# Understanding REITs: What They Are and Tips for Investing Smartly

Plus tips on how to get started with these alternative investments

> **Definition**
>
> A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate and sells shares to raise capital to do so.

## What Is a Real Estate Investment Trust (REIT)?

Real estate investment trusts (REITs) are companies that own, operate, or finance income-producing real estate across a wide range of property sectors. These investments, which can often be purchased through [top brokerage](https://www.investopedia.com/best-online-brokers-4587872) and [real estate crowdfunding platforms](https://www.investopedia.com/the-best-real-estate-crowdfunding-sites-8761523), allow you to earn income from [real estate](https://www.investopedia.com/terms/r/realestate.asp) without having to buy, manage, or finance properties yourself.

Created by a 1960 law, REITs were designed to make real estate investing more accessible so smaller investors could diversify their portfolio with skyscrapers, shopping malls, or apartment complexes with the same ease as buying stocks. By pooling capital from many investors, REITs have changed and funded much of American real estate, often in ways few in the public understand. Below, we’ll explore how they work, what benefits and risks you need to know about, and how to invest in them.

### Key Takeaways

*   Real Estate Investment Trusts (REITs) allow investors to own shares in income-producing real estate without managing the properties themselves.
*   REITs must distribute at least 90% of taxable income as dividends to maintain their tax-advantaged status, leading to steady income streams for investors.
*   There are three primary types of REITs: equity REITs, mortgage REITs, and hybrid REITs, each with unique investment focuses and risks.
*   REITs are mostly traded publicly like stocks, providing liquidity and accessibility not commonly found in direct real estate investments. These investments can often be purchased through an [online broker](https://www.investopedia.com/best-online-brokers-4587872) or a [real estate crowdfunding platform](https://www.investopedia.com/the-best-real-estate-crowdfunding-sites-8761523).
*   Investors should be mindful of REIT-related fraud and are advised to verify the registration and legitimacy of non-traded and private REITs through the SEC's EDGAR system.

![Real Estate Investment Trust (REIT)](https://www.investopedia.com/thmb/qNxT3vGAwbTuDINC2rM2EkwPZb0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Real-Estate-Investment-Trust-189c6cf51a03412b880b12f10ff1ee05.jpg)

*— Eliana Rodgers / Investopedia*

## Understanding How REITs Function

Congress created REITs in 1960 via an amendment to the Cigar Excise Tax. This allowed firms to gather funds from investors to purchase large [real estate portfolios](https://www.investopedia.com/articles/mortgages-real-estate/08/real-estate-mutual-fund.asp). REITs operate like mutual funds—firms manage pools of funds for the sake of many investors—but for real estate instead of stocks and bonds. Investors earn returns from dividends and increases in the REIT's share value.

Central to REITs is that they take the quintessential example of illiquid assets—real estate—and make them liquid. REITs invest in all kinds of properties: apartment complexes, data centers, healthcare facilities, hotels, infrastructure (fiber cables, cell towers, and energy pipelines), office buildings, retail centers, self-storage units, timberland, and warehouses. REITs tend to specialize in specific real estate sectors, like commercial properties. However, many hold diversified portfolios of many kinds of properties.

As you can see below, the amount investors have pooled in REITs has risen significantly in the past quarter-century, almost exactly tenfold. Also notable is the undulation of the line graph as market bubbles inflate, crises and recessions arrive, and interest rates shift. Often thought of as the most stable of stock assets—after all, the sector includes the ground beneath your feet—the value of real estate and, thus, the returns from REITs are certainly not.

## Criteria for REIT Qualification

Most REITs lease space, collect rent, and distribute this income as dividends to shareholders. A small percentage of REITs, called mortgage REITs, earn money from financing real estate, not owning it.

To qualify as a REIT, a company must meet several requirements set by the Internal Revenue Service (IRS).

These include the following:

*   Invest at least 75% of total assets in real estate, cash, or U.S. Treasurys
*   Derive at least 75% of gross income from rent, interest on mortgages that finance real estate, or real estate sales
*   Pay a minimum of 90% of their taxable income to their shareholders through dividends
*   Be a taxable corporation
*   Be managed by a board of directors or trustees
*   Have a minimum of 100 shareholders
*   Have no more than 50% of its shares held by five or fewer individuals

> **Fast Fact**
>
> An example of a REIT is Healthpeak Properties Inc. (DOC), an S&P 500 company that owns, manages, and develops healthcare real estate.

## Different Types of REITs Explained

While REITs are categorized by the different kinds of properties they invest in, there have traditionally been three major types:

*   **Equity REITs.** Equity REITs own and manage real estate that generates income. Revenues are generated primarily through rent, not by reselling properties.
*   **Mortgage REITs.** Mortgage REITs lend money to real estate owners and operators directly through mortgages and loans or indirectly through acquiring [mortgage-backed securities](https://www.investopedia.com/terms/a/aggregator.asp). Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them sensitive to interest rate increases—though equity REITs are also greatly affected by rate change.
*   **Hybrid REITs.** These REITs mix strategies from both equity and mortgage REITs. After the [2007–2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp), these trusts, already on the wane, largely disappeared as regulations changed and REITs became more, not less, specialized.

## A Guide to Investing in REITs

Within the above types are REITs that have different ways of attracting funding. These differences are important for beginners investing in REITs:

*   **Publicly traded REITs.** Shares of publicly traded REITs are listed on a public exchange, where they are bought and sold by individual investors. These fall under U.S. Securities and Exchange Commission (SEC) regulations.
*   **Public non-traded REITs.** These REITs are registered with the SEC but don’t trade on exchanges. As a result, they are less liquid than publicly traded REITs. As such, they tend to be more stable because they’re not subject to market volatility. Shares of a non-traded REIT can be bought through a broker or financial advisor who participates in the non-traded REIT’s offering.
*   **Private REITs.** These REITs aren’t registered with the SEC and don’t trade on securities exchanges. In general, private REITs can be sold only to institutional investors. They are also the site of many REIT-related frauds. While most, of course, are legitimate investments, it’s easier for con artists to ply their trade in this area of real estate than within the regulated markets.

In addition, REITs may be included in [defined benefit](https://www.investopedia.com/terms/d/definedbenefitpensionplan.asp) and [defined contribution](https://www.investopedia.com/terms/d/definedcontributionplan.asp) plans through mutual funds and exchange-traded funds (ETFs). Thus, many U.S. investors own shares in REITs through their retirement savings.

## Essential Tips for REIT Investment Beginners

If you’re new to REIT investing, here are [tips to get you started](https://www.investopedia.com/5-surprising-facts-about-reit-etfs-8754940):

### 1\. Begin with Publicly Traded REITs

For newcomers, publicly traded REITs offer the easiest way to get started. You don’t need a vast amount of money—the cost of entry is the trust’s share price that interests you. Private REITs, meanwhile, are only open to [accredited investors](https://www.investopedia.com/terms/a/accreditedinvestor.asp) and have minimums starting in the low thousands.

When investing in publicly traded REITs, here are strategies to consider:

*   **Do your homework**: Examine a REIT’s portfolio, management team, debt levels, and dividend history before investing.
*   **Think of the long-term**: REITs are customarily best suited for long-term strategies because of how they generate income.
*   **Examine the fees**: There are no direct fees beyond standard brokerage commissions when buying or selling shares. REIT management fees are built into operating expenses, affecting your overall returns. As such, you’ll want to review how comparatively efficient the trust is with managing its expenses—that is, your fees.

> **Tip**
>
> The Financial Industry Regulatory Authority (FINRA) has repeatedly warned investors about fraud in the sector, showing how many REIT scams involve “REITs” that are anything but: They don’t own real estate, aren’t invested in anything, and aren’t trusts or to be trusted.

### 2\. Start Small and Scale Up

Start with a small investment and gradually increase it. You might begin by investing a small percentage of your portfolio—perhaps 2% to 5%—in a broadly diversified REIT or REIT fund. You can then take the time to get familiar with the real estate market—its income potential, its ups and downs, and how its shifts correlate with stocks, bonds, and other assets.

As you do this, pay attention to how your REIT investments affect your risk profile and other parts of your portfolio. Some financial advisors suggest a well-diversified portfolio might include a 5% to 15% allocation to real estate. However, the right amount depends on your financial goals, risk tolerance, and investment timeline. In addition, the real estate market is often cyclical, so scaling up gradually should help you avoid being overexposed when a downturn arrives.

### 3\. Diversify Across REIT Categories

Diversify your investments across different real estate sectors, like residential and commercial, to balance your portfolio. This table gives you a quick view of the different property categories and their characteristics:

### 4\. Invest in REIT Funds for More Diversification

For investors aiming to diversify their portfolios with real estate, [REIT mutual funds](https://www.investopedia.com/articles/investing/040315/reits-versus-real-estate-mutual-funds.asp) and [ETFs](https://www.investopedia.com/terms/r/reit_etf.asp) can help spread risk even further than individual REITs. Both options expose you to a broad spectrum of real estate sectors through a single financial product. However, they come with specific characteristics you’ll need to consider.

*   **REIT mutual funds**, such as the [T. Rowe Price](https://www.investopedia.com/t-rowe-price-review-4587924) Real Estate Fund (TRREX), offer the advantage of professional management. Many fund managers actively select and adjust holdings, potentially capitalizing on market trends or mitigating risks. Some funds are accessible through 401(k) plans (depending on your employer), allowing automatic investing via payroll deductions. This ease of access and expert management is a good way to get into the real estate market while leaving the choice of properties and other assets to the professionals.
*   **REIT ETFs** are either actively managed or passively follow an index. For example, the Pacer Benchmark Industrial Real Estate SCTR ETF (INDS) invests at least 85% of its funds in industrial real estate properties, including warehouses and distribution centers. Pacer’s managers actively oversee the fund, picking the assets they think will outperform the market.

### 5\. Explore Real Estate Index Funds for Low-Cost Diversification

These funds passively track real estate indexes, offering broad market exposure at lower fees than their actively managed peers. For example, the Vanguard Real Estate ETF ([VNQ](https://www.investopedia.com/markets/quote?tvwidgetsymbol=VNQ)) mimics the MSCI US Investable Market Real Estate 25/50 Index, which covers a wide swath of American real estate.

If you want international exposure, the iShares Global REIT ETF ([REET](https://www.investopedia.com/markets/quote?tvwidgetsymbol=REET)) tracks the NAREIT Global REIT Index, which covers REITs in both developed and emerging markets.  

### 6\. Be Tax Savvy

REITs have specific tax implications that should be considered since they can greatly impact your returns. These trusts are not typically subject to corporate income tax as long as they distribute at least 90% of their taxable income to shareholders as dividends.

This pass-through structure can result in higher dividend yields for investors. However, unlike qualified dividends from stocks, which are often taxed at lower [capital gains rates](https://www.investopedia.com/taxes/capital-gains-tax-101/), most REIT dividends are taxed as ordinary income. This could result in higher tax bills, especially for investors in higher tax brackets.

> **Tip**
>
> The returns of REITs have a relatively low correlation with other assets. That means they don’t necessarily follow what’s happening with stocks, bonds, or other parts of the market. That’s why they can help diversify a portfolio: They might stay steady as other assets head downward. As always, it’s wise to consult a tax professional to understand how any of this would apply to your tax situation.

Many hold REITs in tax-advantaged individual retirement accounts (IRAs) or 401(k)s to mitigate these tax impacts. This way, REIT dividends can compound tax-free (e.g., in Roth accounts) or tax deferred (traditional [IRAs](https://www.investopedia.com/terms/i/ira.asp)). This strategy can significantly improve your long-term returns by allowing you to reinvest more of your dividends.

> **Tip**
>
> Many REITs also often use leverage (they borrow) to buy up more properties. When comparing REITs, looking at their debt-to-equity ratios is essential so you’re not putting money into a venture sinking under its debt.

### 7\. Stay Up to Date

You’ll want to keep abreast of real estate trends to make informed decisions about your REIT investments. Keep an eye on basic economic indicators like [interest rates](https://www.investopedia.com/terms/i/interestrate.asp), [inflation](https://www.investopedia.com/terms/i/inflation.asp), and unemployment since these significantly impact real estate values and rental income. You’ll want to key in on the fundamentals for the sectors where your REITs hold property. That might mean following demographic shifts like urbanization and gentrification, changes in households (people living with their parents longer, etc.) that will affect demand in different parts of the country, keeping an eye on how office work is migrating to the ex-urbs, or any number of economic and social changes that affect subsets of the real estate sector.

Sectors that seem very alike—like shopping malls and shopping centers—often perform very differently, and investors need to keep an eye on the specific dynamics for each part of the real estate sector that their REITs are invested in.  

## Pros and Cons of Investing in REITs

Pros

*   Liquidity
    
*   Diversification
    
*   Stable cash flow through dividends
    
*   Can have attractive risk-adjusted returns
    

Cons

*   Low growth
    
*   Dividends are taxed as regular income
    
*   Subject to market risk
    
*   Potential for high management and transaction fees
    

Shares in REITs are relatively easy to buy and sell, as many trade on public exchanges. REITs offer attractive risk-adjusted returns and stable cash flow. Real estate in a portfolio adds diversification and income through dividends.

REITs offer the possibility of capital appreciation, but it's important to note that REITs must pay 90% of their income back to investors. Thus, only 10% of taxable income can be reinvested into the REIT to buy new holdings. In addition, REIT dividends are taxed as regular income, and some REITs have high management and transaction fees.

## Are REITs a Good Investment?

Whether investing in these trusts is a good idea depends on your financial goals, [risk tolerance](https://www.investopedia.com/terms/r/risktolerance.asp), and overall stock market investing strategy. REITs offer the potential for steady income through dividends, portfolio diversification, and exposure to real estate without all the complexities and headaches of directly owning property. Historically, they offer competitive long-term returns and can hedge against inflation.

However, REITs also have risks, such as sensitivity to interest rate changes, economic downturns, and sector-specific challenges.

## How Can Investors Avoid REIT Fraud?

The SEC recommends that investors be wary of anyone who tries to sell REITs that aren’t registered with U.S. regulators. It advises, “You can verify the registration of both publicly traded and non-traded REITs through the SEC’s [EDGAR](https://www.investopedia.com/terms/e/edgar.asp) system. You can also use EDGAR to review a REIT’s annual and quarterly reports, as well as any offering prospectus.” If you stick to regulated REITs, you’ll have the normal risk of such trusts but not the outright fraud that would take off with your whole investment.

## Do REITs Have to Pay Dividends?

By law, REITs must pay out 90% or more of their taxable profits to shareholders as dividends. As a result, REIT companies are often free from most corporate income tax. Many REITs reinvest shareholder dividends, offering deferred taxation and compounding your gains.

## What Is a Paper Clip REIT?

A “paper clip REIT” increases the tax advantages of a REIT while allowing it to manage properties that such trusts normally can’t. It involves two entities “clipped” together via an agreement where one entity owns and the other manages the properties. Paper clip REITs entail stricter regulatory oversight since there can be conflicts of interest. They are uncommon.

## Do REITs Offer Monthly Payments?

While some REITs do, that’s not universal. The dividend schedule for REITs varies, with most paying quarterly, some monthly, and a few annually or semiannually. Monthly-paying REITs are often attractive to income-focused investors seeking regular cash flow since many provide a steady income via dividends. However, the frequency of payments doesn’t necessarily indicate higher returns or better financial health for the REIT.

## The Bottom Line

REITs democratize real estate investment, providing access to property assets traditionally reserved for the wealthy by allowing shares to be traded like common stocks. They reduce financial and managerial burdens associated with direct property investment. REITs offer portfolio diversification, steady income from [dividends](https://www.investopedia.com/terms/d/dividend.asp), and exposure to different property sectors, acting as a hedge against inflation and historically presenting competitive long-term returns.

However, they are affected by interest rate fluctuations and specific sector downturns, such as inner-city office spaces. Potential investors should conduct thorough research and consider consulting financial advisors before investing, weighing the benefits and understanding the associated risks.  

> **Article Sources**
>
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>     
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