Understanding Real Estate Investment Trusts (REITs): A Beginner’s Guide

Real estate investment trusts (REITs) have become an increasingly popular way for both institutional and retail investors to gain exposure to the real estate market. As an accessible investment vehicle that provides stable income streams, long-term growth potential, and portfolio diversification benefits, REITs are an option worth understanding for those new to real estate investing.

This beginner’s guide will provide a comprehensive overview of what real estate investment trusts are, their legislative origin and evolution, the different types of REIT models, qualifications for REIT status, how to invest in REITs, associated risks and benefits, key metrics for analysis, and address frequently asked questions for those new to learning about REIT investing. Equipped with this fundamental knowledge, individual investors can make informed decisions about whether adding exposure to commercial real estate through REITs has a place in their portfolios.

Key Takeaways

Term	Definition
REIT	A company that owns, operates, or finances income-producing real estate and distributes at least 90% of its taxable income to shareholders annually in the form of dividends
Equity REIT	Invests in and owns real estate directly, deriving revenue from rents and capital appreciation
Mortgage REIT	Provides financing for real estate by originating mortgages or purchasing whole loans or mortgage-backed securities

Definition and Core Functionality

A real estate investment trust or REIT is a company that owns, operates, and often manages income-producing real estate assets. Modeled after mutual funds, REITs provide all investors the chance to gain exposure to institutional commercial real estate investments that generate revenue streams from assets invested across property sectors.

REITs were created by Congress in 1960 to allow individual investors into a realm previously only accessible by larger institutions. They are established as tax-advantaged structures that can acquire equity capital from both large and small investors to purchase real estate. In exchange for conforming to certain provisions in the Internal Revenue Code related to assets, revenue, ownership, and distributions, REITs can avoid paying corporate income tax on earnings distributed to shareholders. This tax advantage allows REITs to offer investors regular high-yield dividends derived from the dependable income streams of underlying real estate holdings.

Historical Background

Year	Legislative Action	Significance
1960	Cigar Excise Tax Extension	Enabled creation of the REIT structure
1976	Tax Reform Act	Modified restrictions to limit thinly capitalized REITs
1986	Tax Reform Act	Curtailed certain revenue sources and ownership requirements
1999	REIT Modernization Act	Allowed REITs into more asset classes like prisons, casinos etc.

Operational Models: How REITs Work and Generate Income

At their core, REITs work by pooling funds from investors to purchase assets like apartment buildings, data centers, cell towers, hospitals, shopping malls, hotels, and more. Their revenues are generated primarily through rents, leases, and interest earned on financing real estate.

There are three key operational models REITs employ to earn income:

REIT Income Sources

Model	Description	Revenue Source
Equity	Direct ownership of real estate properties	Rents, capital appreciation
Mortgage	Lending to owners/operators	Interest income
Hybrid	Combines ownership & financing	Rents, interest, sales

Most REITs utilize specialized management teams with local real estate expertise to select and operate assets spanning geography and sectors. By aggregating capital into a professionally managed, diversified portfolio, REIT investors can gain cost-efficient exposure compared to owning individual properties directly.

Benefits of REIT Ownership Structure

Benefit	Description
Economies of Scale	Access to large institutional-grade real estate assets
Professional Management	Specialized executive teams handle day-to-day management and decisions
Diversification	Invest across property sectors, regions, risk profiles
Liquidity	Invest in private commercial real estate through publicly traded securities

Legislative Requirements for REIT Status

In 1960, REITs were established when President Eisenhower signed legislation containing provisions added to the Internal Revenue Code that enabled these real estate investment structures. Firms must meet and maintain the following IRC-based requirements to qualify for preferential tax treatment as a REIT:

IRC Requirements for REIT Status

Category	Rule	Purpose
Asset Holdings	75% in real estate	Focus investment on operating real assets
Revenue Sources	75% from rents, mortgages	Derive income from real estate rather than sales
Ownership	100+ shareholders <50% 5 owners	Ensure a broad, public shareholder base
Earnings Distribution	Payout 90% of taxable income as dividends	Directly pass through the majority of earnings to shareholders

These requirements effectively mandate that REITs primarily invest in, operate, and derive earnings from real estate while distributing income to a dispersed shareholder base. By meeting the rules, REITs avoid being taxed at the corporate level on passed-through earnings.

Types of REITs

Under the REIT umbrella, several distinct business models catering to unique segments of real estate have evolved over time primarily based on the specific assets and activities involved:

Categories of REITs

• Equity REITs own and proactively operate income-producing real estate assets directly. For example, an equity retail REIT would own malls, shopping centers, or freestanding retail locations and handle property management, maintenance, lease negotiations, etc.

• Mortgage REITs finance real estate by originating loans or investing in mortgages and mortgage-backed securities. By lending capital to owners & operators, mortgage REITs earn interest income without taking on the responsibilities of direct property oversight.

• Hybrid REITs utilize strategies from both equity and mortgage models – investing directly in real estate properties while also providing financing by making or purchasing loans secured by real estate collateral. This blend can help balance revenue.

Furthermore, equity REITs that own properties tend to specialize in specific classes:

Key Property Sectors

Sector	Composition	Example Holdings
Residential	Apartments, housing, storage facilities	Apartment communities, single-family rentals, self-storage facilities
Retail	Shopping centers, malls, outlets	Grocery stores, dollar stores, strip centers, regional & super regional malls
Office	Commercial office spaces	High-rises, medical offices, data centers
Industrial	Warehouses, distribution	Manufacturing facilities, truck terminals, storage

Within these models exist hundreds of publicly traded REITs spanning specialized sectors for investors to gain targeted real estate exposure…

Investing in REITs

Gaining investment exposure to the REIT asset class can come through several avenues:

Publicly Traded REITs

The vast majority of REIT structures are publicly traded, SEC-registered companies that list shares for purchase on major stock exchanges such as the New York Stock Exchange and Nasdaq like traditional stocks. This gives individual investors liquidity to buy or sell at any time while operating within the public regulatory system. Some of the most prominently traded REITs include names like:

• American Tower (AMT) – Owns and operates over 220,000 telecommunication cell towers globally, leasing antenna/equipment space to wireless carriers/operators in lucrative long-term contracts
• Prologis (PLD) – The largest industrial REIT in the world that develops, manages, and leases sprawling logistics and distribution centers to organizations involved in global supply chain operations and facilitating e-commerce.
• Equity Residential (EQR) – Focused strictly on acquiring, constructing, and managing multi-family rental apartment communities predominantly located in coastal urban markets and population centers across the United States.

Nearly 150 publicly listed REITs spanning specialized property verticals across retail, office, industrial, healthcare, infrastructure, and more are tracked through industry benchmark indexes as documented on aggregation sites like REIT.com.

Top Traded REITs by Market Capitalization

Company	Symbol	Description	Market Cap
American Tower	AMT	Cell tower infrastructure	$122B
Prologis	PLD	Logistics/warehousing	$97B
Public Storage	PSA	Self-storage units	$65B

Public Non-Traded REITs

Serving smaller pools of investors, public non-traded REITs register with the SEC for regulatory oversight but, as their name implies, do not actively list or publicly trade shares on stock exchanges. Liquidity events depend on set redemption plans with the sponsor usually based on holding periods, meaning capital can be tied up for lengthy periods. However, their niche non-public structure can allow higher dividend yields.

Thorough due diligence on the management team and property holdings transparency is vital before investing. Inland Real Estate Investment Corporation, with a portfolio spanning retail, healthcare, and multifamily, is one the largest public non-traded REITs with over $11 billion in assets.

Private REITS

Only available to high-net-worth individuals and institutional investors like pension funds, private REITs completely avoid SEC registration requirements, thus allowing more operating flexibility but also concentrating risks given no mandate for corporate governance policies, public financial disclosures, or ownership diversity. Liquidity is mostly non-existent without a share listing or mandated redemption options. Their private status enables much higher selectivity in properties, markets, and deal structures – but requires deep analysis around true value prospects.

Access Vehicles

Beyond direct individual company stock purchases, broad diversified exposure across the REIT market can be obtained through:

• Mutual Funds: e.g. Vanguard Real Estate Index Fund (VNQ)
• ETFs: e.g. iShares Global REIT (REET)
• Real estate crowdfunding platforms like Fundrise expanding access to the asset class through micro-investing models

Public Non-traded REITs

Company	AUM	Description
Inland RE Investment Corp	$11B	Retail, health care, multifamily portfolio
Blackstone REIT	$69B	Global commercial real estate
American Finance Trust	$6.4B	Retail, distribution, office assets

In addition to equity market-like returns over time, REITs uniquely offer:

Dividends and Stable Income

REITs are legally required to pay out at least 90% of taxable earnings annually to shareholders – meaning high dividend payout ratios relative to regular stocks. Beyond solely meeting a payout threshold, evaluating the stability and durability of distributions over time-tied metrics like FFO and operating cash flows is vital:

• FFO Payout Ratios: Funds from operations-based payout ratios below 90% are generally considered healthy from a coverage standpoint to support ongoing dividends. As ratios climb about 100%, an increasing reliance on debt or equity issuance potentially signals limitations to maintaining distributions.
• Dividend Yield: Given reliable property rental incomes via typical 5+ year lease contracts, average dividend yields for REITs historically land between 3-4% over the long run – materially higher on an absolute basis than broader equity index averages around 2%. Of course, significant variation exists across the property sector and risk profiles.

Diversification

Modern portfolio theory examining asset class exposures shows traditional 60/40 stock/bond allocations may be lacking real estate – a distinct asset category offering variety in its cash flow, risk, and return characteristics. By diversifying into commercial real estate, overall portfolio risk-adjusted returns can improve.

Low Volatility

The contractual structure of rental incomes from long-duration property leases intrinsically creates earnings stability for REITs, especially relative to more cyclical industries with fluctuating demand. This helps mitigate volatility at the total return level.

Professional Management

REITs frequently employ specialized executive teams with niche real estate investment expertise related to:

• Macroeconomic analysis guiding property acquisition and development pipelines
• Local market proficiency
• Optimizing the mix of debt and equity capital stacks
• Managing tenant relationships through lease negotiations

This can make value unrealizable in individual small-scale property ownership and management.

Risks and Downsides of Investing in REITs

REIT Risk Factor Rankings

Risk	Importance	Description
Interest rates	High	Impacts relative asset valuations and cost of capital
Limited growth	Moderate	Dividend payout requirements restrict reinvestment abilities
Property markets	High	Ultimately tied to underlying real estate asset fluctuations

While compelling benefits exist, risks common across equities remain:

Interest Rate Sensitivity

As an income-centric asset class, increasing interest rates where debt becomes more expensive can pressure REITs on multiple fronts by:

• Raising their overall cost of capital for leveraged property transactions
• Boosting investor hurdle rates potentially lowers underlying property valuations

Limited Growth

Strict income distribution requirements create an inherent structural ceiling on opportunities for significant growth-focused reinvestment of operating cash flows after accounting for capital expenditures. This can constrain earning expansion over time.

Property Market Exposure

While macro REIT indexes exhibit relatively low correlations to equity/bond market swings, at their core their valuations remain tied to supply and demand dynamics in underlying commercial real estate property markets they serve – introducing asset-specific risks related to regional economic health, tenant industry exposures, lease structures beyond senior management control.

Evaluating REITs as Investments

With an understanding of the fundamentals and risks in place, assessing the merits of specific REIT opportunities involves analysis across both quantitative and qualitative factors:

Quantitative

Metric	Description	Preferred Range
FFO	Adjusted Earnings Metric	Healthy growth over time
Dividend Payout Ratio	FFO / Dividends	<90% lower risk
Debt Ratios	Total Liabilities / Total Assets	<50% less risky

Qualitative

• Depth of management team experience, public company leadership track record
• Property type, geographic, tenant exposures, and concentrations
• Average lease lengths and embedded rent escalators
• Strength of parent company sponsor

Compare REITs targeting similar property niches on relatively durable competitive advantages in their space related to offerings, markets, brands, scale, access to deal flow, and proven seasoned leadership steering the ship – just as with traditional equity analysis.

REIT Fraud Awareness

While regulatory standards protect investors focused predominantly on larger publicly-traded REITs, risks still exist investors should be aware of potentially stemming from:

Financial Engineering

Unsustainable dividend yields materially above industry peers can unfortunately signal reliance on destructive return of capital tactics rather than actual operating cash flow generation to boost appearances of performance. Carefully determining the repeatability of headline metrics is key.

Asset Validation

Especially for more complex, opaque private REIT structures, misrepresented statistics tied to property valuations and cash flow coverage relative to earnings distributed to stakeholders occasionally surface. Thinking critically about the alignment of management incentives and external validation methods around stated assets and returns proves vital.

FAQs 

• REITs utilize a pass-through corporate structure to avoid entity-level double taxation if distributing at least 90% of taxable earnings annually to shareholders who pay ordinary income rates on the dividends received, not lower qualified dividend rates from regular C-corps.
• While risks exist, diversified publicly traded REITs with prudent balance sheets and consistent track records of solid leadership can provide durable long-term income and market-beating total returns over the long run for investors – justifying portfolio inclusion. But restraint on position sizing to a moderate overall allocation level is wise.
• Dividend yields average 3-4% historically across all REITs, higher than broader benchmarks in the S&P 500. But an array of variances exists with the property sector, risk profile, FFO payout ratios, and overall distribution policy impacting specific yields greatly from sub-1% into high single digits.
• For publicly listed REITs, the barrier to entry is the current share price. However, some non-traded or private REITs still incorporate high minimum investments, limiting accessibility.

Conclusion

After decades of robust performance through various market cycles, REITs have cemented themselves as a unique asset class offering investors income consistency, commercial real estate exposure, diversification from bonds/equities, long-term capital appreciation potential, and inflation-hedging attributes. They warrant consideration for inclusion as part of personalized portfolio allocation strategies tailored to individual risk preferences. By understanding their foundations, new investors can make educated decisions navigating the nuanced REIT landscape.