Buying shares of real estate investment trusts (REITs) gives investors a convenient way to invest in land and buildings while receiving income and capital appreciation. REITs own and finance real estate and pay 90% of their income from rent, interest and capital gains as dividends. While REITs tend to produce reliable income, they are subject to real estate cycles of boom and bust and are also sensitive to interest rate changes. A financial advisor can help you decide if a REIT fits your goals and risk profile as well as what kind of REIT would be best for you.
The first REITs appeared in the 1960s after the U.S. Congress enabled them as a way to let investors participate in the real estate business. In exchange for agreeing to pay out 90% of taxable income as dividends and meet other restrictions, REITs are allowed to avoid paying the double federal income tax levied on corporations. Instead, dividends are passed through untaxed to investors, who usually pay taxes on the income at their ordinary individual rates.
REIT Advantages
Diversification is one of the main benefits of REIT investing. Real estate has a generally low correlation with other financial assets such as stocks and bonds, and owning it can help portfolios weather market downturns. However, many investors are reluctant to shoulder the responsibility of directly owning and managing properties. REITs allow them to diversify without the burden of collecting rents, maintaining and repairing residential and commercial properties.
Beyond that, REITs are valued for their high dividend payouts. REITs provide some of the highest dividends available on the stock market. The average REIT dividend payout in May 2021 was 3.16%, according to the National Association of Real Estate Investment Trusts (NAREIT), compared to the average S&P 500 stock dividend of 1.34%.
REIT Types
REITs are broadly divided into two types: equity and mortgage. Equity REITs own and usually manage properties. Mortgage REITs participate in real estate financing but don’t own properties. Equity REITs are divided into the types of property they specialize in. Most REITs are active in apartments, manufactured housing, office buildings, shopping centers and industrial properties. Others own healthcare facilities, self-storage projects, hotels and other property types. Equity REITs get much of their income from long-term rental contracts. They also generate capital gains when they sell properties at a profit.
Mortgage REITs, also known as mREITs, don’t own property. Instead, they buy mortgages from lenders and generate income by collecting the mortgage payments. MREITs tend to have higher payouts than equity REITs, but are also viewed as riskier since they are more sensitive to interest rate trends.
About a quarter of equity REITs are in retail, owning malls, outlets and shopping centers as well as properties housing restaurants and other service businesses. The number of indoor shopping malls has been in a long-term decline, which is expected to continue. Competition from online sellers has also created pressure on many other traditional retailers. As a result, with the exception of REITs specializing in convenience stores, big-box discounters and service providers such as auto repair shops, retail is viewed as one of the riskier REIT sectors.
REIT Disadvantages
One of the downsides of REIT investing is that the dividends shareholders receive are generally taxed as ordinary income. Other dividends from regular corporations are usually taxed at the capital gains rate, which for most people is 15%. Ordinary income tax rates are usually higher, which means most REIT dividends create a greater tax liability than other dividends. About three-quarters of REIT dividends are considered ordinary income, according to NAREIT.
While REIT dividends tend to be stable long-term, the total return, including price changes, can vary significantly. Sometimes REITs can drag down a portfolio’s performance. In 2020, for instance, equity REITs generated an average loss of 5.1%, according to NAREIT. The Russell 1000 market index, meanwhile, returned a gain of 21%. And when interest rates are rising, mortgage REITs often cut their dividends.
How To Buy REITs
REITs are listed on major exchanges, including the New York Stock Exchange and Nasdaq. They trade just like ordinary stocks and are easy to buy using a traditional or online brokerage or online trading platform. Unlike owning real estate, which can be illiquid, owning REITs offers the same liquidity as other stocks
Selecting a REIT for investment can involve significant research, including evaluating the rental income and length of the leases on underlying property. Another way to go is to invest in a REIT mutual fund or exchange traded fund. These provide a high degree of diversification along with the same liquidity advantages of REIT shares. Because of the significant income generated by REIT shares, investors may choose to keep them in a tax-advantaged account such as an IRA in order to defer taxes.
Bottom Line
REITs are widely prized by investors seeking convenient diversification into real estate and reliable income. The shares are easy to buy and sell and offer some of the highest dividend payouts of any stocks. However, investors usually pay their individual income tax rates on REIT dividends, and REITs are also subject to the boom-and-bust cycle of the overall real estate industry. It’s also important to understand the different types of REITs to ensure that whichever one you invest in fits your goals and risk profile.
Tips on Investing
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REITs are taxed and valued differently from other stocks, and making a smart REIT investment requires insight into the industry and its many variables. That’s where a financial advisor can be crucial to your success. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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Before you start investing, you will need to choose securities that suit your risk tolerance. You can determine your risk tolerance by evaluating your comfort level in certain investments.
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