What Is a REIT? A Beginner's Guide to Real Estate Investment Trusts

If you've ever wanted to invest in real estate but didn't have hundreds of thousands of dollars to buy a property, a REIT might be exactly what you're looking for. REITs — short for real estate investment trusts — make it possible for everyday investors to earn income from real estate without ever buying a building, dealing with tenants, or managing a property.

Whether you're new to investing or just starting to explore real estate as an asset class, understanding what a REIT is forms the foundation of any REIT investing strategy. By the end of this article, you'll know exactly what a REIT is, how it works, what types exist, and why so many investors include them in their portfolios.

What Is a REIT?

A real estate investment trust, commonly called a REIT (pronounced "reet"), is a company that owns, operates, or finances income-producing real estate. REITs are modeled after mutual funds: they pool capital from many investors to purchase a portfolio of properties — or mortgages secured by real estate — that individual investors could not easily afford on their own.

According to Nareit, the National Association of Real Estate Investment Trusts, REITs allow anyone to invest in portfolios of real estate assets in the same way they invest in other industries — through the purchase of individual company stock, a mutual fund, or an exchange-traded fund (ETF).

REITs were established by Congress in 1960 as part of the Cigar Excise Tax Extension Act, which was signed into law by President Dwight D. Eisenhower. The original goal was to give ordinary Americans a way to benefit from large-scale, income-producing real estate investments that had previously been accessible only to wealthy individuals and large institutions.

Today, REITs own a wide variety of property types, including:

• Apartment buildings and residential communities
• Office buildings
• Shopping centers and retail properties
• Industrial warehouses and logistics facilities
• Hotels and lodging properties
• Data centers
• Cell towers
• Healthcare facilities such as hospitals and senior housing
• Self-storage facilities
• Timberlands and specialty properties

How REITs Work

To qualify as a REIT, a company must meet specific requirements set by the Internal Revenue Code and regulated by the Internal Revenue Service (IRS). These requirements are what make REITs unique compared to ordinary real estate companies.

Key REIT Qualification Requirements

Under U.S. federal tax law, a company must meet several key tests to qualify as a REIT:

Distribution requirement: A REIT must distribute at least 90% of its taxable income to shareholders each year as dividends. This is the rule most investors know — it is why REITs typically pay higher dividends than most other types of stocks.

Income test: At least 75% of the REIT's annual gross income must come from real estate-related sources, such as rents from real property, interest on mortgages secured by real property, or dividends from other REITs. An additional test requires at least 95% of income to come from real estate or other qualifying passive sources.

Asset test: At least 75% of the total value of a REIT's assets must be real estate assets, government securities, or cash. This ensures the company is primarily a real estate business.

Ownership test: A REIT must have at least 100 shareholders after its first year of operation. No five or fewer individuals may own more than 50% of the company's stock during the last half of any taxable year. This anti-concentration rule, sometimes called the "5/50 test," helps ensure REITs remain broadly held investment vehicles.

Organizational requirements: A REIT must be organized as a corporation, trust, or association, and must be managed by a board of directors or trustees. Beneficial ownership must be evidenced by transferable shares or certificates.

Because a REIT can deduct the dividends it pays from its taxable income, it generally pays little or no federal corporate income tax at the entity level. This pass-through tax treatment is the central advantage of the REIT structure. The tax responsibility falls on the individual shareholders, who pay taxes on dividends they receive.

How REITs Work in Practice

Here is a simplified example to show how a REIT works:

Imagine a company forms a REIT and raises $500 million from thousands of investors by selling shares on a stock exchange. The REIT uses that capital to purchase a portfolio of apartment complexes across several cities. Each month, the residents pay rent, and the REIT collects that rental income.

After paying operating expenses such as property management fees, maintenance, insurance, and mortgage interest, the REIT has net income remaining. Because it is required to distribute at least 90% of its taxable income to shareholders, the REIT pays regular dividends to everyone who owns its shares.

As a shareholder, you receive your proportional share of those dividends — potentially each quarter or even each month, depending on the REIT. You can also benefit if the value of the REIT's shares increases over time, producing capital appreciation in addition to income.

Note: The scenario above is hypothetical and used for illustrative purposes only. It does not represent the returns or operations of any specific REIT.

Why REITs Matter to Investors

Access to Large-Scale Real Estate

Buying real estate directly typically requires significant upfront capital — a down payment, closing costs, and ongoing management expenses. REITs allow investors to access diversified real estate portfolios with as little as the price of a single share.

Regular Income Potential

Because REITs are required by law to distribute at least 90% of their taxable income, they often pay higher dividend yields than many other publicly traded companies. This makes them popular with income-focused investors, including retirees.

Diversification

Real estate has historically had a low correlation with stocks and bonds, meaning it does not always move in the same direction as those asset classes. Adding REIT exposure to a portfolio may help spread risk across different types of investments.

Liquidity

Unlike physical real estate, shares of publicly traded REITs can typically be bought or sold on a stock exchange during market hours, similar to any other publicly traded stock. This makes them far more liquid than direct property ownership.

Transparency and Regulation

Publicly traded REITs are registered with the U.S. Securities and Exchange Commission (SEC) and must file regular financial reports. This transparency gives investors access to detailed information about the properties, income, and management of the REIT.

Types of REITs

Not all REITs are the same. They differ in what they own, how they operate, and how investors can access them.

Equity REITs

The most common type, equity REITs own and operate income-producing real estate. They generate most of their revenue from rental income. Examples include REITs that own apartment complexes, shopping malls, office buildings, warehouses, and data centers.

Mortgage REITs (mREITs)

Instead of owning physical properties, mortgage REITs provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities. They earn income from the interest on those loans. Mortgage REITs tend to be more sensitive to interest rate changes than equity REITs.

Hybrid REITs

Hybrid REITs combine elements of both equity and mortgage REITs, owning both properties and real estate loans. They are less common than the other two types.

Publicly Traded REITs

Most REITs are listed on major stock exchanges such as the New York Stock Exchange (NYSE) or Nasdaq. They can be bought and sold like any other publicly traded stock.

Public Non-Traded REITs

These REITs are registered with the SEC but do not trade on a national stock exchange. They are typically sold through broker-dealers and financial advisers. They are generally less liquid than publicly traded REITs.

Private REITs

Private REITs are not registered with the SEC and are not listed on any public exchange. They are typically sold only to institutional investors or accredited investors and are the least liquid type of REIT.

REIT Property Sectors

Within equity REITs, there are many different property sectors. Nareit recognizes more than a dozen distinct REIT sectors, including:

• Residential (apartments, single-family homes, manufactured housing)
• Industrial (warehouses, distribution centers, logistics facilities)
• Office
• Retail (shopping centers, malls, net-lease properties)
• Healthcare (hospitals, senior housing, medical office buildings)
• Data centers
• Infrastructure (cell towers, fiber networks, energy pipelines)
• Self-storage
• Timberland
• Lodging and resorts
• Specialty REITs (casinos, farmland, and others)

Different REIT sectors respond differently to economic conditions, interest rates, and real estate cycles. Understanding which sectors a REIT operates in helps investors assess its risks and opportunities.

Risks and Considerations

Like any investment, REITs carry risks that investors should understand before investing.

Interest rate risk: Rising interest rates can put downward pressure on REIT share prices for two main reasons. First, higher rates increase the cost of borrowing for REITs, which can reduce earnings. Second, REITs compete with bonds and other fixed-income investments for investors seeking income; when interest rates rise, those alternatives become comparatively more attractive, which can reduce demand for REIT shares.

Real estate market risk: REITs are exposed to the broader real estate market. Declining property values, economic recessions, or oversupply of a particular property type can reduce a REIT's income and share value.

Sector-specific risk: Different property sectors face different challenges. Office REITs face headwinds from remote work trends. Retail REITs are exposed to changes in shopping behavior. Healthcare REITs are sensitive to regulatory changes. Understanding the specific sector is important.

Occupancy and tenant risk: A REIT's income depends on tenants paying rent. If properties sit vacant or tenants default, the REIT's income can fall, potentially reducing dividends.

Leverage risk: REITs often use debt to finance their portfolios. High leverage amplifies both gains and losses and can become a problem if interest rates rise or property values fall.

Dividend risk: Although REITs are required to distribute at least 90% of taxable income, dividends are not guaranteed. If a REIT's income declines significantly, it may reduce or suspend its dividend.

Liquidity risk for non-traded and private REITs: Publicly traded REITs are generally liquid. However, public non-traded REITs and private REITs can be very difficult to sell, sometimes for years. Investors in these vehicles should be prepared for limited liquidity.

Management risk: The performance of a REIT depends heavily on the quality of its management team and their decisions about acquisitions, dispositions, and capital allocation.

Tax considerations: REIT dividends are generally taxed as ordinary income rather than at the lower qualified dividend rate. The Tax Cuts and Jobs Act of 2017 introduced a deduction for certain pass-through income (Section 199A) that may apply to some REIT dividends for qualifying taxpayers. Tax rules are complex and subject to change; consult a qualified tax professional for guidance based on your specific situation.

Key REIT Metrics Beginners Should Know

When evaluating REITs, investors often look at metrics that are different from those used to evaluate traditional stocks.

Funds From Operations (FFO): FFO is the most commonly used profitability metric for REITs. Because REITs depreciate their properties on their financial statements, standard accounting net income often understates their actual cash-generating ability. FFO adds depreciation back to net income and adjusts for gains or losses on property sales to give a clearer picture of a REIT's operating performance.

Dividend yield: This is the annual dividend divided by the share price, expressed as a percentage. It tells you how much income you receive relative to what you paid for the shares.

Net Asset Value (NAV): NAV estimates the market value of a REIT's properties minus its liabilities. Comparing a REIT's share price to its NAV can help investors assess whether shares trade at a premium or discount to the underlying real estate.

Occupancy rate: This measures what percentage of a REIT's leasable space is currently occupied by tenants. Higher occupancy generally means higher and more stable income.

Common Mistakes Beginners Make with REITs

Mistake 1 — Assuming a high yield always means a good investment: A very high dividend yield can sometimes be a warning sign that the market expects the dividend to be cut. Always look at whether the REIT's FFO supports its dividend payments.

Mistake 2 — Ignoring the type of REIT: Equity REITs and mortgage REITs behave very differently. Mortgage REITs are generally more sensitive to interest rate changes and carry different risks. Understanding the type of REIT you are buying matters.

Mistake 3 — Overlooking non-traded REIT fees: Non-traded REITs often come with high upfront commissions and fees — sometimes totaling approximately 9% to 10% of the investment, according to the SEC's investor education website, investor.gov. These fees significantly reduce the net investment amount.

Mistake 4 — Not accounting for tax treatment: REIT dividends are generally taxed as ordinary income, which may be at a higher rate than qualified dividends from other stocks. Holding REITs in a tax-advantaged account like an IRA or 401(k) may help manage this.

Mistake 5 — Confusing share price volatility with underlying real estate: Public REIT shares can be significantly more volatile in the short term than direct property values because they trade on stock exchanges and are subject to market sentiment. This is a feature of publicly traded REITs, not necessarily a direct reflection of property values.

Mistake 6 — Thinking all REITs are the same: REITs span dozens of property sectors and multiple structural types. A healthcare REIT, a data center REIT, and a mortgage REIT all have very different risk profiles, income drivers, and sensitivities to economic conditions.

Frequently Asked Questions

How is a REIT different from buying real estate directly?

When you buy property directly, you own that specific asset and are responsible for financing, managing, and maintaining it. A REIT lets you own a small share of a diversified portfolio of real estate properties. REITs also offer much greater liquidity — you can typically sell REIT shares on a stock exchange during market hours, whereas selling a physical property can take months.

Do I need a large amount of money to invest in a REIT?

No. Publicly traded REITs can be purchased through a brokerage account for as little as the price of one share. You can also invest in REIT mutual funds or ETFs, which hold shares of multiple REITs, often with very low minimum investment requirements.

Are REIT dividends guaranteed?

No. While REITs are legally required to distribute at least 90% of their taxable income, dividends are not guaranteed. If a REIT's income declines — for example, due to lower occupancy, falling rents, or rising costs — it may reduce or suspend dividends.

Are REITs a good investment for beginners?

REITs can be an accessible way for beginners to gain real estate exposure in a portfolio, especially through diversified REIT ETFs or mutual funds. Like any investment, they carry risks. Beginners should understand the type of REIT they are considering, the relevant risks, and how it fits into their overall financial goals. This article is educational in nature and does not constitute personalized financial advice.

How are REIT dividends taxed?

Most REIT dividends are taxed as ordinary income rather than at the lower qualified dividend rate. However, portions of REIT dividends may qualify as capital gains distributions or return of capital, which are taxed differently. The Tax Cuts and Jobs Act of 2017 also introduced a deduction for certain pass-through income that may apply to some REIT dividends. Tax rules are complex and subject to change; consulting a qualified tax professional is recommended for personalized tax guidance.

Can I invest in REITs through a retirement account?

Yes. REITs can be held in tax-advantaged accounts such as IRAs and 401(k)s. Because REIT dividends are typically taxed as ordinary income, holding them in a tax-deferred or tax-free account may be tax-efficient for some investors. Consult a financial adviser or tax professional to determine the right approach for your situation.

Conclusion

A REIT, or real estate investment trust, is a company that owns, operates, or finances income-producing real estate. Created by Congress in 1960 to give ordinary investors access to large-scale real estate investing, REITs have grown into a major asset class.

The key features of REITs — the requirement to distribute at least 90% of taxable income, favorable pass-through tax treatment, and accessibility through public stock markets — make them a distinctive and often income-generating type of investment.

Understanding what a REIT is forms the foundation for exploring more advanced topics such as how REITs generate income, the different types of REITs, how REITs are taxed, and how to evaluate a REIT's financial performance. Continue exploring to build your knowledge of REIT investing.

This article is for educational purposes only and does not constitute personalized financial, investment, legal, or tax advice.

Sources

• Nareit — What's a REIT (Real Estate Investment Trust)? — https://www.reit.com/what-reit
• Nareit — The History of REITs — https://www.reit.com/what-reit/history-reits
• Nareit — Types of REITs — https://www.reit.com/what-reit/types-reits
• U.S. Securities and Exchange Commission (SEC) / Investor.gov — Real Estate Investment Trusts (REITs) — https://www.investor.gov/introduction-investing/investing-basics/investment-products/real-estate-investment-trusts-reits
• Internal Revenue Code — Sections 856-860 (REIT Qualification Requirements)
• RSM US LLP — The ABCs of REITs — https://rsmus.com/insights/industries/real-estate/abcs-of-reits.html
• EisnerAmper — Understanding the Basics of Real Estate Investment Trusts — https://www.eisneramper.com/insights/real-estate/reits-basics-1019
• Realized 1031 — When Did REITs Start? — https://www.realized1031.com/blog/when-did-reits-start — June 25, 2022