Investing in real estate is an excellent way to diversify your portfolio, and REITs are a popular option that many investors pursue.
Once only available to the rich, today’s REITs are available to people of nearly all levels of financial wealth.
If you are thinking about investing in a REIT, we’ll cover what you need to know before you put your money on the line.
In This Article
- What is a Real Estate Investment Trust?
- When Should You Invest in REITs?
- What Are the Different Types of REITs?
- How Do REITs Generate Income?
- REITs Pros and Cons
- How to Start Investing in REITs
What is a Real Estate Investment Trust?
A real estate investment trust, also called a REIT, is a company that exists for the purpose of owning and operating income-producing real estate properties.
REITs were established as an amendment to the Cigar Excise Tax Extension. The goal was to make investments previously only available to the wealthy accessible to a larger scale of investors.
A REIT uses income profits to pay dividends to investors. They are often publicly traded and can be much more attainable than traditional real estate investments. This is a nice draw for investors.
There are certain qualifications a company must comply with in order to meet the definition of a REIT.
- Be managed by a board of directors/trustees
- Have at least 100 investors within the first year of existence
- Invest at least 75% of its assets in cash, U.S. treasuries or real estate
- Have 50% or fewer shares held by five or fewer investors
- Be taxable as a corporation
- 75% of revenue must be from rent, real estate sales or mortgage interest
- Pay at least 90% of its taxable income yearly as dividends to investors
REITs don’t have to be registered with the SEC (Securities Exchange Commission). However, the SEC strongly recommends only investing in REITs that are registered.
This registration status can help you avoid investment fraud that preys on trusting investors.
Typically, REITs are long-term investments. However, depending on the company you invest with, they can be much more liquid than traditional real estate.
Furthermore, many REIT investment companies allow you to sell your shares early for a fee.
When Should You Invest in REITs?
REITs may be a smart investment option for several types of investors. Here are some of the reasons you might want to have REIT shares in your investment portfolio.
You Want An Income Source
REITs are required to pay 90 percent of their taxable income to investors in the form of dividends.
This rule makes REITs a viable option if you are looking for real estate investments that provide passive income.
The quarterly or annual check you get from your REIT can be a great income source both in or out of retirement.
You Are Interested In Diversifying Your Portfolio
A REIT is one more way you can diversify your portfolio to help minimize risk. Smart diversification of your investments helps hedge against market downturns.
You Want to Invest In Real Estate Without The Hassle
Traditional real estate investing can be difficult. Making large down payments for purchases, property management responsibilities and working with tenants aren’t every investor’s cup of tea.
With REITs, you can take advantage of some of the profits that come with real estate investing while avoiding all of the hassles.
Similar to crowdfunded real estate investing, REITs offer you an opportunity to make money with real estate without owning properties directly.
You Understand the Risks
As with all investments, REITs do involve the risk of losing your money. It’s wise to understand the risks before you start investing.
What Are the Different Types of REITs?
As an investor, there are several types of REITs you can choose from. REITs are classified based on how they are bought and held.
They are also identified based on how their profits are produced. Here are the three ways REITs can be bought and held.
Private REITs are typically reserved for institutional investors. They’re not registered with the SEC, and they don’t trade on the national securities exchanges.
These types of REITs often offer more risk with a chance for higher returns. Additionally, they offer little to no liquidity for investors.
This is why private REITs are often reserved for institutional investors with more money.
Publicly Traded REITs
Publicly traded REITs are traded on national securities exchanges. They are open to individual investors and are regulated by the SEC.
Non-Publicly Traded REITs
Non-publicly traded REITs don’t trade on national security exchanges. However, they are regulated by the SEC.
One benefit of a non-publicly traded REIT is that it isn’t as impacted by market fluctuations as a publicly-traded REIT.
However, that benefit may be outweighed by the fact that non-publicly traded REITs tend to be less liquid than REITs that are publicly traded.
How Do REITs Generate Income?
When investing in REITs, whether publicly traded, non-publicly traded or privately traded, you can generally choose from three income-producing options.
Like all investments, each type of REIT comes with a certain amount of risk. Keep this in mind before you start investing.
As you decide which kind of REIT to invest in, it’s important to consider the market as a whole and which type of real estate investing you’re most drawn to.
Here’s an overview of how each type works.
Mortgage REITs make money on some form of mortgage profit. For example, the REIT might directly lend money to property owners in the form of a mortgage.
Or they might lend indirectly through mortgage-backed securities. The profits equal the difference between the interest they earn on the loans and the cost of the loans.
Of course, profits on mortgage REITs can be impacted by fluctuating mortgage interest rates.
Equity REITs are the most popular kind of REIT and work differently than mortgage REITs. Income is earned primarily through rents on properties owned by the REIT.
That said, income is not earned on the mortgages existing on the properties or when a property is sold.
Hybrid REITs utilize both equity and mortgage investment strategies to produce income for investors. They hold mortgage loans on properties as well as income-producing rental properties.
If you want a mix of mortgage and equity REIT income opportunities, hybrid REITs could be right for you.
REITs Pros and Cons
All investments come with both good and bad features, and REITs are no exception. Consider these pros and cons before you invest in a REIT.
- Steady Dividend Income
- Access To Commercial Real Estate Investing
- Passive Real Estate Investing
- Portfolio Diversification
- No Corporate Taxation
- Dividend Taxation
- Low Liquidity
- Potential Sensitivity To Interest Rates
- Property Ownership Risks
REIT investing can offer many positives for investors. Here are a few of the top benefits.
Steady Dividend Income
Since they are required to pay 90% of their taxable income to investors, profitable REITs make for a nice source of steady income.
If you’re an investor who wants to create a passive income source in retirement, investing in a REIT could be an excellent option to consider.
Access To Commercial Real Estate Investing
REITs give the average investor access to commercial real estate investing where no opportunity may have existed before.
Since REITs often hold commercial real estate, investors can own commercial properties without investing millions of dollars.
Passive Real Estate Investing
Along with the opportunity to own pieces of commercial and other real estate, REITs offer a passive investment opportunity.
There is no direct management of properties, no dealing with tenants and no forking out 20% or more for a down payment. A profitable REIT is a true source of passive income.
REIT holdings shouldn’t be your only type of investment. However, they can help you diversify your portfolio.
Furthermore, smart portfolio diversification can go a long way in protecting your wealth against market and other fluctuations.
No Corporate Taxation
REITs are exempt from paying corporate tax. This is good because it means that more of the money from a profitable REIT goes into your pocket.
Conversely, when you buy dividend-paying stocks from traditional corporations, their corporate tax burden affects your profit.
As with any investment opportunity, REITs do have some downsides. Here are the primary ones worth keeping in mind.
While your REIT may avoid corporate taxation, you will be taxed on the dividends you receive.
That said, you can avoid dividend taxation if you invest in a REIT in the form of a Roth IRA.
Additionally, investing in a REIT through a traditional IRA can offset some of the dividend taxation. This is because you can deduct traditional IRA contributions up to the yearly limits.
Another negative of REITs is that they are not terribly liquid investments. They are meant to be buy-and-hold investments.
While some may offer you the chance to bow out early for a fee, it’s important to note that REITs are typically considered long-term (five years or more) investments.
Potential Sensitivity To Interest Rates
With REITs being tied to the real estate industry, you should expect some sensitivity to interest rates if you invest in one.
If interest rates jump, it’s wise to expect your REIT profits to go down.
Property Ownership Risks
While real estate ownership does tend to bode well for investors long-term, all property ownership does come with risk.
REITs invest primarily in commercial properties, which means that business industry fluctuations can affect your profits.
We’ve all seen what COVID has done for many types of businesses, such as the restaurant industry.
Whenever you invest in commercial real estate through a REIT, it’s important to be aware that this type of investing can be subject to industry-specific risks.
Those risks, when realized, can affect the profit margin of your investment.
How to Start Investing in REITs
Getting started in REIT investing is simple. Your investment broker can help you buy shares. Visit your online brokerage firm’s website for more details.
Additionally, there are many websites that can help you get started with REITs. Here are some of the top options.
Fundrise offers publicly non-traded REIT shares to all types of investors. It is one of the most popular crowdfunded real estate investing websites.
You can start investing with Fundrise with as little as $500, making this platform accessible to almost anyone.
Modiv is another publicly non-traded REIT investment option. You can invest with Modiv for as little as $1,000.
However, Modiv is only open to accredited investors. Non-accredited investors will have to stick with Fundrise or similar platforms that are open to all investors.
RealtyMogul is another company that can help just about anyone become a real estate mogul. With RealtyMogul, you can invest as little as $1,000 in REITs.
RealtyMogul is open to accredited investors and non-accredited investors alike. Better yet, RealtyMogul REITs hold both commercial and residential real estate properties.
Investing in a REIT may sound daunting. However, REITs, along with a diversified portfolio, can help you develop a plan to use income-producing assets to become wealthy.
Of course, all types of investments involve risk. Consequently, there are no guarantees that your REIT investment will be profitable.
However, using the SEC’s Edgar tool to research REIT companies can help you weed out non-registered companies from registered options.
While REIT investing may not be for everyone, many investors find that they make an excellent contribution to a balanced, diversified portfolio.