A Real Estate Investment Trust (REIT) is a company or corporation that owns or finances income-generating real estate properties on behalf of shareholders.
REITs make it possible for any individual to earn income from real estate without being directly involved in the work and stress associated with owning real estate properties. They can also be a great diversification tool for your investment portfolio.
Read on to learn how to invest in REITs and get a better understanding of how REITs work.
What is a REIT?
A REIT is like a holding company for real estate. The portfolio of properties owned by REITs is often within a specific sector.
REITs use the money of investors to purchase properties that can generate income from rents or interest on the property, and by law, they must pay out 90% of their total annual profits in dividends to shareholders.
The tax on REIT dividends received by shareholders is low.
How to Tell What Companies are REITs
For a company to be regarded as a REIT it needs to make a REIT election by filling a Form 1120-REIT with the IRS, which excludes it from corporate tax and prevents the double taxation of shareholders’ income.
It must also meet the following requirements as stated by the SEC and IRS:
- The company must exist in any of the states as a corporation taxable for federal purposes except for its REIT status.
- A REIT must have at least 100 shareholders after the second year of operation.
- 5 or fewer individuals should not hold more than 50% of the company’s shares during the last half of the taxable year.
- The shares of REITs must be transferable and a board of trustees or directors must manage the company.
- At least 75% of the gross income of a REIT must be from real estate or real estate-related sources. This means that it should invest 75% of its total assets in real estate.
- A REIT cannot own more than 10% of the voting rights of any corporation except if it is another REIT, a Qualified REIT Subsidiary (QRS), or a Taxable REIT Subsidiary (TRS).
- Service fees or non-real estate businesses classified as non-qualifying sources should not constitute more than 5% of the company’s income.
- REITs by law must pay at least 90% of their taxable income as dividends to shareholders annually. If it retains its income, it will pay taxes like every other company.
- REITs by law must mail letters to all their shareholders requesting details of beneficial ownership of shares annually. If the REIT fails to do this on time, it faces penalties.
You can use the NYSE REIT directory or another online database, then search and filter your results to easily see which companies are REITs.
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Types of REITs
There are two major REIT categories: Equity REITs and Mortgage REITs.
1. Equity REITs
Equity REITs generate most of their revenue from rents on properties they own. About 90% of all REITs are equity REITs. Equity REITs can own either residential or commercial real estate properties.
Equity REITs appear more financially stable because they earn revenue from the monthly cash flow of rents that tenants pay.
The Four Major Types of Equity REITs:
- Retail REITs: Retail REITs invest in freestanding retail locations and shopping malls. They earn income from the rent that the tenants of these properties pay. In fact, 24% of all REITs are retail REITs.
- Office REITs: This type of equity REIT invests in commercial office buildings and earns revenue from long-term tenants. The tenants sign a lease agreement that lasts between three to ten years. Office REITs are usually in urban centers where there is job growth.
- Residential REITs: Residential REITs own residential properties. Data shows that REITs own 2% of residential apartments in the U.S. They usually invest in apartment buildings that have nothing less than five units and multi-family properties with 2 to 4 units. Just like office REITs, residential REITs also focus on urban centers with increasing population and job growth. In 2018, residential REITs outperformed the broader REIT sector, with dividend yields averaging 3.97% in one year.
- Healthcare REITs: There are 33 healthcare REITs worldwide with a market capitalization that exceeds 127 billion dollars, and 90% of healthcare REITs are in the US. Healthcare REITs invest in health-related real estate such as nursing facilities, hospitals, retirement homes, and medical centers. The Healthcare sector accounts for about 17% of expenditure in the US GDP. They generate revenue from Medicare reimbursements and occupancy fees. The dividend yield paid by Healthcare REITs is higher than those of companies in the global real estate index.
2. Mortgage REITs
Mortgage REITs purchase existing permanent mortgages with a high-interest rate and they make their money off interest payments. They make a profit on the spread between the short-term and permanent interest rates.
Mortgage REITs can be either residential or commercial. Investing in mortgage REITs is risky. Mortgage REITs only make up about 10% of all kinds of REITs; this is because mortgage REITs operate with high leverage and this makes them volatile.
Before you invest in mortgage REITs you should definitely pursue more investor education.
How to Invest in REITs
The best way to invest in REITs is to invest in an already existing REIT. You can invest in REITs by directly buying its shares or by investing in a scheme like an Authorized Unit Trust, which invests in REITs.
You can get REIT shares by investing in REIT Mutual Funds or REIT Exchange-Traded Funds (ETFs). ETFs are regulated investment companies that raise investment capital by selling their shares to investors. They then invest the money received from the sale of the shares in specific investment objectives.
Here’s a quick guide to investing in two types of REITS—Publicly traded REITs and privately held REITs:
1. Publicly Traded REITs
These kinds of REITs are similar to stocks and ETFs as you can buy and sell them on major stock exchanges like the Nasdaq or the New York Stock Exchange. There are over 225 publicly-traded REITs in the U. S.
There is no minimum or maximum amount for the purchase of publicly-traded REITs. For every trade made, an online brokerage fee of about $8 to $10 is charged.
Investors receive quarterly or monthly dividends that equal 90% of their profits. Assets of investors in public REITs constantly appreciate and grow in value depending on macroeconomic trends and the performance of the company.
A lot of people prefer to invest in publicly-traded REITs because they are highly liquid and have stable growth. They also do not have to pay upfront or annual service fees.
Publicly traded REITs by law must give quarterly financial reports and comply with other financial reporting requirements to increase transparency and accountability.
You can find good publicly-traded REITs to invest in on platforms like Dividends.com, where more than 200 publicly-traded REITs are listed on the website.
2. Privately-Held REITs
These companies meet IRS requirements but they’re listed with the Securities and Exchange Commission (SEC) on an exchange. Private financial advisors or private brokers sell privately traded REITs.
Unlike Publicly traded REITs that are free, privately-held REITs charge about 10 to 16% upfront fees. Privately traded REITs can sell securities to accredited investors who have an annual salary of at least $200, 000 or a net worth of $ 1 million.
Privately held REITs are not transparent because they do not need to adhere to the reporting standards that Publicly-traded REITs are subject to. They do not have to comply with the rules of public cooperation.
Also, investors can’t access their investment for the first 2 to 3 years after investing in privately-held REITs.
When this period is over, they can withdraw their investment. Withdrawals of privately-held REITs are known as redemptions. Despite the three-year period, the managers of private REITs can decide to indefinitely restrict redemptions.
DiversyFund REITs are our top-ranked company for REITs because they only invest in multifamily cash flow positive properties in high growth areas, which is one of the least risky types of real estate.
How REITs Measure Earnings and Dividends
REIT earnings can be measured by net income, as well as Funds From Operating (FFOs). You can calculate this by adding the net income of the company plus the amortization and depreciation minus gain on the sale of properties.
FFO = (Net Income) + (Depreciation and Amortization) – (Gain on Sale of Property).
Depreciation is included in the calculation because the annual depreciation expense of the many real estate assets of REITs distorts earnings negatives. Because the gains on the sales of properties are removed, REITs can reinvest them.
How Much You Should Allocate to REITs
If you’re wondering what percentage of your portfolio should be allocated to REITs, the short answer is that it varies.
The right allocation depends on your investment goals, risk tolerance, and timeline. However, most experts recommend allocating anywhere from 5-15% to a REIT portfolio and adjusting for the factors above.
For example, age can change the ideal REIT allocation for your portfolio. While a 15% REIT allocation might make sense when you’re 30, that allocation should gradually decrease over time. Once you reach retirement, it will likely make sense to have a much more scaled-back REIT allocation.
Advantages of Investing in REITs
There are many advantages REITs investments have over individual real estate investments:
- Yields Tend to be Quite High. According to Nareit, about 145 million investors in the U.S own REITs through investment funds and retirement savings. Investing in REITs diversifies your portfolio and helps in the preservation of the total value of your investment.
- Investing in REITs Provides a Reliable Source of Passive Income. Unlike individual real estate investments, REITs Investors do not have to bother with the buying and selling or renting and maintenance of real estate properties.
- REITs have Professionals Who Handle Every Aspect of the Properties (including the legal work) in a way that yields a high profit. At the end of the quarter, investors get a share of the profit in the form of dividends.
- Most REITs are Larger than Individual Real Estate in terms of the properties they own. This makes them more solid and less volatile.
- Transparency. Publicly traded REITs by law must give a regular report to shareholders. This transparency subjects their activities to market scrutiny and enables investors to be in the know of all that goes on in the company.
- REITs Enable Individuals to Invest in Properties That are too Expensive For Them to Own as Individuals. REIT stocks are also liquid; you can easily buy and sell them.
Disadvantages of Investing in REITs
There are a lot of benefits to adding REITs to your portfolio, but there are also a few potential drawbacks.
Consider these disadvantages, too:
- Taxable dividends: While REITs have tax benefits, keep in mind that dividend income is subject to income tax.
- Fees: If you invest in private non-traded REITs, you may face some steep upfront fees, commissions, and operating costs.
- Volatility: REITs aren’t immune to market volatility. When the real estate market is down, REITs can take a hit.
- Sensitive interest: Depending on the type of REIT you invest in, REIT prices can be pretty sensitive to interest rates. For example, mortgage REITs are more sensitive to interest than residential rental REITs.
Frequently Asked Questions
What determines the value of REIT shares?
Here are a few factors you can use to determine the value of a REIT share:
- Anticipated growth: You can look at the expected growth in earnings and the total expected return of the stock to evaluate it.
- Price to FFO: You can look at the FFO (funds from operations) to assess a REIT’s value, which can be more accurate than anticipated earnings and income when you’re evaluating REITs.
- Comparison: Look at the dividend yield compared to other high-income types of investments, like utility stocks or bonds.
- Debt to EBITDA: Look at the debt to earnings before interest, taxes, depreciation, and amortization ratio to compare REITs.
- Dividend payout ratio: Look at the amount of money paid out in dividends to gauge how sustainable a REIT is.
- Credit rating: Credit ratings assess financial strength based on a REIT’s track record and outlook. Higher ratings can be tied to a higher valuation.
What factors affect REIT growth?
Multiple factors can lead to an increase in REIT earnings. REITs often produce higher earnings in seasons of economic growth.
When real estate assets increase in value, REITs do, too. This revenue growth can come from sources like new properties being acquired, more tenants filling a property, and rent increases.
How do beginners invest in REITs?
Anyone can invest in REITs as an individual investor. It’s as simple as opening a brokerage account. From there, you can deposit funds and start investing in individual REITs that are publicly traded, similar to other assets on the stock market.
To invest in private non-traded REITs, you’ll need to meet income requirements and be an accredited investor.
Do you get paid monthly from REITs?
It depends. Some REITs pay out monthly dividends, which is a major perk of REIT investing. Others pay out quarterly or annually. All REITs are required to pay out dividends at least once per year.
If you care about the frequency of dividend payments, do your homework and check out the payment schedule before investing in an individual REIT.
Do you need a Schedule K-1 tax document or 1099 for REITs?
If you have shares of a REIT, you do not need to complete a Schedule K-1 document, which is for investors in LLCs taxed as partnerships.
Instead, REIT investors are issued a 1099-DIV tax form, which reports dividends and generally lists capital gains distributions.
Should You Invest in REITs?
Investing in REITs is a great way to diversify any investment strategy and also a great way to invest in real estate without having to own any physical properties on your own.
While some people might enjoy being a landlord, the hands-off benefit of REITs makes them attractive investments. If you want to learn more about investing in Real Estate, check out my top picks for Best Real Estate Investing Books!