If you’d like to invest in real estate but don’t have the resources, time, or expertise to buy and manage properties yourself, then real estate investment trusts (REITs) could be alternatives to consider. With a REIT, you buy into a professionally managed real estate portfolio, which has been created by pooling money from many investors.
Read on for more on investing in REITs, how REITs work, and their pros and cons.
What is a REIT?
Real estate investment trusts (REITs) are companies that own, operate, or finance real estate—such as apartment buildings, shopping centers, offices, and data centers—with shares that often trade on exchanges like stock. When you buy a stock, you become a partial owner in the underlying company. Similarly, when you buy a share of a REIT, you become a partial owner of the REIT’s underlying properties.
REITs offer a way to put real estate investing within reach of ordinary people. They function like stocks but are specifically focused on the real estate market.
How Does a REIT Work?
A REIT raises money from many individual investors and uses that capital to build and manage a portfolio of real estate investments. This could involve buying properties and leasing them out to tenants or investing in financial assets like mortgages. The REIT collects rent from its tenants or receives payments on the mortgages it holds, distributing earnings to shareholders as dividends.
To qualify as a REIT, a company must meet certain requirements and follow specific rules. A REIT must generally invest at least 75% of its assets in real estate and pay out at least 90% of its taxable income annually to shareholders as dividends. In exchange, REITs receive special tax treatment, often paying little or no corporate income tax, although investors typically owe taxes on dividends and realized gains.
Types of REITs
REITs can be categorized in various ways. They are primarily divided by their investment focus:
- Equity REITs: These buy and operate properties, leasing them to tenants and collecting rent. They can specialize in particular niches such as warehouses, infrastructure, or data centers.
- Mortgage REITs: These finance mortgages using investor funds, collecting mortgage payments and earning income through interest. They may also buy mortgage-backed securities.
- Hybrid REITs: These invest in a mix of real estate properties and mortgages.
REITs can also be classified by their structure and regulation:
- Publicly Traded REITs: Regulated by the Securities and Exchange Commission (SEC), these are listed on major stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq. They are easy to buy and sell and provide accessible information about the companies.
- Public Non-Traded REITs: Also regulated by the SEC but not traded on major exchanges. These can generally only be purchased through specific brokers and may be more challenging to sell.
- Private REITs: Not regulated by the SEC and do not trade on major exchanges. These are typically available only to institutions and high-net-worth investors.
When people discuss investing in REITs, they usually refer to publicly traded REITs. The remainder of this article will focus on the attributes of investing in publicly traded REITs.
Potential Advantages of Publicly Traded REITs
Publicly traded REITs offer several potential benefits:
- Low Initial Investment: It’s possible to become a real estate investor with the cost of just one share. Some brokers even offer fractional shares, allowing you to start with as little as $1.
- Liquidity: Investors can buy and sell publicly traded REITs whenever markets are open. While you aren’t guaranteed to get your money back, you can quickly turn the value of your investment into cash.
- Ongoing Income: Due to the requirement that REITs pay out 90% of taxable income, they are popular among investors seeking to generate income.
- Diversification: REITs have different characteristics from traditional stocks and bonds, potentially offering diversification benefits. However, diversification does not ensure a profit or guarantee against loss.
Potential Disadvantages of Publicly Traded REITs
Investing in publicly traded REITs also has potential drawbacks:
- Research Requirement: Like buying individual stocks, investing in individual REITs requires understanding the REITs universe and selecting specific investments.
- Tax Rate on Dividends: REIT investors generally owe tax on dividends at higher ordinary income tax rates rather than lower qualified dividend tax rates. Holding REITs in a tax-advantaged account may allow investors to defer these taxes.
- Market Volatility: REITs trade on exchanges like stocks and are subject to market fluctuations.
- Unique Risks: There is no guarantee that the issuer of a REIT will maintain the secondary market for its shares, and redemptions may be at a price different from the original. Real estate value changes or economic downturns can significantly impact REITs.
How to Invest in REITs
Investors can buy publicly traded REITs through a brokerage account, just like stocks, using the REIT’s ticker symbol. Another option is to invest in mutual funds or ETFs that hold REITs. These funds offer a diversified, professionally managed portfolio of REITs without needing extensive research into individual REITs.
Should You Buy REITs?
Deciding whether REITs make sense for your portfolio depends on several considerations:
- Investment Goals: Your investment goal—whether retirement, a child’s education, or something else—will help determine if REITs fit into your strategy.
- Diversification: If you already own a home or have exposure to real estate through a diversified portfolio, adding REITs may offer additional diversification. Conversely, if you lack real estate exposure, REITs can provide that.
- Risk Tolerance and Liquidity Needs: REITs can generate high income but are not guaranteed, and you can lose money. Publicly traded REITs are generally liquid, but market prices can fluctuate.
Ultimately, there are no “best” investments—only trade-offs to consider in relation to your situation. For many investors, REITs may play a valuable role in a broadly diversified portfolio.
Conclusion
Real estate investment trusts (REITs) provide an accessible way for ordinary investors to gain exposure to real estate markets without the need to buy and manage properties directly. With their potential for ongoing income, diversification benefits, and liquidity, publicly traded REITs can be a valuable addition to a well-rounded investment portfolio. However, they come with their own set of risks and tax considerations, making it essential to do thorough research and consider how they fit into your overall financial strategy. As always, consulting with a financial advisor can help tailor your investment approach to your specific goals and needs.
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