A real estate investment trust (REIT) is a real estate company that offers common shares to the public. In this way, a REIT stock is similar to any other stock that represents ownership in an operating business. But a REIT has two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends. Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors.
To qualify as a REIT with the IRS, a real estate company must agree to pay out in dividends at least 90% of its taxable profit (and additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on the entire profits, and then decides how to allocate its after-tax profits between dividends and reinvestment; but a REIT simply distributes all or almost all of its profits and gets to skip the taxation.
The REIT industry has a diverse profile, which offers many alternative investment opportunities to investors. REITs often are classified in one of three categories: equity, mortgage or hybrid.
Equity REITs
Equity REITs own and operate income-producing real estate. Equity REITs increasingly have become primarily real estate operating companies that engage in a wide range of real estate activities, including leasing, development of real property and tenant services. One major distinction between REITs and other real estate companies is that a REIT must acquire and develop its properties primarily to operate them as part of its own portfolio rather than to resell them once they are developed.
Mortgage REITs
Mortgage REITs lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Today’s mortgage REITs generally extend mortgage credit only on existing properties. Many modern mortgage REITs also manage their interest rate risk using securitized mortgage investments and dynamic hedging techniques.
Hybrid REITs
As the name suggests, a hybrid REIT both owns properties and makes loans to real estate owners and operators.
There are about 190 REITs registered with the Securities and Exchange Commission in the United States that trade on one of the major stock exchanges — the majority on the New York Stock Exchange. Total assets of these listed REITs exceed $400 billion.
Investors typically are attracted to REITs for their high levels of current income, REIT dividends can reach 8% to 9% a year, and they offer a soothing sense of predictability that the market usually can’t match, and the opportunity for moderate long-term growth. These are the basic characteristics of real estate. In addition, investors looking for ways to diversify their investment portfolios beyond other common stocks as well as bonds are attracted to the unique characteristics of REITs.
There is a relatively low correlation between listed REIT stock returns and the returns of other market sectors. Thus, including listed REITs in your investment program helps build a diversified portfolio.
REITS are subject to ineptitude on the part of management just like any company’s stock, so diversification is important. As with most things, I would recomend an index fund such as Vanguard’s VGSIX.
And,it must be noted, that REIT dividends are fully taxable. This makes REITs an often-poor choice for taxable accounts, as REIT dividends are considered income by the IRS. As a result, REITs are best placed in a tax-deferred account.
It should also be noted that with the run real estate has been having, many people consider REITs to currently be overvalued.
For individual investors who want to put money into real estate, REITs offer perhaps the most accessible path without any of the expense and difficulty of buying properties directly and financial advisers often recommend that investors looking to build diversified portfolios should allocate 10% to 20% of their holdings to REITs.