How does a REIT make you money?
Real estate investment trusts (REITs) are a way for individuals to invest in income-producing properties without the need for direct property ownership. As companies that own, operate, or finance income-producing real estate, REITs allow investors to earn a steady income and diversify their portfolios.
By law, REITs are required to distribute at minimum 90% of their taxable income to shareholders in the form of dividends, making them an attractive investment option for income-seeking investors.
Investors can profit from REITs through the regular dividends they receive and capital appreciation from the underlying properties. The income generated by REIT-owned properties mainly includes rents, lease payments, and sales proceeds from real estate holdings.
This income is then paid to the investors as dividends, providing a continuous stream of earnings. With various types of REITs available, such as equity REITs, mortgage REITs, and hybrid REITs, investors have the flexibility to choose their preferred investment strategy and level of risk.
Key Takeaways
- REITs offer a way to invest in income-producing properties without direct property ownership.
- Investors can profit from REITs through regular dividends and capital appreciation.
- Various types of REITs cater to different investment strategies and risk levels.
What Are REITs?
Real Estate Investment Trusts (REITs) own, operate, or provide financing for income-producing properties.
They enable individuals to invest in large-scale, income-generating real estate, such as offices, apartments, retail spaces, data centers, cell towers, hotels, and factories. By investing in a REIT, investors can access a diversified portfolio of real estate without managing the properties themselves.
REITs were established in the United States in the 1960s when Congress passed a law to create a new kind of company allowing individual investors to participate in large-scale, income-producing real estate investments.
The law laid out specific requirements for REITs, which are regulated by the Securities and Exchange Commission (SEC) and must comply with specific guidelines set forth by the Internal Revenue Service (IRS).
To qualify as a REIT, a company must meet several key criteria:
- First, it must be structured as a corporation.
- Second, at least 75% of its assets must be invested in real estate-related investments, and 75% of its income must come from real estate operations or interests.
- Third, REITs must distribute at least 90% of their taxable income to shareholders as dividends each year in order to maintain their tax-advantaged status.
As mentioned earlier, several types of REITs can be classified based on the properties they own, operate, or finance. Some common categories include:
- Shopping Center Retail REITs: focusing on shopping centers and malls
- Office REITs: specializing in office buildings
- Industrial REITs: investing in warehouses and distribution centers
- Residential REITs: owning apartment complexes and multifamily housing
Types of REITs
Equity REITs
Equity REITs are the most common REIT type that primarily own and manage income-producing real estate properties.
They generate income mainly through collecting rents from tenants in their properties and then distributing that income as dividends to shareholders. Examples of properties owned by equity REITs include office buildings, retail centers, residential apartments, and hotels. By investing in equity REITs, investors gain exposure to real estate markets without the hassles of direct property ownership.
Mortgage REITs
Mortgage REITs, also known as mREITs, invest in mortgage-backed securities or directly provide financing to real estate owners.
Instead of earning rental income from properties, they generate revenue from the interest on the mortgages they hold. Mortgage REITs can be further divided into two subclasses:
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- Commercial Mortgage REITs: These REITs finance commercial properties, such as office buildings, malls, and hotels.
- Residential Mortgage REITs: These REITs finance residential properties, like single-family homes and apartment complexes.
Investors opt for mortgage REITs generally seek high-dividend yields primarily derived from interest income.
Hybrid REITs
Hybrid REITs combine aspects of both equity and mortgage REITs, as they invest in both income-producing properties and mortgage-backed securities or loans.
By diversifying their investment strategies, hybrid REITs offer potential benefits from higher rental income and interest income streams while spreading the risks associated with the fluctuating real estate market and interest rate changes.
Publicly Traded REITs
Publicly traded REITs are listed on stock exchanges, like the New York Stock Exchange or NASDAQ, enabling investors to buy and sell shares in the same manner as stocks.
They offer high liquidity to investors as an advantage compared to non-traded REITs. Additionally, these REITs must comply with stringent financial reporting and transparency requirements, which provide investors with reliable information for their investment decisions.
Public Non-Traded REITs
Public non-traded REITs are not listed on stock exchanges but are still registered with the Securities and Exchange Commission (SEC).
These REITs are generally less liquid than publicly traded ones, as their shares are not easily purchasable on the open market. Public non-traded REITs MAY offer higher dividend yields than their traded counterparts but also involve higher fees and limited price transparency.
Typically, public non-traded REITs have underperformed publicly trade REITs.
I avoid these types of REITs.
Private REITs
Private REITs are neither listed on stock exchanges nor registered with the SEC.
These REITs often have a narrow investor base, typically targeting institutional investors or high-net-worth individuals. Investing in private REITs can be more complex than publicly traded ones and may involve higher investment minimums and fees.
Private REITs may offer niche investment opportunities but exhibit low liquidity and limited transparency in terms of performance reporting.
Again, I avoid these investments due to their illiquid nature and lack of control/ oversight.
How REITs Make Money
Real Estate Investment Trusts (REITs) invest in various income-producing real estate assets, including residential and commercial properties. Investors can make money through REITs in two primary ways: collecting rent and other income and property appreciation and sales.
Collecting Rent and Other Income
REITs make money as a kind of “landlord.”
They own, manage, and lease properties to tenants. The primary source of income for REITs is the rent they collect from these tenants. Since REITs often invest in various types of properties, they can benefit from diversified sources of income. Some common types of real estate assets a REIT may invest in are:
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- Commercial properties, like office buildings and shopping centers
- Residential properties, like apartment buildings and single-family homes
- Industrial properties, like warehouses and distribution centers
- Hospitality properties, like hotels and resorts
REITs can also earn additional income from ancillary services provided to tenants, such as property management fees or parking fees. By pooling these various income streams, REITs can provide consistent and stable returns for their shareholders.
Property Appreciation and Sales
REITs also make money through property appreciation.
As property values increase over time or through improvements made to the real estate assets, so does the overall value of the REIT’s portfolio. This appreciation can potentially lead to higher share prices for investors in the stock market.
Additionally, REITs may sell assets higher than their initial purchase price for a profit.
This can further contribute to the total returns earned by shareholders. However, property appreciation and sales can be influenced by many factors, such as economic conditions, market demand, and the specific realtors involved.
How Investors Earn from REITs
Dividend Income
One of the primary ways investors earn from REITs is through dividend income.
Most REITs have a straightforward business model where they lease space, collect rents from properties, and then distribute the income as dividends to shareholders.
This makes them an attractive investment option for those seeking consistent income from their portfolio.
Capital Gains
Apart from dividend income, investors can also earn through capital gains.
When a REIT’s property value or portfolio appreciates, the share price increases, leading to capital gains for shareholders who sell their shares at a profit.
Capital gains are not guaranteed, and the performance of the REIT depends on various factors, such as market conditions and the portfolio’s overall performance.
Diversification
Investing in REITs enables investors to diversify their portfolio, reducing risks associated with concentrating on a single asset class.
By holding shares in a REIT, investors gain exposure to real estate without the problems of owning, operating, or directly financing properties.
This diversification helps spread the potential risks across different asset classes, balancing the overall investment portfolio.
Risk Management
REIT investments can also contribute to effective risk management in an investor’s portfolio.
Real estate investments tend to have a low correlation with stock market movements, so they can act as a buffer against market fluctuations. Additionally, mortgage REITs, which invest in mortgage-backed securities, can help reduce potential risks through efficient financing and interest rate management.
By strategically investing in REITs, investors can effectively balance risk and reward in their overall investment strategy.
Taxation and REITs
REITs offer a unique income stream for investors as they distribute a large percentage of their income to shareholders while adhering to certain regulations and guidelines.
Taxation of Dividends
Dividends from REITs are generally taxed as ordinary income rather than qualified dividends because they are derived from the operating profits of the real estate business.
This means that the tax rate for REIT dividends depends on your individual income tax bracket, which can range from 10% to 37%.
However, you may be eligible to claim a 20% qualified business income deduction, which can help offset some of the tax liability on your REIT dividends.
Distributed income from REITs may also be classified as a return of capital, a tax-advantaged income.
Return of capital occurs when a REIT returns its own capital to its investors, lowering the investment’s cost basis and reducing taxable income. Any return of capital is not taxable in the year received but will reduce the investor’s cost basis for future calculations.
Capital Gains Tax
In addition to dividends, the second aspect of taxation for REIT investors is capital gains tax.
When you sell your shares of a REIT, you are subject to capital gains taxes on the difference between your purchase and selling prices. These capital gains are taxed at long-term capital gains rates if the investment was held for more than one year (source). Long-term capital gains tax rates are generally lower than ordinary income tax rates and range from 0% to 20% based on your income level.
On a corporate level, REITs generally do not pay corporate tax, provided they meet specific requirements such as investing at least 75% of their assets in real estate and getting at least 75% of their income from rent, mortgage interest, and other real estate sources (source).
Choosing the Right REIT
Financial Performance Metrics
When selecting a REIT to invest in, evaluating its financial performance metrics is essential.
Some key indicators to consider include the funds from operations (FFO), adjusted funds from operations (AFFO), and dividend yield.
FFO is a widely used metric that measures a REIT’s operating performance by adding depreciation and amortization back to net income. This is an INCORRECT metric to use for REIT analysis.
For REITs, you should always use AFFO.
AFFO further refines this measure by accounting for capital expenditures and other adjustments.
Analyze the dividend yield to assess a REIT’s ability to generate income for its shareholders. A higher yield may indicate an attractive investment, but examining the payout ratios is crucial to ensure that the dividends and the history of dividend growth are sustainable.
Sectors and Industries
REITs operate in various sectors and industries, such as retail, office, industrial, and residential properties, to offer investors diverse opportunities.
Some REITs focus on specific niches, like data centers, healthcare facilities, and cell towers.
It’s important to understand the fundamentals of these sectors when choosing a REIT, paying attention to factors like market demand, growth potential, and potential risks.
Investing in multiple REITs across different industries helps to mitigate overall investment risk.
Management and Corporate Governance
A REIT’s management team plays a critical role in its success. Focus on internal (managed by REIT employees) versus external (hired contractors) management.
Thoroughly evaluate the management team’s capabilities, experience, and track record to ensure they can drive the company’s performance. A strong executive team with a proven history can provide the necessary leadership to navigate market challenges and drive growth.
Additionally, consider a REIT’s corporate governance structure. Transparent and responsible governance can ensure that the organization is well-positioned to protect shareholders’ interests and make sound investment decisions.
Investment Vehicles for REITs
Several investment vehicles are available for investors interested in Real Estate Investment Trusts (REITs).
Stock Market
One of the most common ways to invest in REITs is through the stock market.
REITs trade on major stock exchanges like traditional publicly traded company shares. You need a brokerage account to invest in a REIT via the stock market. This allows you to buy and sell shares of REITs, which lets you participate in the ups and downs of the real estate market and benefit from the income generated by the underlying properties.
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Investing in REITs through the stock market offers liquidity, as you can quickly sell your shares whenever you like.
Mutual Funds and ETFs
Another popular way to invest in REITs is through mutual funds and ETFs.
These pooled investment vehicles allow investors to gain exposure to a diversified portfolio of REITs, rather than focusing on a single one. Mutual funds and ETFs can offer professional management and broad exposure to real estate investments, which can help reduce individual risks associated with specific properties or regions.
To invest in REIT-focused mutual funds or ETFs, you must have a brokerage account, as these funds typically trade on stock exchanges.
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- Mutual Funds: Income from REITs is often distributed through dividends, and mutual funds specializing in REITs can provide a steady income stream for investors.
- ETFs: REIT-focused ETFs offer the same benefits as mutual funds but with the added advantage of real-time trading and generally lower fees.
Crowdfunding Platforms
In recent years, crowdfunding platforms have emerged as another REIT investment vehicle.
I have tried a few, but they have underperformed standard REIT investments.
These platforms pool funds from individual investors, then used to invest in various real estate projects. Investing in REITs through crowdfunding platforms can provide direct access to specific real estate deals.
Crowdfunding platforms have different investment options, such as equity, debt, and hybrid investments. Equity investments allow investors to purchase ownership stakes in a property, while debt investments involve lending money for a real estate project, often secured by a property. Hybrid investments combine aspects of both equity and debt investments.
To invest in REITs through crowdfunding platforms, you must create an account on the specific platform and meet its eligibility and minimum investment requirements.
Note that liquidity on crowdfunding platforms may be more limited than investments through the stock market and mutual funds/ETFs. I typically avoid these investments.
Risks and Considerations
When investing in a REIT, there are several risks and considerations to remember. This section will discuss Market Risks, Interest Rate Risks, and Liquidity and Leverage Risks.
Market Risks
Market risks are inherent in any investment, including REITs.
These risks can arise from fluctuations in property values, changing economic conditions, and regional or local market factors.
Market risks can cause revenue and net operating income losses and depreciation in the value of the underlying real estate assets. Investors need to research and understand the specific markets a REIT operates in to mitigate these risks.
Interest Rate Risks
REITs are sensitive to changes in interest rates.
When interest rates rise, the cost of borrowing increases, potentially reducing a REIT’s profitability and affecting its ability to make distributions to investors.
Rising interest rates can also shift investment capital from REITs to bonds, resulting in share price volatility and liquidity risks.
Some REITs use financial instruments such as interest rate swaps or caps to manage interest rate risks.
Liquidity and Leverage Risks
Liquidity risks refer to the ability of a REIT to sell its properties or convert its assets into cash within a reasonable time frame.
When a REIT faces difficulty selling properties or cannot achieve the desired price, this impacts its overall performance.
In addition, leverage risks arise from using debt to finance a REIT’s property acquisitions and development projects. High leverage can increase the risk of default and lead to losses for investors in the event of a downturn in the real estate market.
To minimize liquidity and leverage risks, investors should consider the following:
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- The debt-to-equity ratio of a REIT, which indicates its level of leverage
- The loan-to-value (LTV) ratio of a REIT’s properties, which shows the percentage of debt compared to the property’s value
- The average lease term and occupancy level of a REIT’s property portfolio, which affects its cash flow stability
Frequently Asked Questions
What are the common methods of payment from REITs?
REITs (Real Estate Investment Trusts) primarily make money for investors through dividends and capital appreciation.
Dividend payments are typically a result of the income generated from the properties owned and managed by the REIT. These payments are often higher than other investments because REITs are required to distribute a minimum of 90% of taxable income to shareholders.
How do REIT dividends impact my earnings?
Dividends from REITs can provide a steady income stream for investors.
These dividends are usually generous compared to other types of investments. However, it’s important to know that REIT dividends are taxed as regular income, which may impact the overall earnings after taxes.
What factors influence the profitability of a REIT?
Various factors can influence a REIT’s profitability, including the quality of the properties in its portfolio, the expertise of its management team, and the overall health of the real estate market.
Additionally, the ability of the REIT to maintain high occupancy rates and raise rents over time can contribute to increasing the dividends distributed to investors.
How do market conditions affect REIT returns?
Market conditions can play a significant role in the performance of REITs.
During economic growth, demand for commercial and residential properties usually rises, leading to higher occupancy rates and increased rental income.
Conversely, in challenging economic times, the demand for real estate might decrease, making it harder for REITs to maintain high occupancy levels and rent growth.
How can I diversify my investments with REITs?
Investing in REITs can help diversify your investment portfolio as they give exposure to commercial real estate, which has a low correlation with stocks and bonds.
Different REIT types specialize in various property sectors, such as office, retail, industrial, residential, and healthcare.
Investing in multiple REITs across various property types and geographic locations can further diversify your exposure to the real estate market.
Are there any tax implications when investing in REITs?
When investing in REITs, there are tax implications to consider.
As mentioned earlier, dividends received from REITs are typically taxed as ordinary income, which may result in higher taxes depending on your tax bracket.
However, some REIT distributions may be classified as return of capital or long-term capital gains, which carry different tax rates.
Consult with a tax advisor when investing in REITs to understand the specific tax implications for your situation.
How Does a REIT Make You Money? Final Thoughts
How does a REIT make you money?
By paying you dividends on the income received from rents and property sales.
I stick with publicly traded REITs because of the liquidity and oversight, and it is my favorite way to invest in real estate (and I give it a very high Lever Rank).
Real estate has always been a popular investment vehicle for growth and income.
Historically, real estate investors were limited to directly buying real estate, managing properties, and collecting rental income.
REITs take all management issues away and give REIT real estate investors liquidity.
This is our favorite way to invest in real estate.
- Requires Little Capital
- Liquidity
- Diversification
- Professional Management
- Better Returns than Direct Investment
- Price of Investment Moves with Stock Market
- No Depreciation Deductions
- Typically Non-Qualified Dividends
