Real Estate Investment Trusts (REITs) enable investors to tap into their investment potential in income-generating real estate without the need to assume direct management or ownership of physical properties. Investors looking for fixed dividend income or diversification of an existing investment portfolio are provided with an available, liquid method of acquiring real estate exposure through REITs. In this article, we cover how REIT investing works, who can utilize them, and how to invest in them.
Looking to diversify your real estate investment portfolio? Kiavi offers a strategic blend of passive and active investment options. For those seeking more control and potential appreciation, its financing solutions empower you to invest directly in properties.
Overview: What are REITs?
A Real Estate Investment Trust (REIT) is a firm that owns, runs, or finances income-generating real estate. These firms enable people to invest in large, diversified portfolios of real estate assets the same way they invest in any other industry — by buying stock.
REITs were established by Congress in 1960 to enable all investors to invest in income-generating real estate. Instead of purchasing property, investors purchase shares of a REIT and receive a proportionate amount of income from rents, leases, or interest.
How REITs work
REITs operate by collecting funds from various investors to buy or finance real estate ventures. The properties can be office buildings, apartment buildings, hospitals, or shopping malls. The majority of REITs specialize in a particular kind of property.
To maintain their tax-advantaged status, REITs must distribute at least 90% of their taxable income to shareholders annually. This structure prevents the REIT from having to pay corporate income tax so that the majority of the income will pass through to investors. REITs that are publicly traded on stock exchanges are easy to buy and sell.
-
Looking to start your real estate investment journey? :
Check The Close’s guides on how to invest and the types of real estate investments to start on the right foot.
How REIT investments are taxed
Investments in REITs are treated differently for tax purposes compared with common stocks. Few REIT dividends are “qualified dividends,” generally subject to favorable long-term capital gain tax rates (0%, 15%, or 20%). REIT dividends are usually ordinary income subject to your ordinary income tax rate, up to 37% depending on your tax bracket. This can result in a greater tax burden compared with most dividend stocks.
However, REIT shareholders can avail themselves of the 20% Qualified Business Income (QBI) deduction to lower the taxable portion of REIT dividends for qualified taxpayers. The deduction was created under the Tax Cuts and Jobs Act.
Capital gains realized on the sale of REIT stock are taxed depending on the holding period of the investment. If the REIT stock is held for more than a year, the gains are long-term and are generally taxed in the capital gains tax rate. Short-term capital gains (on assets held for less than a year) are taxed as regular income, but long-term gains are taxed under more beneficial treatment for tax efficiency. Most investors place REITs in tax-deferred or tax-free accounts like traditional or Roth IRAs. This will postpone or avoid taxes on dividends and capital gains, as determined by the account type.
Types of REITs
Real estate investment trust investing provides a variety of choices to suit various investing styles and risk tolerances. Those investors who want to match their portfolios to their investment objectives must learn the distinctions among the various REIT types: equity REITs, mortgage REITs (mREITs), and hybrid REITs.
Equity REITs are most suitable for investors who want a combination of income stability and possible growth — and the best method to value a REIT is to understand how it makes its revenues. Equity REITs make revenues mainly by renting out space and earning rents on the properties they own. It has the ability to raise steady rental income, which is distributed among shareholders in the form of dividends. This REIT provides a steady flow of income and the possibility of capital appreciation.
Mortgage REITs are appealing to investors interested in income rather than capital appreciation. This type invests in property and earns income from the interest on the financial instruments. Because of its comparatively higher dividend yield, mREITs are more sensitive to changes in interest rates and a riskier, return-oriented investment. Those investing in mREITs need to be well-versed in interest rate trends and be ready for potential volatility depending on economic cycles.
Hybrid REITs combine the strategies of Equity and Mortgage REITs. Hybrid REITs provide diversification within a single investment. By investing in both real estate financing and physical property, these REITs attempt to achieve a balance between growth potential and income generation. These offer a compromise for investors who would like to avoid each other’s respective risks in equity or mortgage-oriented REITs.
Are REITs a good investment?
REIT investing is a smart investment option for those seeking stable income and diversification. Their regular dividend payouts appeal to investors focused on cash flow, and their sensitivity to real estate markets instead of equities provides diversification to a larger portfolio. Since REITs are listed on major exchanges, they provide the kind of liquidity not available to direct real estate owners.
Because of this, REIT performance is significantly driven by interest rates, dynamics in the property market, and overall market conditions. Rising interest rates can crimp REIT profitability, and changes at the sector level — like weakening retail demand — can impact performance. Investors need to weigh these forces carefully and consider the underlying assets, dividend track record, and management record of the REITs they hold.
Advantages and Disadvantages of REITs
Before considering REIT investing, it’s critical to weigh both the benefits and possible disadvantages. REITs offer income, accessibility, and diversification — but it also comes with risks associated with market performance, taxes, and administration.
The table below outlines the key advantages and disadvantages to consider when deciding if REITs are part of your investment strategy.
|
|
|
|
|
|
|
|
How to invest in REITs
Investing in REITs is an option available to most investors and can be a wonderful way to diversify an investment portfolio. To venture into this, there are several steps to follow that guarantee a strategic and informed approach to investing in REITs.
The steps outlined below will guide you from the initial steps of setting up the right accounts to the final step of deciding on the right REITs to include in your portfolio.
- Step 1: Create a business plan. Determine how REITs fit into your overall investment strategy.
- Step 2: Do proper research. Learn about various kinds of REITs, their past performance, and dividend yield.
- Step 3: Open a brokerage account. Open an account with a brokerage firm to purchase and sell REIT shares.
- Step 4: Invest via principal stock exchanges. REITs are publicly traded on principal stock exchanges, just like stocks, providing ease of access.
- Step 5: Invest in mutual funds or ETFs. Invest in mutual funds or ETFs that focus on REITs to diversify within the real estate sector.
- Step 6: Consider key investment factors. Assess the quality of the REIT’s management, sector concentration, and historical performance.
- Step 7: Align REIT selection with investment objectives. Make sure your individual REIT, mutual fund, or ETF selection matches your market analysis and investment objectives.
REITs offer passive income and diversification, but pairing them with active real estate investments — like flipping homes or building a rental property portfolio — can take your strategy to the next level. RCN Capital provides financing for fix-and-flips, rentals, and multifamily deals, making it easy to stay active while your REITs grow in the background.
Tips for REIT Investing
Investing in an REIT is more a matter of making a thoughtful plan rather than pumping a lot of capital into an operation at the start. Whether you are directly investing in particular REITs or indirectly investing through a REIT ETF, it is beneficial to keep some broad principles in mind.
Here are some sound approaches to reducing risk, building durable value, and fully comprehending how REIT behavior changes over different cycles in the marketplace.
- Begin with REIT exchange-traded funds (ETFs) to minimize risk: REIT ETFs will offer an investor exposure to a broader range of investment opportunities. These will provide diversification to minimize the risks of market volatility.
- Reinvest dividends for compounding returns: Instead of receiving cash dividends, reinvesting dividends might provide a portfolio growth advantage through compounding. Reinvestment is automatically provided by most brokerages and adds to your holding over time without further effort from you.
- Expand into diverse industries: REITs spread over diverse sectors, like residential, retail, healthcare, and industry. Distribution over multiple types of property could protect an investor against a decline in a particular industry and provide more stable returns.
- Keep REITs in IRAs to reduce tax impact: Because REIT dividends qualify as ordinary income, keeping them in a tax-beneficial vehicle like a traditional IRA allows one to delay taxation or avoid taxation altogether, as the case may be.
- Monitor interest rate trends that influence prices in REITs: REITs perform less as interest rates increase because their cost of financing increases, and their high dividend yield is less desirable relative to other fixed-income instruments. Tracking movement in rates allows for better timing decisions.
Frequently Asked Questions (FAQs)
What are the differences between public and private REITs?
Public REITs are listed on the major exchanges and are bought and sold the same as stock, while private REITs are not listed on the exchanges and are generally limited to accredited investors. There are fewer price swings with private REITs, but they are less liquid and have a higher minimum requirement for investments.
Can I lose money investing in REITs?
Yes, you can. Although REITs are apt to produce steady income, they are not risk-free. Their stock price may fluctuate with market variations, changes in interest rates, and the performance of the real estate sector. Like any other investment, there is always a chance for loss, particularly over the near term or during a recession.
How do REIT dividends differ from stock dividends?
REIT dividends are usually taxed as ordinary income, not taxed at the preferential capital gains rate applied for qualified stock dividends. The majority of shareholders are entitled to the Qualified Business Income (QBI) deduction, though, which can help offset the impact of REIT distributions on income tax.
Bringing it all together
REIT investing has made real estate investing easy and convenient. With regular dividends, sector diversification, and stock-like liquidity, they represent an attractive means of gaining real estate exposure in your portfolio. For novice investors or seasoned pros, REITs can be a valuable addition to a diversified long-term strategy.
Have more ideas or some tips to maximize your investments? Leave a comment below!
Add comment