Real estate can create a more balanced investment portfolio. A portfolio with between 5% and 20% of real estate has better returns and less risk than a portfolio only of stocks and bonds, according to a meta-analysis of academic articles by Morningstar. But for most investors, that might not justify the headaches of managing tenants and repairs for a rental property. A real estate investment trust, a.k.a. a REIT, could be a more convenient solution.
“A REIT is a fund that buys real estate for investors,” says Lee Harbaugh, a real estate agent in Mansfield, Texas. “It’s a passive way to get real estate exposure where you don’t have to worry about buying or selling properties yourself.”
REITs first emerged in the 1960s and now have more than $4 trillion in assets. That’s still a fraction of the money in stocks and mutual funds. “Asset managers like REITs for portfolio reasons, but I don’t typically have clients asking about them. They’re underutilized,” says Justin Stivers, a financial adviser and estate planning attorney in Coral Gables, Fla.
1. REITs operate like mutual funds for real estate
REITs raise a pool of money from many investors and then buy and run income-generating real estate properties. Some possibilities include apartment buildings, shopping malls, hospitals, office parks, warehouses and storage units. “There’s no way you could buy a mall on your own, but through a REIT, you can invest in one,” says Harbaugh.
As an investor, you purchase shares of a REIT. You then receive a portion of the profits from rental income and property sales as dividends. For example, Digital Realty Trust (stock symbol DLR) invests in data centers. It pays a quarterly dividend with a quarterly yield of 3.6% that has gone up every year since 2005 while shares are up more than 20% over the past year. CubeSmart (CUBE) runs self-storage facilities. It has a 4.67% dividend yield and an 11.03% three-year return.
Professionals working for the REIT research, manage, buy and sell properties on behalf of the investors. In exchange, the REIT could charge fees when you buy shares, ongoing annual management fees and fees for buying and selling properties. The fee structure depends on the REIT.
2. REITs must prioritize short-term income for investors
By law, a REIT must distribute at least 90% of its taxable income annually to shareholders. “They pay out stable dividends, provided the properties are doing well,“ says Stivers, the financial advisor from Florida.
In exchange for more ongoing income, REITs have less to invest for future returns than a growth mutual fund or stock. “REITs are better for short-term cash flow and income versus long-term upside,” says Stivers.
3. REITs use a special structure to help with taxes
Unlike most corporations that pay income tax on profits and then investors pay tax again on dividends, most REITs avoid double taxation by paying out 100% of their taxable income to investors — who then pay ordinary income tax rates rather than lower capital gains rates.
But the REIT could choose to reduce taxes further by claiming depreciation and amortization deductions for the properties. This turns a portion of your dividend into a tax-free return of capital. It reduces how much you owe per year for the dividend income, but also reduces your tax-basis in the REIT. You’d owe a larger capital gain for selling the shares at a profit in the future. You can defer all those taxes if you buy a REIT through your Individual Retirement Account (IRA) or 401(k).
4. Publicly traded REITs are liquid, private REITs are not
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Publicly traded REITs register with the SEC as securities. They can then be listed and traded on the major stock exchanges. Anyone can buy and sell them.
Private REITs generally offer a higher return in exchange for less liquidity. Private REITs do not register with the SEC and do not allow investors to trade shares freely. (Private REITS are open only to high net worth accredited investors.) Instead, you buy and sell directly from the company running the REIT. Private REITs lock up your money with minimal liquidity. You typically agree to keep your money in the REIT for three to 10 years. The private REIT might allow some early redemptions to cash out before then, but it might not.
5. REITs can specialize in different real estate investments
Equity REITs focus only on buying properties. They are the most common. There are also mortgage REITs that invest in mortgage loans and mortgage-backed securities. Finally, there are hybrid REITs that invest in both properties and mortgages.
Large public REITs typically include various property types across different regions. Some REITs specialize in certain areas and properties. For example, a hospitality REIT might only invest in hotels, motels and resorts. “As an investor, you could lean into a market where you have a specialty understanding. Perhaps if you were an office park manager, you’d prefer an office REIT,” says Ken Johnson, real estate economist and business professor at Florida Atlantic University in Boca Raton.
6. REITs help with diversification and inflation
Real estate as an asset class performs differently than stocks.The FTSE All Equity REITs sums up the return of all publicly traded U.S. REITs. One the long haul, the annual return is similar to the S&P 500. In 2023, the FTSE All Equity REITs fund only grew by 11.4% versus 26.29% for the S&P 500 due to high-interest rates.
REITs and real estate usually do well as an inflation hedge, a situation when stocks and bonds have historically struggled. In 2021, when post-pandemic inflation was soaring and bonds were crashing, the FTSE All Equity REITs grew by 41%, outperforming the S&P 500.
7. Returns depend on interest rates
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When interest rates go up, REITs tend to struggle. Higher rates increase real estate borrowing costs and push down the value of properties. REITs have taken hits over the past couple of years as the Fed rapidly increased rates to control inflation. If the Fed stops tightening and starts lowering interest rates, that could boost the future performance of REITs, says Johnson, the real estate economist from Boca Raton.
8. Commercial property REITs are in trouble
The commercial real estate property market has taken a pounding from high vacancies due to the rise of remote work. The number of commercial properties in financial distress hit a 10-year high in late 2023, the highest since the financial crisis. This is dragging the performance of commercial REITs.
For example, the Gladstone Commercial Corp. (GOOD) specializes in office space. It’s down nearly 14% over the past year and is liquidating its commercial properties to focus on retail and industrial properties. On the other hand, Park Hotels and Resorts (PK) is up around 22% over this same period as consumer demand for travel and entertainment remains strong.
9. The fund matters for performance
Some REITs are better run and earn more than others. “You need to trust the companies running the properties know what they’re doing, especially with the ongoing slowdown in commercial real estate,” says Stivers.
Before investing in a REIT, pull up its historical returns for the past few years to compare against other REITs. Many REITs list their properties on their corporate web sites. “We do a Google search for reviews on the properties to see what tenants think,” says Stivers. You could check a fund’s credit rating and debt for stability. Too much debt could be a sign that a REIT is overextended.
Finally, REITs report their market price to funds from operations (FFO). A lower ratio is a sign that the REIT is a better value in the same way that a low price-to-earnings ratio is a sign of a better-valued stock.
10. REITs usually match the returns of owning properties
Buying your own properties involves much more work than a REIT but doesn’t generate extra returns for most investors. “If you’re the go-to house flipper in your community with lots of local connections, you could make more. But 99% of investors interested in real estate make just as much if not more with a REIT,” says Harbaugh, the Texas real estate agent.
With a REIT though, you aren’t able to deduct all the tax breaks you get from buying your own properties, such as depreciation, the cost of repairs, property taxes and mortgage interest. Operating REIT properties is up to the fund manager. “Some people enjoy having the ultimate say of what gets bought, the tenants and how a building is run,” says Harbaugh. “If you want to be in control, you’ve got to do it yourself.”
Note: This item first appeared in Kiplinger’s Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.
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