REITs are investment vehicles that generate income for their investors. Real estate investment trusts (REITs) own and operate various real estate properties in which 90% of income is paid as dividends to shareholders.REITs are classified as publicly traded and non-traded. REITs can offer investors a steady income, but a REIT comes with risks commonly associated with other investments.
Key Takeaways
- Real estate investment trusts (REITs) are investment vehicles that pay dividends to investors.
- Traded like shares of stock on exchanges, REITS provide exposure to diversified real estate holdings.
- REITs are classified as publicly traded and non-traded.
How REITs Work
Since REITs return at least 90% of their taxable income to shareholders, they usually offer a higher yield than the market. REITs pay their shareholders through dividends, and cash payments from corporations to their investors. According to the S&P Global Market Intelligence, 74 publicly-traded REITs in the U.S. increased dividend payouts in 2023.
REITs allow investors to earn dividend-based income from properties while not owning any of the properties.They may specialize in a certain real estate sector or offer more diverse holdings. REITs can hold various properties, including:
- Apartment complexes
- Healthcare facilities
- Hotels
- Office buildings
- Self-storage facilities
- Retail centers, such as malls
REITs must pay 90% of taxable income as shareholder dividends, typically more than most dividend-paying companies.
Risks of Non-Traded REITs
Non-traded REITs or non-exchange traded REITs do not trade on a stock exchange, which opens up investors to special risks such as:
- Share Value: Non-traded REITs are not publicly traded, meaning investors cannot research investments. As a result, it's difficult to determine the REIT's value.
- Lack of Liquidity: Non-traded REITs are also illiquid, which means there may not be buyers or sellers in the market available when an investor wants to transact. In many cases, non-traded REITs can't be sold for at least 10 years.
- Distributions: Non-traded REITs pool money to buy and manage properties, which locks in investor money. However, pooled money is sometimes paid out as dividends from another investor's money—as opposed to income that a property has generated. This process limits cash flow for the REIT and diminishes the value of shares.
- Fees: Most REITs charge an upfront fee between 9% and 10%. Non-traded REITs can also have external manager fees and investors should request transparency. If a non-traded REIT pays an external manager, that expense reduces investor returns.
It's possible to hold REITs in a tax-advantaged account, such as a Roth IRA.
Risks of Publicly Traded REITs
Publicly traded REITs offer investors a way to add real estate to an investment portfolio or retirement account and earn an attractive dividend. Publicly traded REITs allow for more transparency but still come with risks like:
- Interest Rates: A rise in interest rates may reduce demand for REITs, as investors choose other vehicles like U.S. Treasuries that are government-guaranteed, and pay a fixed interest rate. However, some argue that rising rates indicate a strong economy, leading to higher rents and occupancy rates, and better-performing REITs.
- Choosing the Wrong Sector: As online shopping increases and suburban malls decline, REITs with this exposure may be a risky investment. With Millennials preferring urbanliving for convenience and cost-saving purposes, urban shopping centers could be a better play.
- Taxes: REIT dividends are taxed as ordinary income, so the investor must evaluate their tax bracket alongside income generated from a REIT. The ordinary income tax rate is the same as an investor's income tax rate, which is likely higher than dividend tax rates or capital gains taxes for stocks.
500,000+
In 2023, REITs collectively held in excess of 575,000 individual properties.
Are REITs Risky Investments?
When investing only in REITs, individuals incur more risk than when they are part of a diversified portfolio. REITs can be sensitive to interest rates and may not be as tax-friendly as other investments. When a REIT is concentrated in a particular sector like hotels, and that sector is negatively impacted, investors can see amplified losses.
What Are Fraudulent REITs?
Some investors may be defrauded by bad actors trying to sell "REIT" investments that are scams. To avoid this, investors should choose only registered REITs, which can be identified using the SEC's EDGAR tool.
Do All REITs Pay Dividends?
To be classified as a REIT by the IRS and SEC, REITs must pay at least 90% of taxable profits as dividends. This provision allows REIT companies to have exemptions from most corporate income tax.
The Bottom Line
Investing in REITs can be a passive,income-producing alternative to buying property directly.However, investors shouldn't be swayed by large dividend payments alone. REITs come with risks and investors should research management teams and properties based on current trends, and whether the REIT is publicly traded or non-traded.
