REITs

Why this matters

This module is a set of short, optional introductions to assets beyond stocks, bonds, and cash. Each one links to a depth track that covers the subject in full.

Real estate is one of the biggest kinds of wealth there is, but buying an apartment building or a warehouse takes far more money than most people have. REITs are the most common way individual investors own a piece of large-scale property.

What a REIT is

A REIT, short for real estate investment trust, is a company that owns, and typically operates, income-producing real estate or real estate-related assets. These can include office buildings, shopping malls, apartments, hotels, self-storage facilities, warehouses, and mortgages. Most REITs specialize in one type of property. Congress created REITs in 1960 so that individual investors could invest in large-scale, income-producing real estate.¹

Why REITs pay large dividends

REITs get special tax treatment, with strings attached. To qualify, a company must have most of its assets and income tied to real estate, and it must pay out at least 90% of its taxable income to shareholders as dividends every year. In return, a REIT can deduct the dividends it pays from its corporate taxable income. That's why most REITs pay out all of their taxable income and owe no corporate tax.¹

Linden Street Residential is a fictional REIT that owns apartment buildings. All numbers are hypothetical.

Taxable income this year	$80 million
Minimum it must pay out (90%)	$72 million
Shares outstanding	40 million
Minimum dividend per share	$72 million ÷ 40 million = $1.80
Share price	$36
Dividend yield at $1.80	$1.80 ÷ $36 = 5%

Because a REIT keeps so little of its income, it has to raise new money, by borrowing or selling more shares, to buy more property. That's the flip side of the high payout. Dividends and Buybacks explains dividend yield in more detail.

Equity REITs and mortgage REITs

• Equity REITs own and operate properties, and most of their income is rent. Most REITs are equity REITs.
• Mortgage REITs lend money to property owners, or buy mortgage-backed securities, and earn interest. They tend to use much more borrowed money than equity REITs. Many also use derivatives to manage their interest rate and credit risks, which are worth understanding before you invest.
• Hybrid REITs do both.

All of this comes from the SEC's investor bulletin on REITs.¹

Listed and non-traded REITs

Many REITs are registered with the SEC and trade on a stock exchange. Others are registered with the SEC but don't trade on any exchange. These are called non-traded REITs, and the difference matters a great deal.¹

The SEC flags two more concerns with non-traded REITs:¹

• Distributions may come from your own money. Non-traded REITs often pay distributions above what their properties earn, using money raised from investors and borrowing. That lowers the value of the shares.
• Getting your money back can take years. Investors may have to wait for the company to list its shares or sell its assets, and that can be more than 10 years after investing.

How to own REITs, and how they're taxed

You can buy shares of a listed REIT through a brokerage account, the same way you buy any stock, or buy a REIT mutual fund or ETF, either an index fund or an actively managed one.¹ A broad REIT fund spreads your money across many REITs and property types, the same idea as Index Funds.

Taxes are where REITs differ from ordinary stocks. REIT dividends are generally taxed as ordinary income and don't get the lower tax rates that many other corporate dividends do. For that reason, some investors prefer to hold REITs in tax-deferred accounts such as retirement accounts.¹ Taxable vs. Tax-Advantaged Accounts covers how those accounts work.

Key takeaways

• A REIT owns, and usually operates, income-producing real estate or related assets like mortgages.
• To keep its tax status, a REIT must pay out at least 90% of its taxable income as dividends.
• Equity REITs earn mostly rent. Mortgage REITs earn interest and tend to borrow much more.
• Non-traded REITs are hard to sell and value, and usually carry high upfront fees.
• REIT dividends are generally taxed as ordinary income.

Check your understanding

Why do REITs usually pay out such a large share of their income as dividends?

1. To keep their REIT tax status, they must pay out at least 90% of taxable income.
2. Real estate always earns more than other businesses, so there's more to share.
3. The SEC sets each REIT's dividend.

A non-traded REIT has paid a 7% distribution for three years, and its share value hasn't changed. What's the most reasonable read?

1. It's about as safe as a savings account, with a better rate, since its value hasn't moved in three years.
2. The steady value and the steady payout together show its properties are performing well and earning enough to cover the 7% every year.
3. With no market price, the steady value may say little. Check whether distributions came from earnings or from investors' money and borrowing.

What's next

REITs are a claim on buildings that earn rent. The next lesson, Commodities, covers raw materials like oil and gold, which earn nothing at all, and the surprising ways funds that track them can drift from the price you see in the news.