A real estate investment trust, or REIT, is a company that owns or finances income-producing property and lets you buy a share of it like a stock. For anyone looking into REITs for beginners, the short version is this: they offer property exposure and regular income without being a landlord, but they carry market, interest-rate and tax trade-offs worth understanding first.
This FMBanksia.com explainer covers how REITs work, the main types, their benefits and risks, and how they might fit into a diversified portfolio.
Key takeaways
- REITs own or finance real estate and pass most of their taxable income to shareholders as dividends.
- Publicly traded REITs can be bought and sold like stocks; non-traded REITs are much harder to sell.
- REIT dividends are generally taxed as ordinary income, not at lower qualified-dividend rates.
- Prices can fall, dividends can be cut, and some REITs are sensitive to interest rates.
- For most people, a REIT fund is a supporting holding rather than the core of a portfolio.
What is a REIT?
A REIT is a company that owns, and usually operates, real estate that produces income. That can include apartment buildings, offices, shopping centers, warehouses, hotels, self-storage facilities and health care properties. Some REITs instead hold mortgages and other real estate loans.
When you buy a share, you own a small slice of that company. You receive a portion of the income it distributes, and the share price rises or falls with the market’s view of the business.
Why REITs pay out so much income
According to the SEC’s investor bulletin on REITs, a company must distribute at least 90 percent of its taxable income to shareholders each year as dividends to qualify as a REIT. In return, it can deduct those dividends from its corporate taxable income.
The same bulletin notes that Congress created REITs in 1960 so individual investors could share in income from large-scale commercial real estate. That payout rule is why REITs are often associated with steady dividends.
The main types of REITs
REITs can be grouped in two useful ways: by what they own and by how their shares are sold.
By what they own
- Equity REITs own and operate properties and earn mainly from rent. Most REITs fall into this group.
- Mortgage REITs lend money to property owners or buy mortgage-backed securities, earning interest. They tend to use more borrowed money, which adds risk.
- Hybrid REITs combine both approaches.
Many REITs also specialize in a single property type, such as residential, industrial, retail or health care. A specialized REIT rises and falls with the fortunes of that one sector.
By how shares are sold
This distinction matters most for beginners. The table below summarizes key differences from the SEC bulletin.
| Feature | Publicly traded REITs | Non-traded REITs |
|---|---|---|
| Where shares trade | National stock exchanges | Not listed on an exchange |
| Ease of selling | Can be sold like any listed stock | Redemption programs are typically very limited |
| Costs to buy | Normal brokerage costs | Upfront fees of roughly 9 to 10 percent are typical |
| Price information | Real-time market prices | Little independent information on share value |
| Minimum investment | One share | Often $1,000 to $2,500 |
Why investors like REITs
Readers of FMBanksia.com often ask why REITs are so popular. They appeal to many people for a few practical reasons:
- Income. The payout requirement means a large share of earnings reaches shareholders.
- Access. You can own part of large commercial properties for the price of a share.
- Liquidity. Listed REIT shares can be sold on any trading day, unlike a physical building.
- Diversification. Real estate can add a different source of return to a mix of stocks and bonds.
- No landlord duties. Tenants, repairs and vacancies are the company’s job, not yours.
If you are weighing whether to buy a home or keep renting while investing, our guide to renting vs buying a home explores that decision in depth.
The risks to understand
REITs are not a safe substitute for savings. Their prices can drop sharply, especially during broad market sell-offs, and dividends are never guaranteed. A REIT can reduce or suspend its payout when rents fall or costs rise.
Many REITs borrow money to buy property, so changes in interest rates can affect their costs and their share prices. Mortgage REITs, which rely heavily on borrowing, can be especially sensitive.
Extra caution with non-traded REITs
The SEC warns that non-traded REITs can be difficult to sell, sometimes for many years, and that high upfront fees reduce the amount actually invested. Some pay distributions using offering proceeds or borrowed money rather than operating income, which can erode the value of the shares. If someone pitches one to you, ask detailed questions and read the offering documents carefully.
Taxes
REIT dividends are generally taxed as ordinary income rather than at the reduced rates that apply to many other corporate dividends. For that reason, some investors prefer to hold REITs inside tax-advantaged retirement accounts. A tax professional can explain how this applies to you.
How to invest in REITs as a beginner
The simplest route for most people is a low-cost REIT index fund or exchange-traded fund, which spreads money across many property types and companies in one purchase. If you are unsure how those fund types differ, see our comparison of index funds vs ETFs.
- Decide what role real estate should play in your overall plan.
- Choose between individual REITs and a diversified REIT fund.
- Compare fees, holdings and dividend history before buying.
- Consider which account to use, given how REIT dividends are taxed.
- Keep the position sized so a downturn would not derail your goals.
Here is a hypothetical example. Say you invest $1,000 in a REIT fund. If the fund distributes 4 percent over a year, you would receive about $40 in dividends, but the value of your $1,000 could still rise or fall. That illustration is not a forecast; it simply shows that income and price changes are separate parts of your return.
Starting small is fine. Our guide on how to start investing with $500 covers the basics of building a first portfolio, and the investing section has more on diversification.
Where REITs fit in a portfolio
For most investors, REITs work best as a supporting allocation rather than a core holding. Many broad stock index funds already include some REITs, so check what you own before adding more.
You can find related topics in our real estate coverage, along with the wider library of FMBanksia.com money guides.
Frequently asked questions
Are REITs good for beginners?
Publicly traded REITs and diversified REIT funds can be a reasonable way for beginners to add real estate exposure, because they are easy to buy and sell. They still carry market risk, and dividends can be cut. Keeping them as a modest part of a diversified portfolio helps limit the impact of downturns.
How do REITs make money for investors?
Investors can earn in two ways: dividends paid from the REIT’s rental or interest income, and changes in the share price. Because REITs must distribute at least 90 percent of taxable income, dividends are often a large part of the return. Share prices, however, can fall as well as rise over time.
How are REIT dividends taxed?
REIT dividends are generally treated as ordinary income and do not usually qualify for the lower rates that apply to many other corporate dividends. That is why some investors hold REITs in tax-advantaged retirement accounts. Tax rules can change and depend on your situation, so check with a qualified tax professional.
What is the difference between a REIT and buying rental property?
Owning rental property means handling tenants, repairs, financing and a large upfront investment yourself. A publicly traded REIT lets you own a small share of many professionally managed properties with far less money and the ability to sell quickly. You give up direct control in exchange for convenience and diversification.
This guide is for general education only and is not personalised financial, tax or legal advice. Consider speaking with a qualified professional about your situation. See our financial disclaimer.
