Investing in real estate can seem like a smart idea, especially if you're investing long-term with the goal of building wealth. Unfortunately, there are plenty of hassles that come with investing in physical assets — and particularly in commercial buildings, single family homes, and apartment buildings. Not only are there roofs to replace and damages to discover in between tenants, but you may have to deal with renters 24 hours a day.
You can hire a rental management company to oversee your rental's day-to-day operations, but that doesn't get you off the hook for the costs and stress involved in upkeep, maintenance, and repairs.
Fortunately, you can invest in real estate without the hassles of owning physical property. With a REIT, you can have the best of both worlds — an investment in real estate without the work.
- REIT stands for "real estate investment trust."
- This type of company invests in real estate for the purpose of producing income, although some REITs also invest into real estate loans or mortgage-backed securities.
- While REITs let investors diversify into real estate without having to hold physical property, they are not always liquid, and taxes on dividends can be high.
What is a REIT?
A real estate investment trust (REIT) is a type of company that owns a portfolio of real estate they use for income-producing purposes. REITs allow individual investors to purchase shares similar to other types of investments. From there, investors with REITs can receive regular dividends based on how the underlying investments in the REIT perform. However, they never have to step foot in, much less manage, the individual properties held by the REIT company.
How Do REITs Work?
According to information published by the U.S. Securities and Exchange Commission, REITs can invest into various types of real estate including shopping malls, office buildings, apartments, hotels, resorts, self-storage facilities, warehouses, and even mortgages or loans. In other words, your average REIT holds a lot more than real estate for renters.
With that being said, it's important to note that REITs do not develop new properties in order to sell them for a profit. Instead, they aim to buy properties at low prices so they can operate them on a for-profit basis. They use funds invested into REITs to purchase said real estate, and investors are rewarded with dividends when the business is profitable.
On the investor end, REITs work similarly to mutual funds or index funds. You pick the REIT you want and find a brokerage firm or platform that lets you invest, then you deposit your money and wait. You may even be able to buy, sell, and trade REITs just like you would other investments, including stocks and bonds.
What Qualifies as a REIT?
The U.S. Securities and Exchange Commission (SEC) lists very specific rules that govern what does and doesn't qualify as a REIT. For example, companies that want to qualify as a REIT must have the bulk of their assets and income connected to real estate. They must also distribute at least 90% of their taxable income to investors each year in the form of dividends, notes the SEC.
There are other requirements for REITs as well, including a requirement to derive at least 75 percent of their gross income from real estate related sources and to be managed by a board of directors or trustees. You can read over all the additional legal requirements for REITs here.
Pros and Cons of Investing in REITs
There are many reasons investors flock to REITs in droves, although the benefits can vary from person to person. Some of the main advantages of REITs include the fact they let you diversify your portfolio into real estate without having to manage physical properties. Also note that REITs have performed well over the last decade, so they continue to be an attractive asset class.
Unfortunately, there are some downsides of REITs, including the following:
- Not all REITs are liquid investments. While some REITs can be traded like other investments, non-traded REITs are highly illiquid, meaning you can't just cash them out because you want to.
- Taxation can be complicated and expensive. Dividends paid by REITs may not meet the definition of qualified dividends, so you may owe higher taxes on your REITs returns than other investments.
- REITs can be sensitive to numerous market conditions. REITs can take you on a wild ride when the real estate market takes a hit. For example, the ongoing COVID-19 pandemic was particularly hard on REITs that focus on the travel industry (i.e. hotel REITs).
Types of REITs
For the most part, there are three main types of REITs for investors to learn about. These include:
- Equity REITs, which typically own and operate income-producing real estate such as apartment buildings, commercial buildings, and single family homes
- Mortgage REITs, which invest into mortgages and other types of real estate loans, and even into mortgage-backed securities
- Hybrid REITs, which use a combination of the strategies used by equity REITs and mortgage REITs
In other words, you can choose to invest into REITs that actually own and operate real estate, but you can also opt for REITs that focus on the lending side of the equation. If you can't decide, you can also opt for hybrid REITs that diversify into both.
Beyond these basic types of REITs, you can break down investments even further. For example, there are publicly-traded REITs, non-traded REITs and private REITs that are not registered with the SEC. Make sure you understand the type of REIT you're investing in before you take the plunge.
How to Buy REITs
Here's the good news about REITs — investing in them is relatively easy and straightforward. In fact, you can invest in any number of REITs through a broker or an online brokerage firm like Charles Schwab. Various platforms also offer their own private or non-traded REITs, including Fundrise and Crowdstreet.
It's also worth noting that REITs are becoming a popular investment option within traditional retirement accounts. According to research from Nareit, REIT allocations for young workers with 40 years to retirement reached 15.3% in 2020. Meanwhile, investors closer to retirement age still had somewhere close to 10% of their portfolios allocated to REITs.
This means that, in addition to investing into REITs in a brokerage account, you may also have REIT options within a 401(k) or other workplace retirement account you have access to. If you're interested in real estate investing for the long haul, make sure to check so you know for sure.
Frequently Asked Questions (FAQ)
Why should I invest in REITs?
Investing into REITs can make sense if you're striving to build long-term wealth and you want to diversify your portfolio.
How are REIT dividends taxed?
According to Nareit, most REIT dividends are taxed the same as ordinary income, plus a separate 3.8% surtax on investment income. If dividends are considered qualified, taxpayers may also be able to deduct 20% of the combined qualified business income when they file.
How much of your portfolio should be in REITs?
Some experts say no more than 25% of your portfolio should be in dividend-producing REITs, yet other experts say to limit your investments to 5% or 10%. There's no hard and fast rule here, and only you know what's best for your needs.
What are the risks of investing in REITs?
REITs are not always easy to liquidate, and taxation can be complicated depending on your situation. Just like other investments, you can also lose all or part of the money you invest in REITs.