The Definitive Guide to REITs (Real Estate Investment Trusts)

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A Real Estate Investment Trust (REIT) is a security that trades on exchanges like a normal stock, but conducts its business in various aspects of the real estate market. While most REITs focus on owning properties and renting them out to tenants, others work in financing properties and mortgages.

REIT History and Structure

Real estate investment trusts were first created in 1960 by congress to enable both small and large investors to benefit from commercial real estate profit. The government requires REITs to abide by several regulations, including maintaining 75% of their assets and income in real estate, and having a minimum of 100 shareholders.

In addition, REITs must distribute 90% of their earnings to shareholders through dividends. As a result, the company is exempt from paying income taxes on the profits paid to shareholders. In turn, individual shareholders are then responsible for paying taxes on earned dividends. REITs generally have very high yields and payout ratios since they are required to pay such a large percentage of their profits in the form of dividends. In fact, payout ratio is not a useful metric for evaluating REITs at all.

Types of REITs

The two main kinds of REITs are equity and mortgage . Equity REITs focus on property management. Although these firms do finance their properties, they increase income by making acquisitions and managing properties. In contrast to equity REITs, mortgage REITs do not own or manage their properties. They earn their income by investing in real estate loans.

REITs are often categorized depending on the specific type of property that they invest in. Approximately two thirds of REITs are in offices, apartments, shopping centers, malls, and industrial facilities. The remaining REITs own properties such as hotels, health care properties, and self-storage facilities.

Below are the most common types of REITs:

  • Healthcare

    Healthcare REITs own real estate properties such as hospitals, medical centers, nursing facilities, and retirement homes. These REITs depend on factors such as occupancy fees, Medicare and Medicaid reimbursements, and private pay to be successful.

  • Retail

    Retail REITs account for 24% of all REIT investments made in the U.S. These REITs make money from rent from their tenants, so it is important that the retailers are doing well in their businesses so that they able to pay their rent, and provide regular cash flow for the company.

  • Office

    Office REITs invest in office buildings and earn income from their tenants' rent. Most tenants in office REITs have long term leases.

  • Residential

    Residential REITs focus on rental apartment buildings and manufactured housing. The biggest residential REITs tend to own properties in high cost regions such as New York or Los Angeles where they are able to charge higher rent.

  • Mortgage

    Mortgage REITs are relatively new, and account for about 10% of all REIT investments. They focus on investing in mortgages rather than taking ownership of properties.

REIT Advantages and Disadvantages

Many investors invest in REITs for their high yields. Since the companies are mostly tax exempt and are obligated to pay out the vast majority of their earnings in dividends, REIT yields are typically much higher than other types of stocks (averaging about an 8% annual yield for a 15-year investment). REITs also attract investors since their dividends are often secured by ongoing rent and long term leases. Other benefits include simple tax implications, diversification, and the ease of trading on an exchange.

There are a few disadvantages to investing in a REIT, however. One disadvantage is that shareholders are obligated to pay regular income taxes on their dividends. REITs also have high tax obligations themselves due to property taxes, which can be up to 25% of their total operating expenses. Higher property taxes, in turn, can result in a lower cash flow to shareholders.

Like most investments, REITs carry risk. Many investors are attracted to high yield REITs, but those investments can sometimes include the most risk. Unlike other dividend paying companies that pay the same dividend every quarter, mortgage REITs often cut their dividends when there is an increase in interest rates and mortgage defaults. Although the long term returns typically are successful for investors, REITs largely depend on real estate prices. Thus, these investments often go through cycles of boom and bust.

The Bottom Line

REITs are popular instruments for income investors due to their high yields and relatively steady cash flow. As with an investment, these stocks still include a certain degree of risk, and careful research is needed to separate high-quality names from those in decline.

For more information, see our list of high-yield REITs.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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