What Are REITs And How Do They Work?
Updated on: December 2022
Written by: Kelly Koeppel
In the U.S., owning real estate is as American as apple pie. Having a house, a garage, and a white picket fence has long been a part of the American Dream, too.
Unsurprisingly, given the prominence of real estate ownership in our culture, even after achieving the American Dream, many people want to buy more real estate. Some may even become landlords after retiring.
But while many pre-retirees and retirees may be interested in buying more real estate, most wouldn’t want to put up with all the extra work and hassle that comes with being a landlord, which can easily become a part-time (or even full-time) job.
That’s where real estate investment trusts (REITs) enter the picture.
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What is a REIT, Anyway?
According to Investopedia, a real estate investment trust is “a company that owns, operates, or finances income-generating real estate.”
Simply put, a REIT is a company that owns/manages real estate and profits from it. In this regard, a REIT is just like any other company with shares that you can buy on the stock market. And, like regular stocks, REITs have their own stock market symbols.
Nearly all REITs available to the public specialize in a particular sector or sectors of real estate, like residential rentals, offices, industrial spaces, telecom facilities, diagnostics labs, and even data centers, to name a few.
If you want to see what types of REITs you could buy in your brokerage or retirement accounts, here’s the official list of U.S. REITs courtesy of Nareit, a Washington, D.C.-based REIT research firm. As of November 2022, there are 181 publicly-traded REITs in the U.S., and you can sort them by category, location, etc.
Are REITs Trustworthy Investments?
While all publicly traded companies are subject to financial regulations and SEC scrutiny, a company that wants to qualify as a REIT must operate under even more stringent guidelines.
That’s because, after the Great Recession and housing collapse of 2008, the government stepped in to prevent wild, unchecked speculation in the real estate market from ever happening again—at both an individual and corporate level.
That’s why the purchase process for U.S. real estate is so much more rigorous (and stressful) than it used to be. A few decades ago, you could essentially apply and be approved for a mortgage with minimum due diligence, then sign a few papers and get the keys to your new house.
These days? You’d be lucky if the entire application, approval, and underwriting process took less than three months. In fact, for many home buyers—even those with good credit and sufficient funds for a down payment, the closing process can take another 30–45 days after being approved!
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The Rules That All REITs Must Follow
The good news is that companies that want to qualify as REITs have to jump through even more hoops. Not only to prove to the SEC that they’re safe enough for everyday investors to trade on the open market, but also that they have the best interests of their shareholders in mind:
The primary requirement for a REIT is that it must hold income-generating real estate investments for the long term and distribute profits regularly among shareholders. Aside from that, REITs must also:
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries.
- Derive at least 75% of gross income from rents and interest on mortgages that finance real property, or real estate sales.
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year.
- Have no more than 50% of its shares held by five or fewer individuals.
- Have at least 100 shareholders after its first year of existence.
In addition, REITs must also be structured as taxable corporations and must also be managed by a board of directors or trustees.
As we said, there’s a reason millions of investors like to buy REITs: they’re very trustworthy investments.
7 Reasons Why Many Investors Prefer REITs Over Real Estate
According to Nareit, an estimated 145 million U.S. investors own REITs either directly or through their retirement savings and other investment funds.
Nareit also estimates that REITs collectively hold $3.5 trillion in gross assets, the majority of which are real estate investments. Publicly traded equity REITs account for a $2.5 trillion piece of that pie, too.
In other words—a lot of investors really like REITs. Here are 7 major reasons why:
- Owning real estate yourself comes with high upfront costs: Unless you can buy a house in cash, you’ll need to put down a big lump sum (usually 20% down, unless you use a first-time FHA loan) and also pay a bunch of closing fees. Most REITs, on the other hand, are under $100 per share.
- Owning real estate yourself comes with high financing costs: Mortgages are not your friend. If you don’t prepay your mortgage as soon as you can, you’ll easily pay far more than the property was worth when you first purchased it, sometimes by nearly 100% or more over 15–30 years—and just in interest!
- Physical assets are not very liquid: Unlike buildings, which can be hard to offload, REITs trade like stocks, meaning you can buy and sell them instantly without paying any transaction fees. This greatly lowers the risk of holding a REIT compared to physical real estate.
- REITs help investors easily diversify their real estate: Since REITs tend to specialize in a specific real estate sector or niche, they’re a way for everyday investors to gain diversified exposure to property types they wouldn’t normally be able to afford or purchase (like life sciences facilities, hotels, shopping malls, etc.).
- REITs help investors lower the risk of real estate ownership: For example, if a REIT owned thousands of single-family rental homes (SFRs) and 10% of those homes sat empty, the overall value of the REIT would likely still be fine. But if you owned a rental home and couldn’t get renters to stay? Good luck.
- REITs are incentivized to look out for the best interests of their stakeholders: Because REITs are required to give 90% of their annual taxable income back to shareholders in the form of dividends (and shareholders expect this dividend), the interests of a REIT are always aligned with those of its shareholders.
- REITs are passive real estate investments: Last but not least, unlike individual real estate ownership, REITs don’t require their shareholders to participate in any meetings or become landlords themselves. These trusts are actively managed on behalf of their shareholders, who have the freedom to just sit back and let their money work hard for them.
Finally, it’s worth pointing out that REITs, like stocks, can appreciate in value. So on top of receiving annual dividends, REIT shareholders can rest easy knowing that their REIT shares will likely grow in value over the long run, just as if they owned and/or managed income-generating real estate themselves.
Are REITs Right for Your Portfolio?
While REITs can help investors gain much-needed exposure to real estate as a whole, or even to specific real estate sectors, you should always consult your financial advisor and/or tax advisor before making a significant investment decision that could impact your portfolio or nest egg.
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