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What is a Real Estate Investment Trust (REIT)? Here are the basics

At a glance:

  • What is a real estate investment trust (REIT)?

  • How do you earn money from a REIT?

  • What types of real estate does a REIT invest in?

  • How to invest in a REIT

  • Advantages and disadvantages of investing in a REIT

  • Summary of REITs

Unless it is your own home, investing in real estate can be uncertain. A development can fail, and rents can plummet. Mortgage interest rates can decline, and the flood of the century can wipe out your investment.

A real estate investment trust (REIT) aims to lower the risk of investing in real estate. It operates much like a mutual fund, except that instead of investing in stocks or bonds, it invests in a diversified portfolio of real estate.

A REIT might be a good investment choice to help diversify a portfolio with the right asset allocation strategy.

What is a real estate investment trust (REIT)?

Real estate is a favorite among some investors. It provides many investment benefits and flexibility not found in other investments. There is one problem, though: it is not a small investment. For most folks, homeownership is the largest and only real estate investment they have.

Yet many advisors suggest diversifying one's portfolio with assets other than stocks and bonds—like real estate. A REIT might be a way to add that diversification.

What it is

A real estate investment trust, or REIT (pronounced "reet"), is a company that owns, manages, and/or operates real estate in order to earn profits for shareholders.

There are about 1,100 REITs in the United States that have filed tax returns. The assets of all REITs registered with the Securities and Exchange Commission total over $1 trillion, according to the National Association of Real Estate Investment Trusts.

Congress opened the door to REITs in 1960 to enable small investors to participate in large commercial real estate ventures. Originally, REITs could own real estate but not manage or operate it, until the Tax Reform Act of 1986 expanded their powers. Since then, REITs have grown incrementally.

REITs vs. RELPs

Sometimes people compare REITs to real estate limited partnerships. While both entities invest in real estate, significant differences exist between the two. One is organized as a partnership, the other a corporation. One major difference is that a board of directors elected by the investors governs a REIT. A real estate limited partnership, in contrast, is managed by a general partner who sometimes cannot be easily removed by the limited partners.

Who invests in REITs and why?

Individuals and mutual funds are the largest investors in REITs. A wide variety of organizations such as pension funds, endowment funds, insurance companies, and bank trust departments also invest in them.

REITs offer a way to invest in real estate without actually having to buy properties yourself.

How do you earn money from a REIT?

Earning money from a publicly owned real estate investment trust (REIT) is like earning money from stocks. You receive dividends from the profits of the company and can sell your shares at a profit when their value in the marketplace increases.

Factors to consider

Of course, the amount you earn depends largely on the successful management of the REIT, as well as market conditions. A REIT often can provide a reasonable return of 5–10 percent or more.

On the other hand, building a successful REIT requires considerable management skill. When a REIT runs into a problem with a particular property, the REIT cannot sell it as quickly or easily as, say, a mutual fund can sell poorly performing stocks or bonds.

As an investor, you will want to review a REIT's equity and mortgage properties before purchasing its shares. Some REITs carry a lot of risk, while others offer much more stability. In general, shares in REITs that invest heavily in mortgage loans may be more volatile than shares in REITs that focus on equity investments, since fluctuations in mortgage loan interest rates can quickly affect the REITs' performances.

Some tax facts about REITs

REITs have certain tax advantages and rules to follow. For instance, 90 percent of a REIT's net earnings must be distributed each year to shareholders, in order to avoid corporate taxes. This rule results in higher income for the investor.

In the event your REIT investment loses money, you can deduct up to $3,000 of your losses from your taxable income, which can offset other income and gains in other investments.

Do your homework before you invest

While REITs take much of the risk and hassle out of investing in real estate, that doesn't mean they're worry-free. It's important to understand the dynamics of the real estate market, as well as the performance of a particular REIT, before you buy your shares.

What types of real estate does a REIT invest in?

A real estate investment trust (REIT) usually follows one of three investment approaches: it invests in equity, mortgage loans, or a combination of the two. The vast majority (more than 90 percent) of REITs are equity REITs, and only about 5 percent are mortgage-based. An even smaller number are hybrids.

Beyond these basic strategies, a REIT also may focus geographically or by the type of real estate it invests in.

Location, location, location

Some of the nation's 1,100-plus REITs invest nationwide. Others limit their investments to a particular region, or even a single urban center, such as the greater Chicago area.

Types of properties they invest in

About one-fifth of REITs invest in industrial and office buildings, according to the National Association of Real Estate Investment Trusts. About one fifth invest in retail enterprises, including shopping centers and factory outlet malls. Lower numbers of REITs also invest in many other different types of real estate—for example, residential developments, hotels and resorts, self-storage businesses, and healthcare facilities such as hospitals, nursing homes, rehabilitation centers, and assisted living centers. Some REITs also invest in projects that improve community life, such as renovating Main Streets and converting historic, rundown buildings to new uses.

As you can imagine, the holdings of a REIT will have a major impact on the dividends it pays its shareholders, as well as the value of the shares on the secondary market.

How can you invest in a REIT?

Investing in a real estate investment trust (REIT) is similar to investing in any corporate stock. You can obtain shares in REITs from the same sources you might visit to acquire corporate stock—investment brokers or other financial services centers.

Try the mutual fund route

In addition, you can buy shares in mutual funds that invest in REITs. The National Association of Real Estate Investment Trusts (NAREIT) lists on its Website several dozen mutual funds that invest in REITs: www.reit.com. This list includes a number of no-load funds and provides complete contact information for all funds listed.

The Association's Website also provides much other useful information to investors who are in the process of selecting a particular REIT investment. For instance, it offers several historical reports of REIT performance by sector (healthcare, industrial/office, retail, etc.). A real-time market index reports current returns for equity REITs and all REITs.

How to contact NAREIT

Besides online, you can contact the NAREIT by mail or phone:

1875 I St., NW, Suite 500

Washington DC, 20006

(202) 739-9400 or (800) 3-NAREIT

Advantages and disadvantages of investing in a REIT

Like any investment, REITs have pluses and minuses. Certainly, they carry more volatility than government securities and money market funds.

The cons

Some investors and financial advisors steer clear of REITs altogether, believing that their potential downside is too great. They point out that the basic problem with REITs is real estate—property that cannot be moved to other locations or easily altered when a problem arises in a particular sector.

For instance, if you acquire shares in a REIT that invests heavily in residential developments that don't attract buyers or renters, the REIT's managers will have a hard time meeting their profit expectations or selling the property. And REITs that invest in mortgage loans can post poor performances following drops in interest rates.

The pros

Other investors and financial advisors are REIT advocates, strongly believing in the ability of REITs to add considerable income potential to a portfolio with a reasonable level of risk. They point out that many REITs have performed well over time and that conservative investors can lessen their risk by investing in REITs that have diversified investments or in mutual funds that invest in multiple REITs.

These advocates also remind us of the tax advantage of being able to deduct up to $3,000 of regular earnings on your income tax return if you incur a loss through your REIT.

All in all, REITs can provide a high yield and a hedge against inflation for investors comfortable with a certain amount of risk. Remember, the risk—and potential rewards—tend to be higher for REITs that invest in mortgage loans than for those investing in equity.

Summary of REITs

Real estate investment trusts offer a way to invest in real estate without actually having to buy properties yourself. Are REITs right for you? The answer depends on your assessment of your risk comfort level, and your knowledge of REITs and the options for investing in them.

Many investors who would like to invest in REITs at the lowest possible level of risk consider investing in equity REITs that diversify their holdings across several sectors, or they consider mutual funds that invest in REITs.

If you need to diversify your portfolio by adding assets other than stocks and bonds and you have a reasonable tolerance for investment risk, then you might consider REITs. They offer some of the investment benefits of real estate investing without the hassle of being a landlord.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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