| Types of REITs | ||
|---|---|---|
Type of REIT | Percent of Market Share | Holdings |
Equity | 96% in 2023 | Owns and operates income-producing real estate |
Mortgage | 4% in 2023 | Holds mortgages on real estate |
Hybrid | Negligible since 2009 | Owns properties and holds mortgages |
How To Invest in REITs
Within the above types are REITs that have different ways of attracting funding. These differences will be important when we next go through our tips for how to begin 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-benefitand defined-contribution plans through mutual and exchange-traded funds (ETFs). Thus, many U.S. investors own shares in REITs through their retirement savings.
$4.0 trillion
As of 2024, REITs own more than $4.0 trillion in commercial real estate. About 63% of these assets are owned by publicly traded trusts.
Tips on Starting To Invest in REITs
If you're new to REIT investing, here are tips to get you started:
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 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.
The Financial Industry Regulatory Authority 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
It's prudent to begin with a modest allocation and gradually increase your exposure over time. 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
You might also spread investments across real estate sectors (e.g., residential, commercial, healthcare, etc.) 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 and ETFs 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 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.
Fund Fees
You'll want to closely examine the expense ratios for REIT mutual funds or ETFs. Mutual fund and ETF fees are far closer than a generation ago—they are often very similar when holding the same assets—and both types of funds have dropped their fees by more than half over the past 20 years. As such, where in the past you might have looked to invest in REITs on your own to keep more of your returns, that's less the case in the mid-2020s.
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) 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) 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, most REIT dividends are taxed as ordinary income. This could result in higher tax bills, especially for investors in higher tax brackets.
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). This strategy can significantly improve your long-term returns by allowing you to reinvest more of your dividends.
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.
In addition, the Tax Cuts and Jobs Act of 2017 introduced a qualified business income (QBI) deduction with specific benefits for those holding REITs. The deduction is the QBI plus 20% of qualified REIT dividends or 20% of the taxable income minus net capital gains, whichever is less. This deduction allows eligible taxpayers to deduct up to 20% of their qualified REIT dividends, potentially lowering their effective tax rate on REIT income.
The combination of these factors—the QBI deduction, the REIT's tax-advantaged design, and the taxing of dividends—creates a complex but potentially beneficial tax situation for many REIT investors. However, balancing this approach as part of your overall investment strategy and liquidity needs is crucial, especially since retirement account funds have withdrawal restrictions. As always, it's wise to consult a tax professional to understand how any of this would apply to your tax situation.
Many REITs also often use leverage (they borrow) to buy up more properties. When comparing REITs, looking at their debt-to-equity ratiosis essentialso 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, inflation, 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 the real estate sector.
The chart for year-over-year returns for 2023 below suggests why: 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 their REITs are invested in.
Advantages and Disadvantages of 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. Including real estate in a portfolio provides diversification and dividend-based income.
However, REITs don't offer capital appreciation since REITs must pay 90% of their income back to investors. Only 10% of taxable income can thus 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. Here's a summary of their pros and cons:
Are REITs a Good Investment?
Whether investing in these trusts is a good idea depends on your financial goals, risk tolerance, 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. They have historically provided competitive long-term returns and can serve as a 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 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. The paper clip REIT entails stricter regulatory oversight since there can be conflicts of interest. They are uncommon.
Do REITs Offer Monthly Payments?
While some REITs do, but 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 have taken something only the richest historically could afford—properties—and packaged shares in them to trade like other assets on U.S. stock markets and among private investors. They don't just alleviate the amount of funding you would need to buy real estate but the effort and time needed to manage them.
REITs deliver diversification for your portfolio, potentially generate steady income through dividends, and give you exposure to a range of properties. REITs can also serve as a hedge against inflation and have historically delivered competitive long-term returns. However, like all investments, they come with risks, including sensitivity to interest rate changes, and REITs can face challenges when there are dips in industries where they hold property—trusts holding downtown office space in the early 2020s are a prime example. For those considering them, it's crucial to approach the decision with careful consideration and research. Seeking the advice of a financial advisor is prudent as well.
