REITs are a useful tool for investing in real estate without needing to fork over a massive down payment. They also don’t come with all of the headaches associated with managing rental properties yourself. In this article, I’ll break down how REITs work from a legal and tax perspective, their advantages and disadvantages to investors, and some guidance for getting started in REIT investing.
What’s a REIT?
A REIT is a real estate investment trust. It’s basically a company that sells shares of its real estate holdings. Rather than buying the property directly, you buy a share of the company that holds the properties.
You can think of a REIT like a company on the stock market, which sells shares of its ownership to investors. Investors get dividends in return and can cash in on equity appreciation as well. Only, in this case, a REIT must predominantly invest in real estate, so an investor is buying shares of a real estate company.
There are REITs in every area of real estate, ranging from apartments to self-storage and just about every other real estate sector you can think of. So just like companies on the stock market, you can invest in the areas of the real estate market that you think have the greatest upside.
How do REITs Work?
REITs have to follow a number of rules. They must invest 75 percent of their total assets in real estate and cash in order to maintain their status as REITs.
The vast majority (75 percent) of a REIT’s income must come from real estate related sources. These sources can include rents from owned properties, but it can also include mortgages or real estate related derivatives.
Perhaps the most restrictive requirement is that REITs are required to distribute 90 percent of their income to shareholders. In other words, the REIT cannot just sit on all of the cash flow that their properties produce; they have to pass it on to shareholders.
REITs are required to have a minimum of 100 shareholders. No group of five shareholders can hold more than 50 percent of a REIT’s shares.
With all of these rules, why would a firm ever want to become a REIT? The big advantage for the company is that all income is tax deductible for the firm. The taxes are passed onto investors rather than the REIT itself, as will be discussed shortly.
Advantages of REITs
REITS are an easy way to get broader exposure to real estate, particularly expensive commercial real estate. Let’s take a look at the major advantages:
- Diversification: REITs allow you to expose yourself to a different asset class – real estate. You can also invest in hundreds, if not thousands, of different properties within a REIT, giving you greater diversification within the asset class itself.
- Steady Income: Unlike a stock, REIT dividends are not discretionary. A REIT has to pay out the vast majority of its income to shareholders.
- Liquidity: Just like a stock, you can buy and sell REIT shares on the open market. This lets you get your cash back very quickly compared to a real estate deal that you execute yourself. Selling a house, for example, can take many weeks, whereas selling a REIT share can be done in minutes if not seconds.
- No Corporate Taxes: Because REITs don’t pay corporate taxes, they are left with more to invest. Although investors have to pay ordinary income taxes on their REIT dividends, the REIT is left in a better position by being able to avoid corporate taxes, arguably.
- Truly Passive Income: You get many of the benefits of real estate investing without having to manage the properties yourself. You just buy the REIT shares and hold them.
As you can see, REITs have a lot of nice advantages that make them a useful tool for investors. Not only are they great for diversification, they let you invest in real estate without so many of the headaches that can come with investing. Sadly, they are not perfect!
Disadvantages of REITs
Before investing in REITs, it’s very important to understand their major disadvantages:
- Taxes: Although the REIT itself avoids corporate taxes, shareholders have to pay income taxes on their REIT income. This is unlike most stock dividends which are treated more favorably for investors, sometimes being completely exempt from taxes. Check with a tax professional to better understand your tax liabilities.
- No Control: This is a blessing and a curse. Although you avoid the headaches of rental property management, you cannot do much to control the REIT’s strategy. If you are a knowledgeable investor, this can be irritating when the REIT’s decisions do not line up with your ideals.
- Lower Returns: Compared to a well-executed deal that you do yourself, REIT returns will generally be much lower. While you might be able to net double digit returns on a single real estate deal that you manage yourself, you would be lucky to get higher than a 7 or 8 percent return on your REIT holdings. Fees can also hurt returns since the REIT managers need to get paid too.
- Limited Growth: Since so much of its income is paid back to shareholders, a REIT may struggle to grow as quickly as another real estate company. It simply has less cash to invest than a company that can be more flexible with its earnings.
- Volatility: Like a stock, a REIT is subject to market swings. Even if the income stream might be steady, the REIT share price can still move violently.
One drawback as an investor is that REIT income is taxed as regular income. You also do not have direct control over the property management or the day to day operations of the buildings within the REIT, which is a blessing and a curse at the same time.
Want to Get Started with REIT Investing?
Lucky for you, you don’t need to do much to get started with a well-diversified REIT portfolio. Not only can you invest in funds like the Vanguard Real Estate ETF (VNQ), which will expose you to many different REITs, you can also check out the REIT portfolio I created on M1 Finance.
In that portfolio, I break it down by real estate sector so you can easily rebalance it to favor a particular sector (or leave it as is!). To import the portfolio into your own, you will need an M1 Finance Account. For a detailed review of M1 Finance, check out my article here.
There are also privately traded REITs that might be able to avoid the volatile swings of the public market. Fundrise is a great option for investing in unique REITs throughout the nation. Fundrise’s REITs are generally less liquid than publicly traded REITs, but they can be a great option for diversifying your portfolio.
REITs make it easy to invest in real estate. You are buying shares of the company that owns the real estate. You then get a proportional share of the REIT’s income. REITs get special tax advantages in exchange for distributing the vast majority of their income, though investors generally have to pay higher taxes on their distributions as a result. Either way, they are a great way to diversify a portfolio across asset classes and within real estate
Please keep in mind that this article is not financial advice.