immediately with a traditional 401(k) or IRA. Instead, you’ll be taxed at your regular income rate when withdrawing money after you’ve retired. On the flip side, using a Roth 401(k) or Roth IRA means you won’t owe taxes on withdrawals because you've already handled the tax on contributions.

Chatting with a tax professional is a good idea if you're unsure how REITs will fit into your retirement plan.

The bottom line: REITs are generally a mid-risk investment

If you’ve always wanted to invest in real estate but aren’t sure if you have the time or resources to buy, manage, and maintain property, REITs can offer an attractive alternative. REITs allow you to invest in and potentially profit from various forms of real estate by buying shares of a real estate investment fund along with other investors.

REITs come with risks, however, so you should research ones you are interested in thoroughly. In addition, it’s a good idea to consult a professional financial adviser, who can ensure it fits with your overall investment strategy and goals.

If you’re ready to buy real estate yourself, apply for a mortgage through Rocket Mortgage.