Real Estate Investment Trusts (REITs) – A Comprehensive Guide

Infographic that explains what a REIT is, how it works, the different types of REITs, how to invest in REITs, and its benefits and advantages.

Real Estate Investment Trusts are popular investment vehicles worldwide, from the U.S. to Germany, Japan, and Brazil. According to Nareit (National Association of Real Estate Investment Trusts), at the end of 2019, REITs’ total market capitalization in the U.S. was $1.328 billion.

Real Estate Investment Trusts can be a good investment option for long-term investors. They can provide several benefits like diversification, high yields, and an attractive income stream for retirement. In addition, REITs offer investors a simple, affordable way to add the historically strong asset class of real estate to their portfolio. Still, like most investments with high returns, they carry additional risks.

This guide will explain what real estate investment trusts are, how they work, the different types, sectors covered, and their benefits and risks. This way, you can make an informed decision if REITs are a good addition to your portfolio.

What Is a Real Estate Investment Trust (REIT)?

A real estate investment trust or REIT is a company that invests in income-generating real estate and either runs, finances, or owns real estate to generate that income. They are corporations that manage/own portfolios of properties and/or mortgages.

REITs work like mutual funds. They pool capital from many different investors to invest in different kinds of real estate. Like mutual funds, a Real Estate Investment Trust share represents a part of the fund’s total assets owned. Investors buy shares in a REIT, and each share represents partial ownership in all the fund’s assets.

These real estate companies earn their income from equity investments through rent collection or debt investments through mortgage interest payments. In the case of equity ownership, value also is created through property appreciation.

Investors, in turn, typically realize their returns by regular dividend distributions from these income-generating trusts. However, investors in equity real estate trusts will not see their returns in regular payments but instead as a lump sum payment when they sell their shares.

Real Estate Investment Trusts make it possible for individual investors to participate in a bigger investment that they cannot afford independently. It also enables investors of any size to earn returns on real estate investments at relatively low risk compared with direct ownership and having to buy or finance real estate on their own.

How Do REITs Work?

REITs were introduced in 1960 in the United States as an extension of the Cigar Excise Tax to provide ordinary investors the chance to invest in real estate portfolios that were previously available to only rich individuals. This type of ownership resembles the way mutual funds work by pooling different investments in one place.

A Real Estate Investment Trust portfolio can include commercial real estate properties like data centers, apartments, hotels, healthcare facilities, shopping malls, and more. Infrastructure properties such as retail centers, office buildings, warehouses, cell towers, fiber optic cables, and energy pipelines also fall under REITs. While Real Estate Investment Trusts often specialize in a particular real estate sector, diversified ones can be made up of different types of properties like a combination of retail centers and offices.

Many REITs are traded publicly on major security exchanges like ordinary stocks. These trusts pool capital to invest in direct ownership of real estate or mortgages. Like mutual funds, a Real Estate Investment Trust share represents a part of the fund’s total assets owned. REITs are also actively managed by professional fund managers who determine and implement the most effective strategy to create the highest returns possible.

Real Estate Investment Trusts generate income through regular rent payments from tenants, businesses, organizations, and loan interest payments from mortgage holders. Another way they generate returns is through property value appreciation. This means that when the value of a property owned by the trust appreciates, the value of the trust itself goes up, as does the value of the individual trust shares. On the flip side, if the value of a property owned by the trust decreases, the individual REIT shares’ value goes down.

REIT investors typically generate income through regular dividend distributions in proportion to their ownership share in the entire fund. Investors can also generate returns through appreciation, generally in the form of a lump-sum payment upon selling their shares in the fund. However, when Real Estate Investment Trusts sell an underlying property, they can distribute capital gains dividends to investors without requiring investors to sell their fund shares. Typically, any appreciation realized in this way is categorized as a capital gain.

Real Estate Investment Trusts have become popular for many reasons. First, it offers investors access to an asset class that used to be too risky because it required direct ownership. This meant putting out a large initial down payment for one asset class, which prevented many investors from investing in real estate. In addition, direct ownership of real estate requires expertise in managing it, maintaining it, and financially planning its success.

However, REITs enable investors to invest in a diversified portfolio of real estate that covers many different sectors and reduces risk. They also do not require any expertise as they are professionally managed. Besides, they are easy to buy through a brokerage account.

Qualification Requirements for Real Estate Investment Trusts

To be considered a REIT, a company can’t just buy a few properties and call itself a REIT. Unlike most other real estate companies, a REIT is not in the business of reselling real estate. Instead, it buys and develops properties primarily to operate them as part of its investment portfolio.

Real Estate Investment Trusts are heavily regulated on the local, regional, and federal levels. Most are registered with the SEC (U. S. Securities and Exchange Commission). The SEC provides quick facts on REITS, as well as investor alerts and bulletins. Besides, many government agencies provide information that can enhance your knowledge and research on these trusts.

To qualify as a Real Estate Investment Trust, a company must comply with certain requirements. Here are the qualification requirements for a REIT:

  • Must be structured as a corporation or trust
  • Has to have a board of directors or a group of trustees for its management
  • Must be a taxable entity
  • Must have 100 or more shareholders
  • Payout a minimum of 90 percent of its income as dividends every year
  • Should have a minimum of 75 percent investment in real estate assets
  • Get 75 percent or more of its gross income from rent on property or interest on their mortgages

Major Types of REITs

Real Estate Investment Trusts can be classified in 3 different ways. The following are the primary types:

By Investment Type

Infographic that explains that there are 3 different types of REITs when divided by investment type: Equity REITs, Debt REITs, and Hybrid REITs which are a combination of both equity and debt. It also explains the advantages and disadvantages of each REIT type.

Equity – The most popular type is equity REIT trusts. These trusts are associated with direct ownership and often the operation and management of the income-generating real estate and for-sale housing. In this case, revenue is mostly created through rent collection. However, they also derive some income from property appreciation, especially in high-growth areas and renovated properties. Within the equity category, some REITs specialize in specific segments, such as properties that require a lot of renovations.

Typically, the greater the amount of work involved in generating returns, the greater the return potential and the higher the risk. Equity Real Estate Investment Trusts are good for long-term investors because of their high-growth and high-income generating potential. Sector-based investing is possible in Equity REITs.

Mortgage – This type of real estate trust only invests in debt and lends money to property owners through loans and mortgages. Mortgage REITs further tend to acquire mortgage-backed securities. The revenue comes from the margin between the cost of funding and the interest on the loans. Such a model makes these trusts dependent on changes in interest rates and the state of the economy. As a result, long-term growth potential is limited, but income is mostly steady and fixed.

Hybrid​ – These trusts invest in both equity and mortgages. A such, they do better during market downturns thanks to their diversified portfolio of assets. However, these trusts do not clearly focus on equity or debt, often resulting in lower returns.

By Market Type

Infographic that explains that REITs can also be divided by market type: Publicly Traded, Public Non-Traded, and Private REITs

Publicly Traded – Publicly traded REITs extend shares listed on the national securities exchange where investors trade them. The U.S. Securities and Exchange Commission (SEC) regulates them. Publicly traded shares can be easily bought through a brokerage and are highly liquid.

Public Non-Listed – Non-listed Real Estate Investment Trusts must register with the exchange commission for regulation but are not available for trading on the national securities exchange. This means they are less liquid as compared to publicly traded trusts. However, they typically are more stable as they are not prone to market fluctuations.

Private – Private REITs are not traded on national exchanges and aren’t registered with the exchange commission. They work as private placements and can only be sold to accredited investors, which typically means high-income or high-net-worth individuals or institutional investors. They usually require high minimum investments.

In the last decade, many new real estate online platforms have been created with relatively easy investor access. Although some platforms still have some restrictions, others offer easy, low-cost access to high-quality REITs.

The best example of one such online platform is Fundrise E-Reits, which offers a low-cost way for anyone to invest in high-quality private market real estate for as little as $500. This trust holds a diversified portfolio.  

By REIT Sectors

REITs are classified based on the types of real estate they invest in. There are several different types of real estate trusts operating across different sectors.

You can find REITs focusing on every imaginable type of facility, from apartments to shopping malls and data centers to self-storage space. Here is an explanation of some of the Real Estate Investment Trust sectors.

Office – These REITs manage commercial properties and lease office spaces to tenants. Some trusts in this category focus on specific markets like suburban areas, while others emphasize special types of tenants like government agencies.

Industrial  This type of REIT owns and operates industrial properties. Some of these REITs focus on specific facilities like warehouses.

Retail – These trusts own and operate retail properties and rent them out. Examples of retail REITs include malls, shopping centers, and more. Lease Real Estate Investment Trusts own properties and lease them out to generate income.

Lodging – This type of trust manages properties like resorts and hotels and rents the space to travelers. These properties are meant to offer services to different classes of people, from business travelers to vacationers.

Residential – Residential REITs own and operate different types of residential properties. These Real Estate Investment Trusts specialize in homes, apartment buildings, and other classes of properties.

Timberland – They own and manage different types of timberland properties. Examples include selling and harvesting timber.

Health Care – Health care trusts manage different health care facilities like hospitals, senior living facilities, nursing facilities, and medical offices.

Self-Storage – These Real Estate Investment Trusts own and operate storage facilities and collect rent from individuals and businesses.

Infrastructure – This type of REIT is responsible for managing infrastructure real estate and collecting rent from tenants occupying these properties. Examples include wireless infrastructure, fiber cables, energy pipelines, and telecommunication towers.

Data Center – These trusts manage commercial facilities that store customer data. These companies offer services like power supplies and security.

Diversified – This type manages a mix of the different types of properties like office and industrial.

Specialty – There are more types of real estate than the 12 we have discussed here. Any other types belong in this category. Some of these specialty trusts are farmland, casinos, outdoor advertising sites, and theatres.

How to Invest in REITs

Buying shares of Real Estate Investment Trusts can be done in the following ways:

Individual REIT stocks – Individual REIT stocks are ideal for those who want to invest directly in a particular Real Estate Investment Trust. Publicly traded shares can be traded on a stock exchange. Non-traded shares can be bought through a broker that participates in the non-traded REIT’s offering.

REIT mutual funds and ETFs – Such an investment lets you diversify your portfolio to a great extent. You can choose to buy a basket of Real Estate Investment Trust funds. This will get you instant diversification at an affordable price. ETFs are traded like stocks on stock exchanges, while mutual funds can be bought through a mutual fund provider. This option lets you get indirect ownership of real estate while benefiting from its returns and increased diversification.

Please note that millions of Americans already directly or indirectly own Real Estate Investment Trusts through mutual funds, ETFs, or target-date funds that are part of their 401K retirement investment plans.

When considering individual investments in these real estate trusts, it is a good idea to conduct extensive research into the different trusts and companies. Investors might want to seek professional financial advice for strategic investments in REITs.

How to Assess Real Estate Investment Trusts

Here are some useful tips that will help investors assess the merit of any REIT.

  • Investors should find companies with good records in dividend yields and long-term capital appreciation before investing in any REIT.
  • Earnings per Share (EPS) and Price-to-Earnings ratio are not good value estimators for Real Estate trusts.
  • A better metric to use for valuation is Funds From Operations (FFO), which adjusts for depreciation, preferred dividends, and distributions.
  • Use FFO in conjunction with other metrics.
  • Look for Real Estate Investment Trusts with a strong management team and a good history.
  • Buy mutual fund or ETF REITs, so a pro does most of the research and work for you. Make sure to pay attention to the fees.
  • The trust’s total return comes from dividends paid and price appreciation.
  • Look for REITs that offer true diversification for your portfolio.

You can choose from over 225 publicly traded Real Estate Investment Trusts in the United States. It is essential to do some research to pick the best one. Make sure you have a close look at the management team and determine how they are compensated. It is also beneficial to consider the REIT’s cash flow, growth prospects, and current dividend income to maximize returns.

Benefits and Risks of Investing in REITs

Real Estate Investments Trusts have their own benefits and limitations. It is a good idea to carefully weigh its advantages and limitations before adding them to your investment portfolio.

BENEFITS

Diversification option – Real Estate can be a good addition to a portfolio as it increases diversification.

Steady income – Real Estate Investment Trusts provide dividend-based income, which is often higher than what you can expect with other types of investments. Besides, they can facilitate potential long-term capital appreciation.

Risk-adjusted returns – REITs offer some risk-adjusted returns and help create a steady income flow to depend on in adverse times.

Transparency – As Real Estate Investment Trusts are regulated, they must file financial reports that are audited. This allows investors to acquire information on zoning, ownership, and taxation, making them relatively transparent.

Liquidity – As most real estate trusts are listed on public stock exchanges, they are easy to trade, which means they are quite liquid.

DISADVANTAGES AND RISKS

Apart from advantages, Real Estate Investment Trusts have some associated risks and limitations.

Tax consequences – Real Estate Investment Trust income has unique tax consequences for investors. Although REITs might be advertised as having great tax benefits to investors, most REIT distributions are actually classified as ordinary income, which is taxable at your marginal tax rate. Dependent on the situation, income is often treated as ordinary income, capital gains, or return on capital. The tax rate on REIT dividends is usually higher than on stock dividends. As tax implications on Real Estate Investment Trust income are often complex, investors might want to consult with their financial advisor to understand better how REIT dividends will impact their tax obligations.

Economic risk – During bear markets, many trusts see their vacancies increase and their pricing drop. Besides, some sectors see a lot of volatility and cyclical fluctuations. For example, hotels are susceptible to a down market, whereas the healthcare sector is pretty recession-proof. REITs are prone to market-related fluctuations, and for some investors, this might be too big a risk.

Low growth prospects – For REITs, there is a much lower growth prospect for capital appreciation. This is because they return up to 90 percent of their earnings to their investors and reinvest only 10 percent into the venture.

Interest rate risk – Rising interest rates hurt REITs as mortgage rates increase and become less desirable for customers.

Fees – Non-traded REITs can have another disadvantage, high fees. Non-traded REITs are typically sold through a broker or financial adviser. Most charge an upfront fee, and together with commissions, the total can easily be 10%. Sometimes those fees are even higher. Remember that these costs lower the value of the investment by a significant amount.

Although there are non-traded REITs that are well managed, have lower costs, and have a history of great returns, there are also publicly-traded REITs that offer the same, so why run the risk?

If you choose to invest in a non-traded REIT, it is crucial to do in-depth research into the fund, its management, and its returns. The more you find out before you invest, the better your chance that your investments will have the returns you are counting on.

Fraud – Especially for non-publicly traded REITs, there is a significant risk for fraud. These types of trusts pose the following fraud risks: lack of liquidity, lack of share value transparency, and conflict of interests,

American Tower – Maintaining its position as the largest REIT for several years, the telecommunications infrastructure trust American Tower owns and runs a big communication towers network. It leases land, space at the top of the tower and builds towers. The company owns over 170,000 sites across locations around the world. Its market capitalization is $102.3 billion.

Crown Castle International – Another popular REIT also operates communications property and has a market cap of $58.9 billion. This company also owns a network of communication towers.

Apart from this, they operate other types of infrastructure, like wireless equipment installed on rooftops. It has more than 40,000 towers, over 75,000 miles of fiber optic cable, and 70,000 small cell nodes. Crown Castle operates mostly within the United States.

Equinix – One of the best value stocks in real estate investment in recent years, Equinix reported a gain of 66 percent in 2019.

It is a data center REIT that operates over 200 centers in different parts of the world. This stock’s growth attributes to the demand for secure data storage and an increasing number of connected devices.

Conclusion

There are many different types and classes of REITs in many different sectors. All of them present an opportunity for individual investors to add real estate to their investment portfolios at relatively low risk without putting out a large amount of capital because they do not involve direct ownership of property.

For many investors, another major attraction of REITs is their potential to offer returns in the forms of both appreciation and income.

As with all other investments, Real Estate Investment Trusts are not without risks, such as interest rate risk, fraud risk, and economic risk.

2020 was a real challenging year for Real Estate Investment Trusts. They took a big hit due to the Covid 19 pandemic, and that damage will most likely be felt for several years. According to NAREIT, Some real estate sectors saw a decrease of more than 20% in returns due to the pandemic, such as the office, retail, diversified, financing, and lodging/resorts sectors. Other sectors saw a return increase, such as the data center and the self-storage sectors. Most likely, many sectors will recover. However, some might not.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.