Real estate is a popular niche for investors to diversify their portfolios away from stocks and bonds. However, many investors don’t want the hassle or responsibility of owning individual properties. Real estate investment trusts (REITs) offer the ability to invest in multiple real estate properties within a single investment while benefiting from professional management of the underlying assets. If you’re wondering how to invest in REITs, this article will explain what a REIT is, how they work, and share how to buy REITs.
What is a REIT?
A real estate investment trust (REIT) is an investment vehicle that allows investors to buy fractional ownership of real estate properties. These fractional interests provide instant diversification of your portfolio, even with a small investment. Each REIT has professional management that researches and selects properties, manages the buildings, and determines the timing of selling assets. REITs operate similar to how mutual funds enable investors to buy shares in stocks and bonds, but with some distinct differences.
There are three primary types of REITs:
- Equity REITs. Invest in real estate that produces income from monthly rents, dividends, and capital gains on sale of properties.
- Mortgage REITs. Invests in mortgages and mortgage-backed securities. These REITs are more sensitive to changes in interest rates because of the effect on the assets they own.
- Hybrid REITs. Are a combination of the two and may own both types of investments.
Crowdfunding sites like RealtyMogul offer access to REITs that are not publicly traded.
How REITs work
REITs buy real estate properties and hold them in a special type of trust. These trusts do not pay corporate income taxes as long as they distribute at least 90% of their taxable income to investors.
Many REITs focus on distinct niches of the real estate market. Just like you can buy a mutual fund that specializes in small-cap stocks or certain parts of the world, REITs also allow investors to pick where to invest. For example, you can invest in REITs that specialize in apartment buildings, commercial properties, hotels, or healthcare.
How are REITs different than mutual funds?
While REITs offer instant diversification of your real estate holdings like a mutual fund does, they are very different when it comes to taxes, liquidity, and other features.
- Taxes. REITs must distribute at least 90% of their taxable income to maintain their tax-exempt status. This means that they pass through almost all of their income to investors. Most distributions are taxed as ordinary income, which is taxed higher than long-term capital gains.
- Liquidity. Most mutual funds are publicly-traded investments that can be liquidated at any time. Many REITs are private and require that an investor maintain their position until a “liquidity event” (aka the REIT sells a property). Other REITs may have periodic redemption periods throughout the year where investors have the option to sell.
- Transparency. Publicly-traded mutual funds publicize their holdings at least once a quarter. Many REITs are not publicly-traded and, therefore, are not required to disclose their holdings. This can make it harder for investors to hold the REIT managers accountable or decide whether to invest or not.
- Concentration of assets. To qualify as a REIT, it must have at least 75% of its assets in real estate and must derive at least 75% of its income from real estate. A real estate mutual fund does not have this requirement.
Ways to invest in REITs
Investors who want to know how to invest in REITs have many options when it comes to the types of REITs available. These are a few of the most common REIT investment options for investors:
- Publicly-traded REITs. These REITs are publicly-traded stocks that you can buy shares in like any other company available in the market.
- REIT mutual funds and ETFs. A mutual fund or ETF invests in companies associated with the real estate market or buys shares in REITs.
- Non-traded/Private REITs. Private REITs are not publicly-traded and therefore do not have the same liquidity and disclosure requirements.
How to buy REITs
If you’re ready to invest in a real estate investment trust (REIT), there are numerous options available depending on which type of REIT you want to invest in.
- Direct investment. With mutual fund REITs, you can invest in them directly through the mutual fund company. Additionally, private REITs are generally sold directly through a representative of the company. Both mutual funds and private REITs generally have minimum investment requirements. Some private REITs are available only to accredited investors.
- Brokerage account. A brokerage account allows you to buy publicly-traded REITs, REIT ETFs, and REIT mutual funds.
- FinTech apps. Many FinTech companies allow the average investor to invest in private REITs through smaller investments.
The bottom line
Investing in REITs can be a smart way to diversify your portfolio to reduce volatility and generate recurring income. REITs offer instant diversification into multiple properties, even with a small investment. Because most distributions are taxed as ordinary income, many investors hold REITs in a retirement account to avoid paying higher taxes each year. If you want to learn how to invest in REITs, there are many options, including individual stocks, mutual funds, ETFs, and FinTech apps that offer an affordable minimum investment amount.
Are REITs Good Investments?
REITs can be a solid addition to your overall portfolio. Studies have shown that adding real estate investments to your portfolio reduces volatility while maintaining or improving your returns. As with any investment, most advisors recommend keeping a diversified portfolio by rebalancing on a regular schedule to ensure one sector does not dominate your holdings.
How Do You Make Money on a REIT?
Real estate investment trusts make money in two ways - income from tenants and capital gains when selling a property. REIT managers tend to liquidate holding when they feel that a property has reached peak value, such as when rents have been maximized, or if they’ve identified new opportunities that offer better returns. Investors also make money by selling their shares for more than what they bought them for.
Can You Lose Money on a REIT?
As with any investment, it is possible to lose money in a REIT. Property values can drop if their occupancy or rents decline. Additionally, REITs can be interest-rate sensitive investments whose values are affected as rates increase.
Are REITs Safe During a Recession?
REITs can be a safer investment during a recession because they are highly durable and their rents offer a stable source of income. Risks vary depending on what sector the REIT invests in and how rate-sensitive its portfolio is.
How are REIT dividends taxed?
To maintain their tax-exempt status, REITs must distribute at least 90% of their taxable income to investors. Dividend distributions are taxed as ordinary income on an investor's tax returns. Generally, ordinary income tax rates are the highest rates that investors owe when filing their tax returns. Capital gains from the sale of assets may be long or short, depending on how long the REIT owned the property.
Are REIT dividends qualified?
Most of the distributions from a REIT are not qualified dividends. Since they are not qualified, these distributions are taxed as ordinary income. If a REIT sells a property, dividends related to that sale may be considered a qualified dividend payment, which are taxed at capital gains rates.