What Is a Real Estate Investment Trust (REIT)?

Real Estate Investment Trusts (REITs) offer a way for individual investors to participate in large-scale, income-producing real estate without the direct ownership and management responsibilities. These investment vehicles provide access to a diversified portfolio of real estate assets, which might otherwise be inaccessible to many. By structuring themselves as REITs, companies can acquire and operate various types of properties, generating revenue primarily through rent or interest. This structure allows for a more liquid form of real estate investment, trading on exchanges similar to traditional stocks.

Understanding Real Estate Investment Trusts

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. These entities allow individuals to invest in large-scale real estate portfolios, such as apartment complexes, shopping malls, office buildings, and warehouses, without directly buying or managing physical properties. REITs function as a vehicle for real estate investment that trades like other securities on major stock exchanges, making real estate investment more accessible to the general public.

Historically, investing in commercial real estate required significant capital and expertise. REITs pool capital from numerous investors, enabling them to collectively own and manage a diverse range of properties. This structure provides a liquid way to invest in real estate, offering shares that can be bought and sold with ease.

REITs are typically structured as corporations or trusts and must meet specific requirements set by the Internal Revenue Service (IRS) for special tax treatment. For instance, a REIT must be managed by a board of directors or trustees, and its shares must be transferable for public trading. To ensure broad ownership, a REIT must have a minimum of 100 shareholders, and no more than 50% of its shares can be held by five or fewer individuals during the last half of its taxable year.

Different Kinds of REITs

REITs are categorized primarily based on their investment focus, with the most common types being Equity REITs, Mortgage REITs (mREITs), and Hybrid REITs. Understanding these distinctions helps investors align their goals with specific real estate market exposures.

Equity REITs

Equity REITs represent the majority of the REIT market and directly own and operate income-producing real estate. Their revenue is generated primarily from collecting rent on their properties. These REITs often specialize in specific property sectors, allowing investors to target particular areas of the real estate market. Examples include:
Retail REITs (shopping centers)
Residential REITs (apartment complexes, student housing)
Office REITs (commercial office buildings)
Healthcare REITs (hospitals, senior living facilities)
Industrial REITs (warehouses, distribution centers)
Data center REITs
Timberland REITs
Infrastructure REITs (cell towers, fiber optic cables)

Mortgage REITs (mREITs)

Mortgage REITs (mREITs) do not own physical real estate but instead provide financing for income-producing properties. They lend money to real estate owners and operators, either directly through mortgages and loans or indirectly by acquiring mortgage-backed securities. Their income is primarily derived from the net interest margin, the spread between the interest they earn on their mortgage investments and their borrowing costs.

Hybrid REITs

Hybrid REITs combine strategies from both Equity and Mortgage REITs. These REITs hold a mix of direct property ownership and real estate-related debt investments. This diversified approach allows hybrid REITs to generate income from both rental revenues and interest payments.

How REITs Operate

The operational mechanics of REITs are designed to enable them to avoid corporate income tax, provided they meet stringent federal requirements. A defining characteristic is the mandate for REITs to distribute at least 90% of their taxable income to shareholders annually in the form of dividends. This distribution requirement is fundamental to their tax-advantaged status.

By distributing nearly all of their taxable income, REITs effectively bypass corporate income tax. The income is taxed at the shareholder level, avoiding the double taxation that applies to traditional corporations where profits are taxed at the corporate level and again when distributed as dividends. Most REITs aim to distribute 100% of their taxable income to shareholders to fully utilize this tax deduction.

REITs generate income primarily through rent collection (Equity REITs) or interest on loans (Mortgage REITs). While property sales can contribute, their core business model focuses on stable, recurring income streams.

To maintain their REIT status, these companies must also satisfy specific asset and income tests. At least 75% of a REIT’s gross income must come from real estate-related sources, such as rents from real property, interest on mortgages, or gains from property sales. Additionally, at least 75% of a REIT’s total assets must consist of real estate, cash, or U.S. Treasuries.

Shareholders receive detailed information early each year clarifying how their prior year’s dividends should be allocated for tax purposes. While REIT dividends provide a regular income stream, they are generally taxed as ordinary income at the investor’s marginal tax rate. However, under recent tax laws, a 20% deduction on qualified REIT dividends can reduce the effective tax rate for individual investors.

Ways to Invest in REITs

There are several practical methods for the general public to gain exposure to the real estate market through REITs. The most common way to invest in REITs is by purchasing shares of publicly traded REITs, which are listed on major stock exchanges. This process is similar to buying shares of any other publicly traded company through a brokerage account.

Individual investors can directly purchase shares of specific REITs that align with their investment goals. This direct ownership provides control over the selection of the underlying real estate sectors, but it requires individual research into each REIT’s performance, management, and property portfolio.

For those seeking broader diversification with less individual research, indirect investment options like REIT mutual funds and REIT Exchange Traded Funds (ETFs) are available. These funds hold portfolios of various REITs, providing instant diversification across multiple property types and companies. Mutual funds and ETFs can also be purchased through standard brokerage accounts.

REIT ETFs, such as the Vanguard Real Estate ETF (VNQ) or Schwab U.S. REIT ETF (SCHH), offer a convenient way to invest in a basket of real estate securities. These funds often track specific real estate indexes, providing exposure to the broader real estate market with relatively low expense ratios. They are designed to offer diversification and liquidity.

It is also possible to invest in public non-traded REITs or private REITs, typically through a broker or financial advisor. However, these options generally involve higher upfront fees and less liquidity compared to publicly traded REITs, as they are not traded on national securities exchanges. Publicly traded REITs offer the advantage of market-determined pricing and ease of buying and selling shares.