What Are Real Estate Investment Trusts?

Offering a unique blend of real estate ownership and stock market liquidity, real estate investment trusts (REITs) have gained popularity for their potential to generate consistent income and long-term capital appreciation. Here, we dive into the intricacies of REITs, exploring what they are, how they work, and why they have become a pivotal player in the investment world.

What Are Real Estate Investment Trusts?

A REIT is a specialized investment vehicle that allows individuals to invest in income-generating real estate assets without having to directly own or manage them.¹

REITs operate under a specific tax structure that requires them to distribute a significant portion of their income to shareholders in the form of dividends. This unique structure enables investors to access the benefits of real estate ownership while enjoying the liquidity and ease of trading associated with stocks. In generic terms a real estate investment trust, or REIT, is essentially a mutual fund for real estate.

How REITs Work

REITs provide investors with diversified exposure to various real estate sectors, including residential, commercial, industrial, and retail properties. This diversification helps mitigate risks associated with a specific type of property or location.

One of the most attractive features of REITs is that they distribute at least 90% of their taxable income as dividends to shareholders. This consistent income stream makes REITs an appealing choice for income-focused investors.

Unlike direct real estate investments, which may require a lengthy sales process, REIT shares are traded on stock exchanges, offering investors the flexibility to buy and sell their holdings easily.²

REITs are managed by professional teams with expertise in real estate investment and management.

Types of REITs

There are three types of REITs:³

Equity REITs

These REITs own and manage income-generating real estate properties. The income generated through these properties is primarily rental income.

Mortgage REITs

Mortgage REITs invest in real estate mortgages and mortgage-backed securities. Their income is derived from the interest on these loans.

Hybrid REITs

Combining elements of both equity and mortgage REITs, hybrid REITs offer a diversified investment strategy by engaging in both property ownership and mortgage lending.

Benefits of Investing in REITs

As with any investment option, REITs have benefits and drawbacks. Let’s look at some of the main benefits:

Steady Income—The mandatory distribution of income ensures a steady stream of dividends for investors, making REITs an attractive option for income-focused portfolios.
Portfolio Diversification—REITs offer diversification benefits by providing exposure to various real estate sectors and geographical locations, reducing the risk associated with concentrated investments. Additionally, the low correlation of REITs with U.S. and global equity indexes has continued to provide meaningful diversification opportunities.⁴
Professional Management—Investors benefit from the expertise of professional management teams responsible for property acquisition, management, and disposition.
Liquidity and Accessibility—The ability to buy and sell REIT shares on stock exchanges provides investors with liquidity and easy access to their investments.
Potential for Capital Appreciation—In addition to dividend income, investors may also benefit from capital appreciation as the value of underlying real estate assets increases over time.

Risks Associated with REIT Investments

While REITs offer many benefits, they also come with some potential risks. Here are a few:

Interest Rate Sensitivity—REITs are sensitive to changes in interest rates, and rising rates can negatively impact their profitability and stock prices.⁵
Market Fluctuations—Economic downturns or real estate market fluctuations can affect the performance of REITs, impacting both income and capital appreciation.
Property-Specific Risks—Certain REITs may be more vulnerable to specific risks, such as changes in local real estate markets, tenant defaults, or property depreciation.
Income Tax Rules- As a proportional owner of the REIT company, the shareholder receives this payout as ordinary income and will be taxed at their marginal income tax rates as nonqualified dividends.⁶
Regulatory Risks—Changes in tax laws or regulations affecting REITs can impact their operation and profitability.

How to Invest in REITs

Most REITs are publicly traded and can be bought and sold on major stock exchanges, providing easy access for investors. A broker, investment advisor, or financial planner can help analyze an investor’s financial objectives and recommend appropriate REIT investments.⁷

Investors can also gain exposure to a diversified portfolio of REITs through mutual funds or exchange-traded funds (ETFs) that specialize in real estate. Or, some investors may choose to invest directly in individual REITs, allowing for a more targeted approach to real estate sectors or strategies.

REITs have revolutionized the investment landscape, offering a unique blend of real estate ownership and stock market accessibility. Given their potential to offer a consistent income, their diversification benefits, and their professional management, REITs have become a staple in many investors’ portfolios. However, like any investment, investors should conduct thorough research and talk to their advisor prior to investing in REITs.