Real estate investment trusts (REIT) are corporations that own or finance income-producing real estate properties. They are modeled after mutual funds and typically own a portfolio of real estate within a specific sector. REITs pay out 90% of their annual profits in dividends to their investors and are taxed at a low rate.
In this article, you’ll learn all there is to know about a real estate investment trust, including what it is and why it’s beneficial for real estate investors. By the end of this article, you should know exactly how to invest in a REIT or start one of your own.
What a Real Estate Investment Trust (REIT) Is
A real estate investment trust (REIT) is like a holding company for real estate. REITs collect money from investors and use the funds to purchase income-producing properties. In return, investors receive a portion of the REIT’s profits in the form of dividends, which are taxed at a low rate. These profits typically come from rental income and/or interest income.
Real estate investment trusts can be either publicly-traded or privately held. As of 2016, there are roughly 1,000 REITs that filed a tax return with the IRS. of those, 200 are publicly-traded REITs that can be bought and sold on an open exchange. However, while there are more private REITs than public, it’s more common to invest in a public REIT.
To qualify as a REIT, both public and private corporations must meet very strict guidelines. For example, all REITs are required to invest 75% of their capital in real estate and pay out 90% of their annual profits in dividends. Specifically, the SEC requires that all real estate investment trusts adhere to the following:
- Be a taxable corporation (LLCs and partnerships don’t qualify)
- Have shares that are fully transferable
- Have a minimum of 100 shareholders (investors) after the first year
- No more than 50% of a REIT’s shares can be owned by 5 people
- Invest at least 75% of its total assets in real estate and/or cash
- Earn at least 75% of its gross income from real estate-related sources
- Pay out 90% of its annual profits in the form of dividends
If a corporation fulfills all of these requirements, they can fill out IRS form 1120-REIT and claim themselves as a real estate investment trust on the company’s year-end tax documents.
Of the public and private REITs that qualify, they can be either an equity REIT or a mortgage REIT. We discuss the differences in the section below. Regardless, all REITs make their profits through what’s known as funds from operations (FFO). Funds from operations is calculated using the following equation:
- FFO = (net income) + (depreciation & amortization) – (gain on sale of property)
Net income can either come from a stream of rental income or interest income made on mortgages that the REIT owns. Depreciation is added back because REITs hold so many real estate assets that the annual depreciation expense skews earnings negative. Any gains on property sales are also removed, meaning that the REIT is free to reinvest them.
How REIT Profits are Taxed
The main benefit of a REIT is that the annual profits are typically paid out in quarterly dividends. These dividends are taxed at an investor’s qualified dividend tax rate, which is currently between 0% – 23.8%, depending on tax bracket. REITs are also taxed at the corporate level, but any distributed profits are not taxed to the REIT.
This means that you’re saving money on income taxes when compared to buying real estate directly, thanks to the dividend tax rate. What’s more, when you receive a qualified dividend from a REIT, a portion of that dividend will be attributable to depreciation, thanks to the fact funds from operation is a measure of cash flow.
Depreciation isn’t included in the taxable part of the dividend. This is because qualified dividends are only taxed as capital gains. So, if a REIT distributes a quarterly dividend of $1.00 per share, it’s possible that as much as 30% or more of that dividend is from depreciation. This means that only $0.70 of the $1.00 qualified dividend is taxed at the dividend tax rate.
Finally, real estate investment trusts can deduct all expenses related to rental income as “normal business expenses.” This means that REITs can write-off many of their expenses and maximize their profits. This is in contrast to buying real estate in which you might only be able to write-off a portion of your expenses.
Real Estate Investment Trust vs. Buying Real Estate
The underlying strategy of a real estate investment trust is much the same as buying long-term real estate directly. Both real estate investment trusts and individual buy-and-hold investors seek out long-term residential or commercial investment properties that fit their investment criteria. However, there are also many differences, such as liquidity, diversification, taxation, and more.
When you buy real estate, you typically get pre-approved for an investment property loan, find a property you like, purchase and/or renovate it, and then rent it out to long-term tenants. With a REIT, people typically purchase shares of an existing real estate investment trust, basing their decision on the sector focus as well as the management team in place.
Specifically, when compared to buying real estate, real estate investment trusts have the following benefits:
Publicly-traded REITs are the most liquid and give investors the chance to own a portion of a real estate portfolio that’s traded like a stock. Privately-held REITs are less liquid. Still, they’re typically more liquid than taking out a mortgage and purchasing a property yourself.
Lower Investment Threshold
Unlike with buying real estate, you can increase your real estate exposure for the price of a single share, typically between $10 – $100+. Conversely, if you buy real estate you’ll need a large down payment as well as cover any occupancy and pay for maintenance and upkeep.
Existing REITs, both publically-traded and privately held, typically have a large portfolio of sector-focused real estate assets. This means you can buy into an existing REIT that offers a more diversified group of assets than if you were going to purchase an investment property yourself.
Unit-Investment Trust Tax Structure
REITs are taxed as unit-investment trusts, meaning that they can pay out profits as qualified dividends. Further, these dividends aren’t taxed at the corporate level as long as they’re distributed to shareholders.
In addition, real estate investment trusts reduce much of the required work and headaches for investors. Those who purchase their own properties are often subject such risks as landlord and occupancy risk, which increase an investor’s maintenance and holding costs. They also increase the amount of time a person has to invest in the property.
Of course, there are also downsides of real estate investment trusts when compared to buying real estate directly. These include, but aren’t limited to the following:
When you buy real estate on your own or with partners, you get to call the shots. With a REIT, however, many people invest via existing REITs, meaning that there is a management team in place that makes all the investment decisions. Those who invest in REITs do so based on sector-focus and the strength of the team.
No Depreciation Write-Offs
While REITs can pass through depreciation as profit, individual owners of real estate can write-off their depreciation on their year-end tax returns. This can save investors as much as 39% per dollar written off as depreciation.
Smaller Dollar Returns
Of course, if you invest a few thousand dollars in a real estate investment trust, the dollar return will be less than if you finance an investment property with a large down payment. The larger the investment the more money you stand to make in dollar-terms.
When you’re looking to increase your real estate exposure, it’s smart to look into real estate investment trusts, too. Let’s now take a look at the different types of REITs that can be either publicly-traded or privately held.
Types of Real Estate Investment Trusts
Within the realm of public and private REITs, there are 3 main types of real estate investment trusts. They include equity REITs, mortgage REITs, and hybrid REITs. All 3 of these REITs adhere to the strict qualifications and guidelines of a REIT. However, the way they each make their revenue differs by type.
Here are the 3 types of REITs:
1. Equity REIT
An equity REIT is the most common type of real estate investment trust. In fact, as many as 90% of all REITs are equity REITs. These real estate investment trusts make their money off of rental income. Equity REITs can be either residential or commercial real estate investment trusts, and there are typically 4 types of equity REITs.
The 4 types of equity REITs include:
Retail REITs make up 24% of all real estate investment trusts and invest in shopping malls and freestanding retail locations. Revenue is earned off of the rent they charge their corporate tenants. The best retail REITs are those that invest in properties with a strong anchor tenant to reduce occupancy risk.
Real estate investment trusts that own and operate residential properties are considered residential REITs. It’s typical that these REITs invest in multi-family properties between 2 – 4 units as well as apartment buildings with 5+ units. These REITs tend to focus on large urban centers with population and job growth.
These REITs typically invest in hospitals, medical centers, nursing facilities, and retirement homes. A majority of their revenue comes from occupancy fees, Medicare and Medicaid reimbursements, as well as private payments. Clearly, these REITs are dependent on the healthcare system.
An office REIT is one that invests in commercial office buildings. Revenue is earned from long-term tenants who have signed a lease with a term between 3 – 10 years. Like residential REITs, these REITs look for investments in urban centers where there are population and job growth.
Since Equity REITs typically earn their revenue off of monthly cash flow from tenants, they’re thought of as stable investments. This is in contrast to mortgage REITs, which we’ll speak about next.
2. Mortgage REIT
A mortgage REIT is a real estate investment trust that makes its money off interest payments. Mortgage REITs typically borrow money at a lower short-term interest rate and purchase existing permanent mortgages with a higher interest rate. Mortgages can be residential or commercial. Profits are made on the spread between the short-term and permanent interest rates.
A mortgage REIT will typically raise investor funds as well as use short-term loans. For example, a mortgage REIT can raise $10 million from investors and borrow $40 million loans at a 2% interest rate (equal to an $800k interest expense). The REIT will use the $50 million in total capital to purchase permanent mortgages at a 4% interest rate (or $2 million in interest income).
The difference between the interest income of $2 million and the interest expense of $800k is the profit. In this example, the profit is $1.2 million. Of that $1.2 million, 90% will be distributed to shareholders in the form of a qualified dividend.
Mortgage REITs usually operate with high leverage. It’s common to see a mortgage REIT leveraged as high as 5-1 with mortgages and other real estate loans. For this reason, mortgage REITs are considered to be volatile and somewhat risky investments. This is why only 10% of all REITs are mortgage REITs
3. Hybrid REIT
A hybrid REIT, like its name suggests, is a REIT that owns both income-producing properties as well as mortgage loans. Hybrid REITs attempt to achieve greater diversification across both types of investments and receive the same or similar benefits with less risk. Profits are made off of rental income and the spread between interest income and interest expense.
Now that you understand the three types of real estate investment trusts, let’s discuss the ways you can invest in a REIT. These ways include investing in real estate using an existing REIT as well as starting a REIT of your own.
How to Invest in an Existing REIT
The easiest way to invest in a REIT is to invest in an existing REIT. Existing real estate investment trusts can be either publicly-traded or privately held. Public REITs can be bought and sold on an open exchange like a stock or ETF. Private REITs aren’t traded on a stock exchange. Instead, they take investments from private investors.
Publicly-traded REITs are offered on public exchanges like the New York Stock Exchange or the Nasdaq. These REITs trade just like a stock or ETF in that you can purchase shares on the open market, typically with no minimum or maximum amount. Also like a stock or ETF, an online brokerage fee around $8 – $10 is charged for each trade.
Public REITs pay investors quarterly dividends equal to 90% of their profits. Some REITs can even pay monthly dividends. Further, investors in public REITs own an appreciating asset that grows in value based on company-specific performance as well as macroeconomic trends. Publicly-traded REITs can be sold without restriction.
Publicly-traded REITs are a good option for investors because they typically have stable growth and are highly liquid. What’s more, public REITs typically don’t have any upfront or annual service fees. Public REITs must also comply with financial reporting requirements under the Sarbanes-Oxley Act, including quarterly financial reports that increases transparency.
Private REITs, also known as private placement REITs, are corporations that meet the strict IRS requirements for real estate investment trusts but aren’t listed with the SEC on an exchange. However, while these REITs are private, they’re allowed to sell securities to accredited investors with a net worth of $1 million or $200k in annual salary.
Shares of a private REIT are most commonly sold by a private broker or private financial advisor. It’s important to note here that privately-held REITs are “sold” in that they cost as much as 10% – 16% in upfront fees. This is unlike public REIT which is free except for the nominal transaction fee.
Further, investors of a private REIT typically can’t touch their investment for the first 2 – 3 years. After this time period is over, they can withdraw their investment with what’s known as a “redemption.” Still, managers of private REITs have the right to restrict redemptions indefinitely, making your investment potentially illiquid.
Since privately-held REITs are private, they also don’t have to adhere to the reporting standards of publicly-traded REITs. This means that they don’t have to comply with the mandated governance and compliance of public corporations, thus reducing transparency. This also reduces credibility and security and increases risk.
However, some people argue that the returns of a private REIT outperform the returns of a public REIT. This would really be the only reason to invest in a privately-held REIT vs a publicly-traded REIT.
Still, the number one factor when investing in an existing REIT is often the underlying assets themselves. This means that investors are typically more concerned with the portfolio of properties rather than the structure of the REIT itself. If the portfolio is good enough, there will be people willing to invest.
While private REITs aren’t traded on any open exchanges, it’s still possible to find listings of privately-held REITs. These lists can be found on such websites as NAREIT or through REIT-specific real estate brokers. However, most private funds are typically financed on the front-end, with fewer chances for additional investments.
How to Start Your Own REIT
Rather than investing in an existing real estate investment trust, it’s also possible to form your own REIT. If this is the case, you’ll need to comply with IRS regulations for real estate investment trusts. These regulations include organizational, operational, distribution, and compliance. Corporations that comply fill out form 1120-REIT on their year-end tax returns.
Before you classify yourself as a REIT, you’ll first have to establish a corporation. This corporation can’t be an LLC or a partnership. Once this corporation is formed, you’ll have to adhere to the following 4 things in order to be classified as a REIT:
1. Organizational Structure
All REITs have to be incorporated in the U.S. and taxable as a corporation. The corporation has to be governed by directors or trustees and its shares have to be transferable. After its second year, a REIT must have at least 100 shareholders with no more than 5 people owning 50% of the stock.
2. Business Operations
REITs are required to earn 75% of its annual gross income from real estate-related activities. Further, an additional 20% of a REIT’s annual gross income must come from either real estate activities or interest or dividends from non-real estate sources, such as deposit interest. REITs must meet these requirements every quarter.
3. Profit distribution
In order to qualify as a REIT, your corporation will need to pay out 90% of its annual profits in the form of quarterly or monthly qualifying dividends. This amount is taxed on the investor level at their dividends tax rate. The remaining 10% is taxed at the corporate level.
If the above 3 are met, your corporation can qualify as a REIT. In order to do so, the corporation has to make a REIT election by filing its income tax using form 1120-REIT. This form is due every March, meaning that a corporation doesn’t have to make its REIT election until the end of its first year. Still, the REIT will have to prove that it complied with IRS guidelines during that first year.
“If you’re looking to start your own REIT, a common scenario is when a few investors get together and form a corporation to buy a specific property, and each contributes something in addition to the money invested. One might obtain the mortgage under his name, another might handle any repairs, and a third might handle the leasing and property management.”
— Jeff Rohde of Condo Capital
Overall, starting your own real estate investment trust might be a good strategy. For more information on how to start your own REIT you can refer to the SEC. However, the most common types of REIT investments are with publicly-traded REITs.
Bottom Line: Real Estate Investment Trusts
Real estate investment trusts (REITs) are public and private corporations that invest in a portfolio of income-producing real estate. REITS are a way to invest in real estate without having to actively landlord yourself. These REITs can be either equity REITs or mortgage REITs. Equity REITs make their money off of rental income while mortgage REITs make their money off of interest income. Overall, equity REITs are the least volatile.