How REITs Work: Structure, Income, and Requirements Explained

How REITs Work: A Plain-English Guide for Beginners

If you have ever wished you could invest in commercial real estate — apartment buildings, shopping centers, office towers, or data centers — without buying an actual property, then understanding how REITs work is an important first step.

A real estate investment trust, or REIT, is a company that owns, operates, or finances income-producing real estate. Congress created REITs in 1960 specifically to give individual investors access to large-scale, income-producing real estate that was previously only available to wealthy institutions or well-connected private investors.

REITs are structured in a way that is governed by specific rules under U.S. federal tax law. These rules determine what a REIT must own, what income it must earn, how much it must distribute to shareholders, and how it is taxed. Understanding those rules is the key to understanding how REITs work.

This article explains the mechanics of REITs — how they are organized, how they generate income, what legal requirements they must follow, and what that means for you as an investor.

What Makes a REIT Different from a Regular Company?

Most companies can keep the profits they earn, reinvest them, and pay taxes on them at the corporate level. Shareholders then pay taxes again when they receive dividends. This is known as double taxation.

REITs operate under a different set of rules. When a company qualifies as a REIT under the Internal Revenue Code, it can deduct the dividends it pays to shareholders from its corporate taxable income. This means that a REIT that distributes all of its taxable income to shareholders effectively owes no corporate income tax.

In exchange for this tax advantage, REITs must follow strict rules about what they own, what income they earn, and how much they pay out to shareholders. The U.S. Securities and Exchange Commission (SEC) explains: a company that qualifies as a REIT is allowed to deduct from its corporate taxable income all of the dividends it pays out to shareholders. Because of this special tax treatment, most REITs pay out at least 100 percent of their taxable income to their shareholders and, therefore, owe no corporate tax.

The Core REIT Requirements

To qualify and maintain status as a REIT under U.S. federal tax law, a company must satisfy a set of ongoing organizational, operational, distribution, and compliance requirements. Here is a plain-English summary of the key rules, sourced from Nareit and the SEC.

Organizational Requirements

A REIT must be organized as a corporation, trust, or association that would ordinarily be taxable as a corporation. It must be governed by a board of directors or trustees, and its shares must be fully transferable. Beginning with its second taxable year, a REIT must have at least 100 shareholders and no more than 50 percent of its shares can be held by five or fewer individuals during the last half of the taxable year.

Income Tests

A REIT must pass two annual income tests to ensure the overwhelming majority of its income comes from real estate-related sources.

• 75% Income Test: At least 75% of the REIT's annual gross income must come from real estate-related sources — including rents from real property, interest on obligations secured by mortgages on real property, and gains from the sale of qualifying real estate.
• 95% Income Test: At least 95% of the REIT's annual gross income must come from the 75% sources plus dividends, interest, and gains from the sale of securities. No more than 5% of a REIT's income can come from non-qualifying sources such as service fees or unrelated business activities.

These income tests are governed by Sections 856(c)(2) and 856(c)(3) of the Internal Revenue Code. They are designed to ensure that REITs remain genuine real estate investment vehicles rather than general operating companies that happen to hold a small amount of real estate.

Asset Tests

A REIT must also pass quarterly asset tests to confirm that most of its investments are tied to real estate.

• 75% Asset Test: At least 75% of a REIT's total assets at the end of each quarter must consist of real estate assets — such as real property or loans secured by real property — along with cash and government securities.
• 10%/5% Concentration Limit: A REIT generally cannot own more than 10% of the voting securities of any corporation (other than another REIT, a taxable REIT subsidiary, or a qualified REIT subsidiary). No single corporation's securities can represent more than 5% of the REIT's total assets.
• 25% Taxable REIT Subsidiary Limit: The value of a REIT's taxable REIT subsidiaries — subsidiaries that can engage in businesses a REIT itself cannot — cannot exceed 25% of the REIT's total assets.

Distribution Requirement

This is the rule most investors associate with REITs: a REIT must distribute at least 90% of its taxable income to shareholders each year in the form of dividends. Any taxable income retained by the REIT is subject to ordinary corporate income tax. Because of this, most REITs choose to distribute 100% of their taxable income rather than retain any earnings and pay tax on them.

This distribution requirement is the primary reason REITs tend to pay significantly higher dividend yields than most other publicly traded stocks.

How REITs Generate Income

The income a REIT earns depends on its type and the properties or assets it holds. The two primary categories are equity REITs and mortgage REITs.

Equity REITs

Equity REITs own and typically operate income-producing real estate properties. They generate the majority of their income from rents collected from tenants. Equity REITs are the most common type of REIT and span a wide range of property sectors, including:

• Residential REITs: apartment buildings and multifamily housing communities
• Office REITs: office buildings and business parks
• Industrial REITs: warehouses, distribution centers, and logistics facilities
• Retail REITs: shopping malls, strip centers, and freestanding retail properties
• Healthcare REITs: hospitals, senior living facilities, medical office buildings, and skilled nursing facilities
• Data Center REITs: facilities that house computer servers and IT infrastructure
• Self-Storage REITs: storage facilities for individuals and businesses
• Hotel and Lodging REITs: hotels, motels, and resorts
• Infrastructure REITs: cell towers, fiber optic networks, and energy pipelines
• Timberland REITs: forested land used for harvesting timber

Most REITs specialize in a single property sector, although some diversified REITs hold multiple property types. According to Nareit, REITs invest in the majority of real estate property types, including offices, apartment buildings, warehouses, retail centers, medical facilities, data centers, telecommunications towers, infrastructure, and hotels.

Mortgage REITs

Mortgage REITs, often called mREITs, do not own physical properties. Instead, they provide financing for income-producing real estate by originating or purchasing mortgages and mortgage-backed securities. Their income comes primarily from the interest on those loans and securities rather than from rent.

Mortgage REITs tend to use more leverage than equity REITs and can be more sensitive to changes in interest rates. The SEC notes that many mortgage REITs manage their interest rate and credit risks through the use of derivatives and other hedging techniques.

Hybrid REITs

A small number of REITs combine the strategies of both equity and mortgage REITs, owning properties while also originating or investing in real estate loans. These are sometimes called hybrid REITs.

How REITs Work in Practice: A Hypothetical Example

To see how REITs work in practice, consider a simplified hypothetical example. The numbers below are invented for illustration purposes only and do not represent any actual REIT or its performance.

Imagine a hypothetical REIT called Clearfield Property Trust that owns 50 apartment buildings across five states. It collects a combined $40 million in rent from tenants each year.

• After paying operating expenses (maintenance, property management, insurance, property taxes) of $15 million, the REIT earns $25 million in net operating income.
• After accounting for depreciation and interest expenses, suppose the REIT's taxable income is $20 million.
• To maintain its REIT status and avoid paying corporate income tax, Clearfield Property Trust distributes 100% of its $20 million in taxable income to its shareholders as dividends.
• If the REIT has issued 10 million shares, each share would receive $2.00 in dividends for the year.
• If the shares trade at $40 each on the stock exchange, the annual dividend yield is 5% ($2.00 divided by $40).

This hypothetical example illustrates the basic mechanics: a REIT earns income from real estate operations, passes that income through to shareholders as dividends, and — by doing so — avoids paying corporate income tax on the distributed amount.

Note: This example uses invented figures for educational purposes only. Actual REIT income, expenses, dividend amounts, and yields vary widely and change over time.

How REITs Are Organized and Managed

Publicly traded REITs are registered with the SEC and list their shares on major national stock exchanges such as the New York Stock Exchange. Investors can buy and sell shares just like shares of any other publicly traded company.

Most large REITs are internally managed, meaning the employees who run the company work directly for the REIT. Some smaller or non-traded REITs are externally managed, meaning a separate management company is hired to operate the REIT under a contract. The SEC notes that external managers may receive significant fees, and their financial interests may not always align perfectly with those of shareholders.

A REIT must be governed by a board of directors or trustees, who oversee management on behalf of shareholders. Stock exchange rules typically require a majority of directors to be independent of management, providing an additional layer of oversight.

Why the 90% Distribution Rule Matters to Investors

The requirement to distribute at least 90% of taxable income each year is one of the most significant features of the REIT structure — and it directly shapes the investor experience.

Because REITs pay out most of their earnings rather than retaining them, they have historically offered dividend yields that are higher on average than other types of stocks. According to Nareit, about half of listed REIT total returns over the long term have come from dividends, compared to less than one-fourth for the S&P 500.

However, the high distribution requirement also means REITs tend to grow less through retained earnings than other companies. To fund property acquisitions and expansion, REITs often raise additional capital by issuing new shares or borrowing money. This reliance on external capital markets is an important characteristic of the REIT structure that investors should understand when evaluating a REIT's growth strategy.

Risks and Considerations

Understanding how REITs work also means understanding the risks that come with investing in them.

• Interest Rate Risk: Because REITs borrow money to finance properties, rising interest rates can increase borrowing costs and reduce profitability. Higher interest rates can also make REIT dividend yields look less attractive compared to lower-risk fixed income options like bonds.
• Real Estate Market Risk: Property values and rental income can decline during economic downturns, reducing a REIT's revenue and potentially its dividends.
• Property Sector Risk: REITs concentrated in a single property type are exposed to sector-specific risks. Office REITs, for example, face headwinds from remote work trends. Retail REITs can be affected by shifts in consumer shopping behavior.
• Occupancy and Tenant Risk: If tenants leave or fail to pay rent, a REIT's income will be affected. High vacancy rates or tenant bankruptcies reduce cash flow.
• Leverage and Debt Risk: REITs frequently carry significant debt. High debt levels increase financial risk, particularly when interest rates rise or property values fall.
• Dividend Risk: Although REITs must distribute at least 90% of taxable income, dividends are not guaranteed and can be reduced or suspended if earnings fall.
• Liquidity Risk: Publicly traded REITs offer liquidity similar to stocks. Non-traded REITs, however, can be very difficult to sell and investors may have to wait to receive a return of their capital until the REIT chooses to list its shares or liquidate assets.
• Management Risk: The decisions made by REIT management — including what properties to acquire, how much debt to carry, and how to allocate capital — significantly affect performance.

As with any investment, investors should carefully review a REIT's SEC filings and understand its specific risks before making investment decisions.

Key Metrics Investors Use to Evaluate REITs

Because of the unique way REITs are structured, standard measures of corporate profitability — like net income or earnings per share — can be misleading. Real estate companies take large depreciation deductions that reduce net income on paper, even when actual cash flow remains healthy.

For this reason, REIT investors commonly rely on metrics specifically designed for the asset class:

• Funds From Operations (FFO): Defined by Nareit as net income computed in accordance with GAAP, plus depreciation and amortization, and excluding gains or losses from property sales. FFO is widely used because it is considered a closer approximation of a REIT's actual cash-generating ability than net income alone.
• Adjusted Funds From Operations (AFFO): Takes FFO and further adjusts for items such as recurring capital expenditures needed to maintain properties. Often considered an even more accurate picture of the cash available to pay dividends.
• Net Operating Income (NOI): Measures a property's revenue less its direct operating expenses, before debt service and taxes. A useful measure of how much income a property generates on its own.
• Dividend Yield: The annual dividend divided by the share price. Helps investors evaluate the income a REIT investment generates relative to its cost.
• Occupancy Rate: The percentage of a REIT's properties currently leased and occupied. Higher occupancy generally means more stable income.

Common Mistakes to Avoid

• Assuming all REITs work the same way: Equity REITs that own properties and mortgage REITs that lend money have very different risk profiles and income sources. Understanding which type you are evaluating is essential.
• Ignoring the property sector: A REIT that specializes in office buildings operates very differently from one focused on industrial warehouses or cell towers. Sector-specific dynamics matter significantly.
• Treating the 90% distribution rule as a guarantee: REITs must distribute at least 90% of taxable income, but dividends can still be reduced or suspended if earnings fall.
• Using net income alone to evaluate REITs: Net income is reduced by large depreciation charges that do not represent actual cash outflows. REIT investors commonly use FFO or AFFO instead.
• Overlooking debt levels: REITs regularly carry significant debt. High leverage can amplify both gains and losses, particularly when interest rates rise.
• Not distinguishing between publicly traded and non-traded REITs: Non-traded REITs are far less liquid than publicly traded ones and carry different risks and fee structures.

Frequently Asked Questions

Why do REITs pay such high dividends?

REITs must distribute at least 90% of their taxable income to shareholders each year to maintain their REIT status and tax advantages. Most REITs distribute 100% of taxable income, which is why their dividend yields tend to be higher on average than most other stocks.

Are REIT dividends taxed differently from regular stock dividends?

Yes. REIT dividends are generally taxed as ordinary income rather than at the lower qualified dividend rates that apply to most U.S. corporate dividends. However, under current tax law, non-corporate taxpayers may be able to deduct up to 20% of qualified REIT dividends under Section 199A of the Internal Revenue Code. Tax situations vary by individual, so investors should consult a qualified tax professional for advice specific to their situation.

How is a REIT different from owning individual rental properties?

Owning rental properties directly requires substantial capital and involves active management responsibilities. REITs allow investors to buy shares in large, professionally managed real estate portfolios with relatively small amounts of capital, without the responsibilities of direct property ownership. Direct property ownership, on the other hand, offers greater control and certain tax benefits — like mortgage interest deductions and 1031 exchanges — that are not available through REIT shares.

Can any company call itself a REIT?

No. To operate as a REIT, a company must satisfy ongoing organizational, income, asset, and distribution requirements established under U.S. federal tax law (primarily Internal Revenue Code Section 856). A company formally elects REIT status by filing Form 1120-REIT with the IRS and must continue meeting all REIT tests to maintain that status.

What happens if a REIT fails to meet its requirements?

If a REIT fails to meet one or more qualification requirements, it may lose its REIT status and be treated as a regular corporation for tax purposes — meaning it would be subject to corporate income tax. Certain cure provisions exist for specific types of failures, but a complete loss of REIT status would significantly affect the company's taxes and potentially its ability to sustain dividends.

Do REITs grow in value over time or just pay dividends?

REITs can provide both dividend income and capital appreciation. When the value of a REIT's properties increases, or when a REIT grows its portfolio and earnings, its share price can rise as well. However, because REITs distribute most of their income rather than retaining it to reinvest, a larger portion of total REIT returns has historically come from dividends compared to most other stocks. According to Nareit, about half of long-term listed REIT total returns have come from dividends.

Conclusion

Understanding how REITs work comes down to grasping a straightforward but carefully regulated structure. REITs are companies that own or finance income-producing real estate, earn income primarily from rents or interest, pass most of that income through to shareholders as dividends, and in return receive favorable tax treatment at the corporate level.

The key rules — the income tests, asset tests, distribution requirement, and shareholder requirements — exist to ensure that REITs remain genuine real estate investment vehicles that serve a broad base of individual investors. Congress created REITs in 1960 with this goal in mind, and the structure continues to reflect that intent today.

For investors, the practical takeaway is clear: REITs offer a way to participate in the income generated by commercial real estate through the purchase of shares on a stock exchange, with the high dividend yields that come from the mandatory distribution requirement.

As you continue learning about REIT investing, future articles in this series will cover equity REITs vs. mortgage REITs, REIT dividends, how REITs are taxed, and the metrics used to evaluate them — including FFO, AFFO, and dividend yield.

Sources

• U.S. Securities and Exchange Commission (SEC) — Investor Bulletin: Real Estate Investment Trusts (REITs) — https://www.sec.gov/files/reits.pdf — December 2011
• Nareit (National Association of Real Estate Investment Trusts) — How to Form a Real Estate Investment Trust (REIT) — https://www.reit.com/what-reit/how-form-reit
• Nareit — REIT Sectors — https://www.reit.com/what-reit/reit-sectors
• Nareit — REITs and Dividend Income — https://www.reit.com/investing/investment-benefits-reits/reits-and-dividend-income
• Internal Revenue Service (IRS) — Definition of a Real Estate Investment Trust, IRC Section 856 — https://www.irs.gov/pub/irs-drop/rr-98-60.pdf
• EisnerAmper — What Are the Basics of REITs? — https://www.eisneramper.com/insights/real-estate/reits-basics-1019
• Cohen & Co — Understanding REITs: A Complete Guide for Real Estate Investors — https://www.cohenco.com/knowledge-center/insights/march-2026/understanding-reits-a-complete-guide-for-real-estate-investors