Real Estate Investment Trust (REIT) Overview Bookmark and Share

For most investors, creating a diversified real estate portfolio is out of reach, especially when it comes to commercial real estate. Real estate investment trusts, or REITs, allow investors to pool their resources and invest in a portfolio of real estate. Specifically, a REIT is a company that owns, and in most cases, operates income-producing real estate. Some REITs finance real estate. To be a REIT, a company must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. The majority of REITs trade on exchanges and offer investors superior liquidity when compared with holding physical real estate assets.

A REIT is designed to operate as a pass-through entity which allows it to avoid paying state and federal income taxes. The responsibility of paying these taxes are passed on to its shareholders. In order for a corporation to qualify as a REIT and gain pass-through entity status, it needs to meet several criteria, the most important of which are the following:

  • Pay dividends of at least 90% of the REITs taxable income
  • Have 95 percent of its income derived from dividends, interest, and property income
  • At least 75% of total investment assets must be in real estate

Types of REITs

REITs are classified in the following three categories.

  • Equity REIT

    • Equity REITs are the most popular REIT and are what most people are familiar with. Equity REITs purchase, own and manage income-producing real estate properties such as apartments, regional malls, lodging facilities, and office buildings. Equity REITs are great for a long-term investor because they earn dividends from rental income as well as capital gains from the sale of properties.

  • Mortgage REIT

    • Mortgage REITs lend money directly to real estate owners and their operators, or indirectly through acquisition of loans or mortgage-backed securities. They do not invest in properties, but generate revenue through the interest that they are paid on their mortgage loans.

  • Hybrid REIT

    • Hybrid REITs are a combination of equity and mortgage REITs. They own property and make loans to real estate owners and operators. Hybrid REITs earn money through a combination of rents, capital gains, and interest.

To the outside investor, REITs function very similarly to a stock. Public REITs have an Initial Public Offering (IPO) to raise funds for real estate investment. When selecting REITs to invest in, it is important to look at earnings or funds from operations (FFO). FFO is designed to measure a REITs operating cash flow produced by its properties, less administrative and financing costs.

REIT Performance Characteristics

REITs offer investors a powerful tool for portfolio balancing and diversification. They also provide investors with ongoing dividend income, while offering the potential for long-term capital gains through share price appreciation. Because of their pass-through taxation, REITs have greater profits from which to pay shareholder dividends than similar sized corporations, as a result, shareholders get more of the REITs earnings. REITs have outperformed most other major market benchmarks over the last three decades with significantly less volatility.

Investors can combine REITs as well as property ownership in order to diversify his or her investment portfolio.

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