How Do REITs Work? The Complete Guide to Understanding REIT Investing

Real estate investment trusts (REITs) have become an increasingly popular way for investors to gain exposure to the real estate market. But how exactly do REITs work and what are the pros and cons of investing in them? This definitive guide answers all the key questions on understanding REITs.

What is a REIT?

A real estate investment trust, or REIT, is a company that owns, finances, operates and sometimes manages income-producing real estate assets. The properties generating this rental income that gets passed to REIT investors can include apartments, data centers, health care facilities, hotels, infrastructure, cell towers, offices, retail centers, self-storage, timberlands, and warehouses.

REITs were created by Congress in 1960 to provide individual investors with access to income-producing real estate assets. By owning shares of a REIT, an investor can gain exposure to a much more diverse collection of properties than they may be able to purchase outright themselves.

There are two main types of REITs:

• Public REITs: Publicly traded on major stock exchanges, allowing investors to easily buy and sell shares
• Private REITs: Do not trade on public exchanges, can have high investment minimums

Over 200 public real estate investment trusts now exist in the United States with over $1 trillion in assets under management globally. Approximately 80 million Americans invest in REIT stocks through their 401(k) and retirement funds.

Check Out This Guild: Understanding Real Estate Investment Trusts (REITs): A Beginner’s Guide

How Do REITs Make Money?

REITs make money from earning rental income from the properties they own. Well-managed REITs are constantly acquiring valuable real estate assets that demonstrate strong occupancy and rent growth potential.

As rental income gets generated from these commercial or residential properties, REITs retain a portion of earnings to reinvest or pay down debt. Above all, they distribute at least 90% of taxable income back to shareholders annually in the form of dividends. This avoids double taxation and makes them a uniquely tax-efficient investment.

REITs offer investors predictable income potential as well as moderate capital appreciation from real estate equity increasing over longer holding periods. Just like owning physical rental properties without the same hands-on management responsibilities.

Revenue Source	Description	Links
Rental Income	REITs earn revenue by charging rent to tenants occupying the properties they own. These properties can include apartments, data centers, healthcare facilities, hotels, infrastructure assets, cell towers, offices, retail centers, self-storage units, student housing, you name it. Strong REITs acquire in-demand property types with high occupancy rates they can charge competitive rent prices for in favorable economic environments.	Top REIT Property Types
Sales Proceeds	Sometimes REITs will strategically sell assets that have appreciated substantially in value to realize gains that can be passed onto investors. The sale proceeds provide capital that can be reinvested into new property acquisitions with better growth outlooks as well.	Harvest Capital Gains
Funds from Operations (FFO)	Since net income financial metrics don’t always accurately reflect REIT performance given large non-cash depreciation expenses, REITs report Funds From Operations (FFO) instead. FFO more accurately depicts cash flow generation. Strong and consistent FFO allows funding of dividend payouts to shareholders.	REIT FFO

Types of REITs

The REIT universe contains a number of distinct property sector categories:

Retail REITs

As their name suggests, retail REITs invest in retail rental spaces including malls, shopping centers, big box stores, restaurants, and more. Examples include Simon Property Group, Realty Income Corporation, and STORE Capital.

• Pros – Consumer spending can fuel reliable dividends. High barriers to entry protect market dominance.
• Cons – Disruption from e-commerce, bankruptcies (i.e. large anchor tenants closing).

Residential REITs

Residential REITs acquire and manage residential rental properties including apartments, single-family homes, housing developments, student housing complexes, manufactured homes, and senior living facilities. Examples include AvalonBay, Equity Residential, and Invitation Homes.

• Pros – Strong tailwinds from housing shortages, demographics benefiting rentals.
• Cons – Exposure to swings in the housing market, and vacancy risks during recessions.

Office REITs

As remote work arrangements have fluctuated during COVID-19, office REITs maintain attractive long-term value by acquiring and renting out office spaces from towering city high rises to suburban business parks. Examples include Boston Properties and Alexandria Real Estate.

• Pros – Stable income from long-term leases to corporate tenants.
• Cons – Declining demand for office space, shifting to hybrid remote work arrangements.

Healthcare REITs

Demographic trends continue fueling increased healthcare spending as aging baby boomers require more care. Healthcare REITs provide real estate enabling care delivery by providing hospitals, senior living facilities, medical office buildings, and more. Examples include Ventas and Omega Healthcare Investors.

• Pros – Rapid industry growth from the aging population drives steady demand. Essential healthcare services with recession-resilient attributes.
• Cons – Regulatory risks, rising expenses in labor, technology, and high fixed costs.

Industrial REITs

With exponential growth rates accelerated by booming e-commerce sales, industrial REITs meeting skyrocketing demand for modern logistics facilities such as warehouses, distribution centers, and storage units. Examples include Prologis, Duke Realty, and STAG Industrial.

• Pros – Online shopping funneling increasing tenant demand for well-located distribution centers.
• Cons – Highly competitive potentially commoditized assets, cyclical to broader economy.

There are also more specialized REIT subsectors ranging from data centers, cell phone towers, casinos, theaters, prisons, lumber mills, and self-storage units. Investors can target very specific property categories based on macroeconomic trends and forecasted market rental growth rates.

Diversified REIT ETFs and mutual funds provide broad exposure to a blended portfolio of REITs across multiple property types as well.

How to Invest in REITs

Investors aiming to potentially achieve diversification, income stability, inflation resistance, and moderate growth have several options for accessing REIT investments such as:

• Individual REIT Stocks – The most direct route, allowing investors to select specific REITs trading publicly on exchanges like NASDAQ and NYSE. Provides an opportunity to cherry-pick assets aligned with views on property sectors.
• Index-Based ETFs / Mutual Funds – Offer a basket approach of investing in a diversified blend of REIT stocks matching or replicating an underlying index. Traded on major stock exchanges with no minimum outside of fractional ETF/mutual fund share costs. Examples include FREL, IYR, VNQ.
• Actively Managed Funds – Opt for fund managers aiming to outperform benchmarks through active selection and weighting of various REIT securities based on risks and opportunities. Much higher expense ratios compared to passive index funds to consider. Examples include Cohen & Steers Real Estate, and Fidelity Real Estate Investment.
• Non-Traded REITs – Less liquid investments targeted primarily towards accredited investors and sold through brokers. Can offer above-average dividend yields but require holding periods of up to 10 years in some cases and have murkier fee structures. Examples include Inland, Jones, and SmartStop.

Newer fintech platforms focused exclusively on increasing access and liquidity to previously hard-to-access alternative assets including REITs have also emerged. Examples include Fundrise, DiversyFund, RealtyMogul, Rich Uncles. These can lower investment minimums but have less established track records so far.

Method	Description	Major Providers
Individual REIT Stocks	Investing in shares of individual REITs traded on major stock exchanges offers the most direct access and control over specific assets.	Vanguard REIT ETF, iShares US Real Estate ETF
REIT Mutual Funds	Professionally managed mutual funds provide access to a basket of REIT stocks aiming to outperform underlying benchmark indexes. Higher expense ratios but potential for active alpha.	Cohen & Steers Real Estate, Fidelity Real Estate Investment Portfolio
REIT ETFs	Exchange-traded funds track an underlying index or rules-based methodology for REIT inclusion. Traded like stocks but with intraday pricing. Very low costs but no active management.	Schwab US REIT ETF, Fidelity MSCI Real Estate Index ETF
Non-Traded REITs	Sold through brokers, non-traded REITs have no public market listing. Limited liquidity but can offer above-average dividend yield potential in exchange for multi-year hold periods.	Jones Lang LaSalle Income Property Trust, Inland Private Real Estate Trust
REIT Investment Platforms	Newer fintech apps focused exclusively on alternative real estate investments, including REITs. Lower investment minimums with easy online access but most lack long-term performance track records so far.

Benefits of Investing in REITs

So what leads so many investors to allocate a portion of their portfolio towards REITs? At a high level, key benefits include:

Diversification

Owning shares of a REIT provides exposure to a professionally managed portfolio of real estate assets rather than having capital concentrated in just one physical building or local market. Their value may not always correlate directly with stocks and bonds.

Inflation Resistance

As inflation rises, REITs can potentially keep pace by increasing rental rates over longer-term leases. This helps preserve purchasing power better than fixed-rate bonds more susceptible to losing value during inflationary periods.

Liquidity

Investing in publicly traded REIT shares through major stock exchanges allows investors to buy and sell daily since an actual property sale is not required. This differentiates them from direct real estate ownership’s prolonged closing timelines.

Take a look At: What is Private Equity? A Thorough Guide to Understanding This Alternative Investment

Passive Income

REITs pay no corporate tax as long as they meet distribution requirements. Avoiding double taxation allows reliable dividends with payout ratios averaging 75-85% of yearly taxable income. Income investors can gain stability.

Transparency

Publicly traded REITs must adhere to SEC reporting compliance and file extensive financial disclosures providing heightened transparency for shareholders to review holdings.

Here is a comparison chart of traditional rental real estate ownership vs REITs:

Direct Rental Property Ownership	Investing in REITs
Full control and decision-making power	No direct control over properties
Deal with maintenance issues	Professionally managed
Costly property taxes and insurance	Avoid direct costs and effort
Illiquid asset, difficult to buy/sell quickly	Liquid vehicles traded daily
Requires large downpayment	Low minimum investments
All income and appreciation taxed	Dividend and capital gains tax efficiency

This demonstrates the hands-off nature of REIT investing. By owning a small piece of a large, professionally managed portfolio of properties, individual investors can gain exposure to the real estate sector without having to take on the day-to-day responsibilities of physical building ownership and management.

While direct real estate investing may allow for more customization and control, REITs offer a more passive approach. They allow investors to participate in the income and growth potential of various real estate assets with much lower capital, and barriers to entry, and without needing specific industry expertise.

REIT Investing Risks and Considerations

Despite their many advantages, REIT investing also comes with a unique risk profile that investors should evaluate before allocating funds, including:

• Interest Rate Risk – As rates rise, REIT share prices tend to decline as investor capital rotates towards fixed-income products newly offering higher yields in comparison. Additionally, their cost of capital increases making it more expensive to acquire additional assets.
• Lack of Control – Investors have no direct influence or decision-making control over the properties owned when investing through publicly traded REIT shares versus direct ownership.
• Expenses – Large REITs can support extremely skilled management teams to source deals and manage properties efficiently. But these teams also demand above-market compensation, increasing costs.
• Special Tax Considerations – While REIT dividends can include the return of capital benefitting certain investors, short-term gains distributions get taxed as regular income rates up to 37% federally. REIT investing within qualified retirement accounts can mitigate tax drag.

Getting Started with REIT Investing

For investors considering incorporating REITs as part of their broader investment strategy, here is a step-by-step process:

1. Assess Overall Portfolio

First, analyze your current investment portfolio holistically across account types – taxable, retirement, and savings. Determine if there are any gaps REITs could potentially fill:

• Lack of income-generating assets
• Overconcentration in any one sector like technology stocks
• Need for an inflation hedge
• Limited exposure to alternative assets

Compare historical correlations of REITs to your existing holdings to see if meaningful diversification benefits exist.

2. Set Portfolio Allocation Target

Investment advisors generally suggest allocating between 5-10% towards commercial real estate through REITs depending on risk tolerance. Conservative investors may start with 3-5% allocation while more aggressive traders could allocate up to 15-20% into REITs.

3. Choose Investing Strategy

Key decision points to evaluate:

• Active vs passive: Seeking market outperformance through expert security selection? Or prefer an index tracking approach via ETFs?
• Individual stocks vs funds: Aim to cherry-pick specific REIT stocks with growth prospects yourself or utilize a fund.
• Tax preferences: Better to hold REITs generating ordinary income dividends in retirement accounts than taxable if possible.

Narrow focus towards REIT subsectors offering attractive fundamentals. For example, industrial REITs seeing strong e-commerce-driven tenant demand for distribution warehouses.

4. Select & Implement Specific Investments

Based on investing strategy, finalize chosen investment products like a real estate ETF, individual company stock picks, or non-traded REIT. Open positions accordingly, consider dollar cost averaging over time.

5. Monitor & Rebalance

Check in on REIT investments quarterly, and assess any fund exits/entries to rebalance to the initial allocation target. Make adjustments and evaluate tax loss harvesting opportunities in taxable accounts. Ensure continued suitability and portfolio diversity alignment as markets shift.

REIT Investing FAQs

What is the minimum amount to invest in REITs?

The minimum investment amount varies substantially by the REIT type and specific offering. Publicly traded REIT stocks can be purchased for the share price, often $10-50 per share. Some non-traded REITs require accredited investor status and have minimums of $5K+. New REIT platforms offer lower hurdles.

How often do REITs pay dividends?

Most REITs pay dividends on a steady quarterly distribution schedule. Dividend reliability and payout ratios vary significantly based on the REIT sub-sector, management competency, and overall real estate cycle.

Are REIT dividends taxed differently?

Up to 20% of REIT dividend distributions are taxed as long-term capital gains. The remaining portion gets classified as non-dividend return of capital distributions, saving typical dividend income tax until the shares get sold for capital gains rates.

What percentage should I allocate to REITs?

Investment experts often suggest allocating between 5-10% of a diversified portfolio into commercial real estate through REITs. The exact allocation depends on the time horizon, risk tolerance, income needs, and extent of existing real estate holdings.

Conclusion: Evaluate REIT Investing for Income and Diversification

REITs offer a way for all types of investors to gain exposure to large-scale institutional quality real estate assets that would otherwise only be accessible to high-net-worth individuals and institutions. By providing portfolio diversification, dividends, inflation-mitigating characteristics, and transparency relative to direct building ownership, REITs play a compelling role in well-balanced portfolios aiming for total return strategies over long time horizons. As with any investment, due diligence steps around suitability and risk alignment are still critical before allocating funds.