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A real estate investment trust (REIT) is a company that invests in income-producing properties. Investors can buy shares of REITs on major stock exchanges or through a broker and receive a share of the income that the company receives from properties in the form of dividends.
If you want to invest in real estate, but you don't have enough money to buy an investment property of your own, here's what you should know about REITs.
How a REIT Works
REITs are modeled after mutual funds to provide a level of diversification that individual investors have a hard time obtaining on their own. REIT companies invest in a portfolio of investment properties, including office buildings, apartment buildings, warehouses, data centers, medical facilities, hotels and more.
The companies own the properties and get a regular income from the rent payments they collect from tenants. They then distribute that money to their shareholders. REITs are required by law to distribute at least 90% of their income in the form of dividends, but many pay out 100%.
The risk of investing in a REIT is generally lower than owning your own investment properties, but that doesn't mean it's entirely risk-free. For example, REITs are less appealing to investors during periods of rising interest rates because safer investments like Treasury bonds can provide decent returns with little to no risk.
There are also other short-term risks that can impact individual property types. For example, office building REITs took a significant hit in 2020 due to the pandemic sending many workers home, with total returns dropping by 18.44%, according to the National Association of Real Estate Investment Trusts (Nareit). The sector recovered in 2021 with a 22% return on the year.
That said, REITs can provide competitive long-term returns, according to Nareit. Here's how two of the top REIT indexes have historically performed:
| Historical REIT Investment Return | ||||
|---|---|---|---|---|
| 5-Year Return | 10-Year Return | 20-Year Return | 30-Year Return | |
| FTSE Nareit All-Equity REITs | 8.10% | 10.29% | 10.48% | 11.13% |
| FTSE EPRA/Nareit Developed | 5.97% | 7.29% | 8.83% | 8.80% |
Source: National Association of Real Estate Investment Trusts
For context, investment portfolios entirely composed of stocks have shown an average annual return of about 10.3% historically, according to Vanguard.
Types of REITs
There are a few different types of REITs you can invest in, though some are far less common than others:
- Equity REITs: The most common type of REIT is an equity REIT that's traded on a major stock exchange.
- Mortgage REITs: Also called mREITs, this type of company originates or purchases mortgages and mortgage-backed securities to earn income from the investments.
- Hybrid REITs: These companies combine the approach of equity REITs and mortgage REITs, giving shareholders some diversification between the two.
- Public non-listed REITs: These companies are registered with the Securities and Exchange Commission (SEC), which means that their information is publicly available. However, they don't trade on stock exchanges like equity REITs.
- Private REITs: This type of REIT is not registered with the SEC and isn't publicly traded.
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Pros and Cons of REITs
As with any investment opportunity, REITs have both advantages and disadvantages for investors. Here's what you should consider before you decide to put your money into a REIT.
Pros
- Good for income-minded investors: If you prioritize income-producing investments like bonds and high-yield dividend stocks, REITs may be a good fit because they're required to disburse the vast majority of their income to shareholders.
- Competitive returns: In the long term, REITs can provide competitive returns compared with the stock market.
- Lower investment requirement: Buying an investment property can require thousands or even tens of thousands of dollars in cash to cover the down payment, closing costs and ongoing expenses. With a REIT, you don't have to worry about any of that.
- Diversification: As an individual real estate investor, it's tough to diversify your portfolio of properties without a massive sum of money. In contrast, buying one share of a REIT gives you access to income from hundreds of properties. REITs also help you diversify your investment portfolio across multiple asset types.
- Liquidity: If you own an investment property and want to sell it, the process can take several months. With a REIT, you can sell your shares with a simple click of the button in your brokerage account.
Cons
- Dividend taxation: REIT dividends are taxed as ordinary income, which is a higher rate than you'd pay on long-term capital gains with stocks.
- Interest rate risk: During periods of rising interest rates, REIT prices tend to lose value as other, safer income-producing assets increase in value. In particular, Treasury securities tend to be a more attractive option because they're backed by the U.S. government and considered to be risk-free investments.
- Lower returns in the short term: As noted above, REITs tend to provide lower returns in the short term than the stock market. If you're investing in REITs, it's best to hold on to them for the long haul.
- Property-specific risks: Economic conditions can impact certain property types differently, so if you don't diversify your portfolio across multiple types of properties, you could be exposed to more risk.
How to Invest in REITs
Because equity REITs are the most common type of REIT, your best bet is to open a brokerage account and do some research on the different options that are available.
If you already have a brokerage account, you don't need to worry about opening a new one. Simply search for REITs the same way you'd search for stocks or funds and trade as usual. You can even buy into REIT mutual funds and exchange-traded funds if you prefer that approach. You can also invest in REITs through your individual retirement account if you want to include them in your long-term investment strategy.
If you don't already have a brokerage account, take your time to compare the different brokers to determine which provides the best fit for you. Look at fees, investment options, account options, resources, tools and other factors to find the right one.
Work With a Professional to Determine Your Investment Strategy
Anyone can invest in REITs, but it's often a good idea to consult with a financial advisor before making big investment decisions. An advisor can help you by providing expert, personalized advice for your particular situation. They can even help manage your money for a fee if you don't want to do it alone.
Whatever you do, avoid making investment decisions without first taking the time to research and understand what you're investing in and how it might impact your financial future. Also, be sure to have your financial obligations covered before committing any money to an investment opportunity. Missing bill payments can lead to late payments and drag down your credit score, which can make it harder to secure credit in the future.