If you’d like to invest in real estate but don’t have the resources, time, or expertise to buy and manage properties yourself, then real estate investment trusts (REITs) could be alternatives to consider. With a REIT, you buy into a professionally managed real estate portfolio, which has been created by pooling money from many investors.
Read on for more on investing in REITs, how REITs work, and their pros and cons.
What is a REIT?
Real estate investment trusts (REITs) are companies that own, operate, or finance real estate—like apartment buildings, shopping centers, offices, data centers, and more—but in many cases with shares that trade on exchanges, like stock. When you buy a stock, you become a partial owner in the underlying company. Similarly, when you buy a share of a REIT, you become a partial owner of the REIT’s underlying properties.
REITs are kind of like stocks, but for the real estate market. They offer a way to put real estate investing within reach of ordinary people.
How does a REIT work?
A REIT raises money from many individual investors. The REIT then uses that money to build and manage a portfolio of real estate investments. This could mean buying properties, which it then leases out to tenants, or it could mean investing in financial assets like mortgages. The REIT collects rent from its tenants or receives payments on the mortgages it holds. It then generally distributes its earnings to shareholders.
To qualify as a REIT, a company must meet certain requirements and follow certain rules. A REIT must generally invest at least 75% of its assets in real estate and pay out at least 90% of its taxable income annually to shareholders as dividends. In exchange for following those rules, REITs get special tax treatment that may allow them to pay little or no corporate income tax1 (though REIT investors still generally owe taxes on any dividends and realized gains).
Because of their focus on paying out relatively high ongoing dividends, REITs are often popular among investors who seek to earn steady income from their investments. That said, it’s important to be aware that those dividends aren’t guaranteed, and a REIT can always reduce its dividend payments.
Types of REITs
There are several different ways of categorizing REITs. First off, you can sort them by what they invest in. Most REITs can be categorized as equity, mortgage, or hybrid REITs. Here’s what those labels mean:
Equity: Equity REITs buy and operate properties—leasing them out to tenants and collecting the rent. Equity REITs can specialize in particular niches of the real estate market, like warehouses, infrastructure, data centers, and more.
Mortgage: Mortgage REITs use investor funds to finance mortgages—collecting mortgage payments from borrowers and earning income via interest. Mortgage REITs could also buy mortgage-backed securities.
Hybrid: Hybrid REITs invest in a mix of real estate properties and mortgages.
Another way of categorizing REITs is by how they’re structured and regulated. In this case, most REITs can be classified as publicly traded, public non-traded, or private.
Publicly traded: Publicly traded REITs are regulated by the Securities and Exchange Commission (SEC) and are listed on major stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq. It is generally easy to buy and sell these REITs, and to look up key information about the companies.
Public non-traded: Public non-traded REITs are also regulated by the SEC but do not trade on major exchanges. Non-traded REITs can generally only be purchased through certain brokers, and they can be more difficult to sell.
Private: A private REIT is not regulated by the SEC and does not trade on major exchanges. Generally, only institutions and high-net-worth investors can invest in private REITs.
Most often, when people talk about “investing in REITs,” they’re really referring investing in publicly traded REITs. The remainder of this article will focus specifically on the attributes of investing in publicly traded REITs.
Potential advantages of publicly traded REITs
Publicly traded REITs can come with a number of potential advantages:
Low initial investment: With REITs, it’s possible to become a real estate investor for the cost of just one share. If you invest with a broker that offers fractional shares, then you may even be able to start with as little as $1. (Learn more about fractional shares with Fidelity.) That’s much more achievable for many investors than buying an entire property.
Access to cash if you need it: Investors can buy and sell publicly traded REITs whenever markets are open. While you aren’t guaranteed to get your money back if you sell, you can quickly turn the value of your investment back into cash.
Potential to earn ongoing income: Due to their structure and the requirement that they pay out 90% of taxable income, REITs tend to be popular among investors looking to generate income from their investments.
Potential diversification: REITs have different characteristics and attributes from traditional stocks and bonds. They might perform well at different times and perform poorly at different times than other investments. This means they might help provide diversification to a portfolio—like a way of not putting all your eggs in the same basket. Keep in mind however, diversification does not ensure a profit or guarantee against loss. (Learn more about the importance of diversification.)
Potential disadvantages of publicly traded REITs
Publicly traded REITs also come with a number of potential drawbacks to be aware of:
Require research: Just as with buying individual stocks, if you’re going to invest in individual REITs, you need to do some work to understand the REITs universe and choose specific investments.
Tax rate on dividends: REIT investors generally owe tax on the dividends they receive, and these dividends are typically taxed at higher ordinary income tax rates, rather than at lower qualified dividend tax rates.2 Holding REITs in a tax-advantaged account may allow investors to defer these taxes.
Subject to potential market volatility: Because REITs trade on exchanges like stocks, they can be subject to market fluctuations in the same way as stocks.
Come with unique risks: There is no guarantee that the issuer of a REIT will maintain the secondary market for its shares, and redemptions may be at a price that is more or less than the original price paid. Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry.
How to invest in REITs
Investors can buy publicly traded REITs the same way they buy stocks. In a brokerage account, an investor can place an order for an individual publicly traded REIT using its ticker symbol.
Another option for investing in REITs is to buy one or more mutual funds or ETFs that hold REITs. Mutual funds and ETFs are professionally managed portfolios that combine your money with that of other investors and invest it in a basket of securities. They can offer a way to invest in a diversified, professionally managed portfolio of REITs without having to research a lot of individual REITs. (Learn more about the different ways to potentially invest in real estate.)
Should you buy REITs?
Now you’re more familiar with what REITs are and how they work. But how can you decide whether they make sense for your portfolio? Some considerations to weigh may include:
What you’re investing for: The first step in building a portfolio is generally to decide on your investing goal. That might be retirement, or a child’s college education, or something else. Once you understand your goal, you can also start to zero in on an appropriate investment mix to help you reach that goal and consider whether REITs might make sense as part of that mix. (Fidelity customers can get an investment strategy for their goals at the Planning and Guidance Center.)
Diversification: If you already own a home, your net worth may already be significantly exposed to real estate. You may also already have exposure to REITs if you own a broadly diversified portfolio, or invest in a broadly diversified fund like a target-date fund. On the other hand, if you don’t own a home or own REITs, then adding some to your portfolio might help give you exposure to real estate and provide diversification. (Learn more about ways to diversify.)
Risk tolerance and need for liquidity: REITs can have the potential to generate relatively high income. But they are not guaranteed investments, and it is possible to lose money with REITs. Publicly traded REITs are generally liquid—meaning you can quickly sell your investment and convert its value into cash if you need to—but the price at which you can sell is subject to market fluctuations and is never guaranteed.
Ultimately, it’s important to remember that there are no “best” investments—only tradeoffs to consider in relation to your situation. For many investors, it may make sense for REITs to have some role in a broadly diversified portfolio.
Ready to take the next step? Learn more about real estate investing with Fidelity, or explore companies in the real estate sector.
