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While directly owning real estate is a tried and true method for generating income and building wealth over the long term, many real estate investors also invest in REITs—Real Estate Investment Trusts.
Owning a REIT can allow an investor to generate more passive income while diversifying capital across different real estate markets and asset classes, which in turn may reduce potential investment risk. REITs are traded on public markets and can be bought and sold much like a stock. Here’s a breakdown of REITs vs real estate investing, and what investors should know about this asset class.
What is a REIT?
A REIT is a private or publicly-held company that owns, manages or finances residential or commercial income-producing real estate. By law, a REIT is required to distribute at least 90% of its taxable income as dividends to shareholders, making a REIT an attractive option for investors looking for passive dividend income.
In many ways, a REIT is similar to an ETF (exchange-traded fund) that holds various institutional-grade real estate assets that are professionally managed. By owning shares of a REIT, an investor can easily diversify a real estate portfolio by asset class and geography while generating recurring dividends, provided the REIT is profitable.
By comparison, directly owning real estate requires an investor to conduct extensive market and property research, make a significant capital investment in the form of a down payment, and either self-manage or manage a local property manager.
Unlike shares of a publicly-traded REIT that can easily be bought and sold on major stock trading platforms, real estate that is directly owned is illiquid. It can easily take months or more to buy or sell a property, and buyers and sellers can collectively expect to pay around 10% of the property sale price in transaction fees such as real estate commissions, escrow, and financing fees.
What is REIT Investing?
Although the majority of REITs focus on a specific real estate asset class, some REITs hold an array of different property types in their portfolios. In general, there are over on dozen real estate sectors that REITs invest in, according to Nareit, an organization that advocates REIT-based real estate investment in the U.S.:
- Office REITs include suburban office parks, central business district office buildings, and skyscrapers.
- Retail REITs own and manage outlet centers, life-style shopping centers, grocery-anchored malls, and single-tenant net lease retail buildings such as gas stations or fast food outlets.
- Industrial REITs focus on property types such as warehouses, distribution centers, and cold-storage facilities leased to e-commerce businesses.
- Residential REITS may include large apartment buildings, student housing, manufactured homes, and build-to-rent single-family home subdivisions.
- Lodging/Resorts REITs focus on the entire spectrum of lodging used by consumer and business travelers, including luxury and upscale hotels, resorts, and casinos.
- Health Care REITs own and operate facilities such as hospitals, medical office buildings, and assisted living facilities.
- Self-Storage REITs own, manage, and rent storage space to individuals and businesses in primary, secondary, and tertiary markets.
- Infrastructure REITs include properties such as telecommunications towers, oil and gas pipelines, wireless infrastructure, and fiber cables.
- Data Centers REITs own and manage facilities that house storage systems and routers used by companies such as Amazon and Facebook, and also provide services such as air-cooled chillers and uninterruptible power supplies.
- Timberland REITs specialize in owning and operating land and businesses used for growing, harvesting, and selling timber.
- Diversified REITs include a mixture of different property types rented to tenants, such as a portfolio made up of office, retail, and mixed-use buildings.
- Specialty REITs own property built for specific uses, such as movie theatres, car washes, and outdoor advertising sites.
- Mortgage REITs invest in debt by originating mortgages for commercial real estate investors, purchasing existing loans and mortgage-backed securities (MBS) and generate income from mortgage interest paid by borrowers.
4 Types of REITs to Know
While most REITs are publicly-held and traded on major stock exchanges, there are also public REITs that are not listed on the stock exchanges, and private REITs.
REITs may invest in the equity end of the capital stack and generate income by collecting rents, or they may invest in the debt end by earning money from mortgage interest payments received from borrowers.
Equity REITs
Equity REITs own, operate, and manage institutional-grade properties such as office buildings, shopping centers, industrial, and residential property. Rent is collected from tenants, and income is distributed to shareholders in the form of recurring dividends.
Mortgage REITs
Also known as mREITs, mortgage REITs make money by originating mortgages, or purchasing existing mortgages and mortgage-backed securities. Income is generated from mortgage interest payments from loans on both residential and commercial real estate.
Public Non-Listed REITs
Also known as PNLRs, these REITs are registered with the SEC but are not traded on the stock exchanges. Public non-listed REITs generally work the same way that publicly-traded REITs do, except there may be redemption restrictions and other limitations that make PNLRs less liquid.
Private REITs
Private REITs are not registered with the SEC and do not trade on public stock exchanges. As a rule of thumb, private REITs are only sold to large institutional investors, family offices, or accredited investors. Private REITs generally have a high minimum investment, require capital to be locked up for an extended period of time, and are exempt from regulatory oversights.
How to Invest in a REIT
Shares of publicly-traded REITs can be bought or sold on trading platforms such as Fidelity Investments, TD Ameritrade, and Charles Schwab. REITs that are publicly-traded are registered with the SEC, and shares can be bought and sold like any stock.
Some REITs are public but non-traded. While they are registered with the SEC, they do not trade on exchanges, are less liquid, and generally require an investor to keep capital invested for a minimum time period.
Private REITs are not listed and not registered with the SEC. In general, private REITs are sold to institutional investors such as pension funds or hedge funds, and to accredited, high net worth investors.
Pros and Cons of REITs vs Real Estate
Here’s a quick look at some of the pros and cons of investing in REITs compared to directly owning real estate.
Pros
- Income through dividend distributions from collected rent and profit when a property is sold. While directly owning real estate requires an investor to be active to some degree, REIT dividends may be considered truly passive income.
- Diversification by asset class and geography is much easier with a REIT by purchasing whole or fractional shares versus making a large down payment on a rental property.
- Liquidity is much greater with REITs, because shares can be bought and sold in a few seconds via an online trading platform. On the other hand, selling physical real estate can take months or more, with significant fees paid to real estate brokers, title companies, and lenders.
Cons
- REIT distributions are generally taxed as ordinary income, which may be a higher tax rate for many taxpayers. Investors who directly own real estate receive tax benefits such as deducting owner expenses and depreciation to reduce taxable net income.
- Correlation with the overall stock market is low with both REITs and real estate. However, REIT share prices may decrease during a stock market downturn simply because shares are easy to sell.
- Concentration risk may be created by focusing on REITs that only invest in one real estate asset class or geographic area. Of course, concentration risk also applies to real estate that is directly owned.
Final Thoughts
REITs can offer an investor consistent, bond-like returns through dividend distributions without the effort and risk of owning real estate directly.
However, as with any other real estate investment, it’s important to understand the risks and potential rewards of each REIT, the REIT’s investment strategy, and the type of real estate the REIT is investing in. Explore how to start a real estate investment company.