Real Estate Investment Trusts (REIT)

Matt Wilbur is the senior director of Advisory Investments at Northwestern Mutual.

When it comes to building a well-diversified investment portfolio, there’s so much more to consider than just stocks and bonds. There are many additional asset classes that may also have a role to play in your portfolio—as potential diversifiers, income generators, growth drivers and more.

Real estate can fulfill many of these needs. Unfortunately, not everyone has the money available to purchase an investment property outright; and even those who do might not want to lock away so much of their wealth in an asset as illiquid as physical property.

The good news is that there are ways to invest in real estate that don’t involve purchasing physical property. Buying shares of real estate investment trusts (REITs) is one way to do it.

Below, we take a closer look at real estate investment trusts, explain how they work and how to invest in them, and answer other common questions that investors often ask about REITs.

What is a REIT?

A real estate investment trust (REIT) is a type of company that owns, operates or finances income-generating real estate. REITs can be privately held or publicly traded companies.

Some REITs are specialized, focusing on just one or two types of real estate. Other REITs are diversified, owning, operating or financing many different types of real estate. Virtually any type of real estate capable of generating income, typically in the form of rent, can be owned, operated or financed by a REIT. Popular real estate categories owned by REITs include the following:

• Apartment complexes
• Single-family and multi-family homes
• Hotels and motels
• Health care facilities
• Data centers
• Office buildings
• Retail centers
• Warehouses

By law, a REIT must pass on (distribute) at least 90 percent of its income in the form of dividends; otherwise the REIT risks losing its status as a REIT and the preferable tax treatment that makes the business model possible. So, REITs are extremely popular among investors looking for income generation in their portfolios.

Types of REITs

There are three varieties of REITs to be aware of, each with its own unique benefits, risks and means of operating: equity REITs, mortgage REITs and hybrid REITS.

An equity REIT is a business that directly owns and operates income-generating real estate. Income is typically generated through rent payments. Equity REITs are the most common type of REIT.

A mortgage REIT (also called an MREIT), by comparison, does not directly own real estate. Instead, it finances real estate. It can do this in multiple ways. For example, it can lend money directly to real estate owners and developers or purchase mortgage-backed securities originated by other lenders. Instead of rent, MREITs generate income from interest payments on the debt that they own.

A hybrid REIT takes a page out of both playbooks, directly owning some real estate (like equity REITs) while also financing other real estate (like mortgage REITs).

How does a REIT work?

As mentioned above, a REIT is a business that either directly owns and manages real estate or finances it. REITs generate income either by collecting rent payments or by collecting interest payments on debt.

To qualify as a REIT, a business must meet a number of requirements. The most important requirements to understand include these:

• At least 90 percent of the company’s taxable income must be paid to shareholders each year in the form of dividends.
• At least 75 percent of the REIT’s assets must be in real estate assets and cash.
• The company must be managed by a board of trustees or directors.
• No more than 50 percent of the company can be owned by five (or fewer) shareholders.
• Shares of the company must be held by at least 100 investors after its first year.

REIT vs. real estate fund

A REIT is an individual business that owns, operates or finances real estate to generate income for investors. A real estate fund, by comparison, is a type of mutual fund that specifically invests in a variety of REITs and other businesses related to real estate. Some real estate funds may also invest directly in real estate. This makes investing in real estate funds a more diversified option compared with investing in individual REITs.

While real estate funds may provide investors with dividend payments, they are not required to do so by law, and yields tend to be lower than when investing directly in REITs. Real estate funds instead aim to provide value to investors through price appreciation.

How to invest in a REIT

Shares of publicly traded REITs can be bought and sold on an exchange, just like stocks and bonds. That means that all you need to do to invest in REITs is open a brokerage account. In addition to holding REITs in a taxable investment account, REITs can also be held in qualified accounts (like an IRA).

Of course, investors must perform their own due diligence before making any investment decision, whether that includes investing in stocks, bonds or REITs. When evaluating REITs, you’ll want to consider their cash flow, debt levels, dividend payout history and other factors to ensure that the business is healthy.

While a REIT is itself a great way to invest in a diversified portfolio of real estate, it’s important to recognize that, at the end of the day, a REIT is a single company. So, it’s typically a good idea to select multiple REITs when building your portfolio. Another way to properly diversify your holdings is to purchase a real estate fund.

Pros and cons of REITs

Advantages of investing in REITs

Real estate investment trusts offer investors several potential benefits, including that they provide:

• An easy and convenient way of investing in real estate without having to purchase physical property.
• An investment in real estate without a significant amount of upfront capital.
• Diversification for your portfolio.
• A more diversified way to invest in real estate compared to purchasing a single piece of property.
• The ability to buy and sell shares (just like stocks and bonds), making them a much more liquid asset than physical real estate, which may take significant time and effort to sell.
• An excellent means of income generation due to distribution requirements that they must meet.

Drawbacks of investing in REITs

But just like other asset classes, REITs also come with certain drawbacks that may make them less than ideal for certain investors or for certain investment scenarios. These include the following:

• REITs are designed to return value to shareholders through dividend payments. Because only 10 percent of taxable income can be reinvested back into the business, this limits how much the business can grow and, by extension, how much share prices can appreciate.
• Dividends that investors receive from their REIT investments will typically be taxed at the investors’ ordinary income tax rates.
• Due to the nature of how they do business, REITs tend to carry significant levels of debt.
• REITs are sensitive to changes in interest rates, like the broader equities and fixed income markets. That’s because rising rates can make it more expensive for REITs to operate.

REITs and your financial strategy

Real estate investment trusts can offer investors an easy and convenient means of investing in real estate. By doing so, REITs can play several important roles in an investment portfolio—especially as a diversifier and income generator.

Of course, REITs are only one asset class and are typically paired with others, like stocks, bonds and commodities, in a well-diversified portfolio. If you’re interested in REITs, your financial advisor can help you see how they can fit into your larger financial picture.

This information is for educational purposes only and is not a recommendation for any particular investment. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future performance. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. This publication is not intended as legal or tax advice. Financial representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.