REITs explained: how do you invest in a real estate investment trust?

What are REITs?

A REIT or real estate investment trust is a company that owns and sometimes operates income-producing real estate. Some REITs invest in a variety of real estate properties, such as offices, warehouses, and retail, while some specialize in just one type of property. Many REITs are publicly traded on major stock exchanges, and therefore open to anyone with a brokerage account who wants to invest in real estate assets.

How do REITs work?

Real estate investment trusts are similar to mutual fundsboth pool various investments in one place. When you buy a share of a REIT, you own a piece of all the real estate assets held by that REIT. Share prices for REITs tend to reflect the current status of that trusts investments.

But while mutual funds and REITs function similarly, REITs have certain requirements that make them stand apart from other investment opportunities. For example, REITs must derive at least 75% of gross income from real-estate related endeavors.

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Returns from REITs

Over the long term, the total return on REITs has been similar to that of value stocks. REITs also tend to provide relatively high dividends because of their structure. Thats because 90% of a REITs gross income must be distributed to investors.

However, not all REITs are the same and its important to understand the different types of real estate investment trusts.

Types of REITs

REITs are usually classified by the sector or industry they specialize in within the real estate environment. Most REITs derive their income from commercial real estate, though some buy residential real estate.

While most real estate investment trusts are equity REITs, meaning they own the properties they invest in, others invest in mortgage assets instead. Hybrid REITs mix elements of equity REITs and parts of mortgage REITs, allowing them to own mortgages and mortgage-backed securities as well as directly own real estate.

1. Retail REITs

Retail REITs own and operate shopping malls and stand-alone retail shops. This is a popular form of REIT, comprising around of overall REIT investments. These REITs make money by charging tenants for rentif there arent enough businesses to fill the properties, the fund could lose money.

2. Residential REITs
   

Residential REITs own and operate multi-family dwellings, like apartment buildings or prefab housing complexes. Most residential REITs focus on large urban centers where home affordability is low, which allows them to purchase properties and charge rent on them.

3. Healthcare REITs

These REITs invest in real estate related to the healthcare industry, including medical centers, hospitals, and retirement homes. Many of these REITs derive their income from occupancy fees and Medicare reimbursements. In the long term, healthcare REITs are betting that demand will increase as the population in the US continues to age.

4. Office REITs

Office REITs invest in commercial office buildings. Since tenants in these properties tend to sign long-term leases, these REITs often invest with a long time horizon. When considering office REITs, investors often look at the economic health of the areas in which the fund invests, as well as the overall unemployment rate.

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5. Mortgage REITs

Unlike the other 4 types of REITs, which are equity REITs, mortgage REITs dont invest in real estate directly. Mortgage REITs (mREITs) derive income by collecting interest on their investments in mortgages and mortgage-backed securities. mREITs get a large amount of the capital they use to make their investments from debt offerings. This means that, if interest rates rise, loan financing gets more expensive and the value of its portfolio decreases.

Pros and Cons of REITs

Individual investors often find that REITs help diversify their portfolio and grant easy access to real estate properties that would otherwise be complicated to invest in. However, all investments come with risks, and REITs are not exempt. Its important to understand the pros and cons of investing in REITs before adding them to your portfolio.

Pros of Investing in REITs

• Diversification: REITs allow you to diversify your investment portfolio by investing in a new asset class. These investments can also allow you to tap new geographic markets, which is key to expanding your portfolio.

• High Dividend Yields: REITs are legally required to pay 90% of their taxable income back to shareholders, so these investments tend to have higher-than-average dividend yields.

• Liquidity: Compared to investing directly in real property, many REITs are a highly liquid investment. This can help you improve your cash flow, which would otherwise be locked up in a traditional real estate investment.

Cons of Investing in REITs

• Interest Rate Sensitivity: REITs are highly sensitive to changes in interest rates, an area of particular concern in the current market. As interest rates rise, REITs can struggle and your yield can decrease.

• Dividend Taxes: Dividends tend to be taxed at a higher rate than some other investments. While you wont have to pay the corporate tax rate, you should consider the capital gains taxes you may pay on dividend income.

• High Fees: Some REITs charge large transaction or management fees. These fees can be hidden in the fine print and, when combined with a difficult market, may result in lower payouts.

Tax Advantages

REITs offer a variety of tax advantages to investors, including the potential for high dividend returns.

Most income from a real estate investment trust will likely come in the form of ordinary income that is passed along from the REITs investments. This is taxed according to the investors marginal tax rate. Income from REITs could be subject to the 20% deduction for pass-through business income that came about through the Tax Cuts and Jobs Act. This benefit is currently set to expire in 2025.

Some dividends will be classified as capital gains, which are subject to capital gains taxes. Investors may be able to reduce these taxes using tax loss harvesting. Others still may be returns of capital, which are nontaxable.

How to Invest in REITs

When investors talk about real estate investment trusts, theyre usually referring to public REITs, or a publicly traded REIT where investors can buy shares on the open market. However, there are private REITs as well.

Publicly-traded REITs allow investors to invest in the real estate industry without taking on the risk of directly investing in properties. Since a single REIT is representative of many different real estate investments and pulls from several real estate companies, some say that investing in a REIT is lower-risk and a way to diversify an investment portfolio.

It is important to take a critical look at different types of REITs and their historical success. Like any investment, the success of a REIT depends on a variety of external economic influences.

Some investors choose to invest in a REIT exchange-traded fund, or REIT ETF. These funds invest in different types of REITs and can offer exposure to a larger range of real estate sectors.

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Bottom Line

REITs let you invest in the real estate market without taking on the traditional risks associated with owning or managing real estate. Some people prefer to invest in real estate investment trusts that are focused on a specific industry such as healthcare, retail, or residential properties.

Like other investments, one industry-specific REIT may perform better than others due to various economic influences. Given that REITs invest in several different properties to generate income, they are generally considered lower-risk than other investments. If diversification is one of your investing goals, REITs could play a crucial part in your strategy.