Real Estate Investment Trust (REIT)

REITs (real estate investment trusts) were established by Congress in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. They allow individual investors to buy shares in commercial real estate portfolios that receive income from a variety of properties, including apartment complexes, data centers, healthcare facilities, hotels, infrastructure (e.g., fiber cables, cell towers, and energy pipelines), office buildings, retail centers, self-storage, timberland, and warehouses.

Most REITs specialize in a specific real estate sector—office buildings, healthcare, residential, retail—but diversified and specialty REITs often hold different types of properties in their portfolios.

Most REITs have a straightforward business model: The REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders.

To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code, including requirements to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a company must meet the following requirements to qualify as a REIT:

• Invest at least 75% of its total assets in real estate, cash or U.S. Treasuries
• Receive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate
• Pay a minimum of 90% percent of its taxable income in the form of shareholder dividends each year
• Be an entity that is taxable as a corporation
• Be managed by a board of directors or trustees
• Have a minimum of 100 shareholders after its first year of existence 
• Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year

There are several types of REITs, including:

• Equity REITs: Most REITs are equity REITs, which buy, own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties).
• Mortgage REITs: Mortgage REITs, also known as mReits, lend money to real estate owners and operators either directly through mortgages and loans or indirectly through the acquisition of mortgage-backed securities. Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
• Hybrid REITs: These REITs use the investment strategies of both equity and mortgage REITs.

REITs can be further classified based on how their shares are bought and held.

• Publicly Traded REITs: Shares of publicly traded REITs are listed on a national securities exchange, where they are bought and sold by individual investors. They are regulated by the U.S. Securities and Exchange Commission (SEC).
• Public Non-traded REITs: These REITs are also registered with the SEC, but don’t trade on national securities exchanges. As a result, they are less liquid than publicly traded REITs but tend to be more stable because they’re not subject to market fluctuations.
• Private REITs: These REITs aren’t registered with the SEC and don’t trade on national securities exchanges. They work solely as private placements.

REITs can play an important part in an investment portfolio. As with all investments, they have their advantages and disadvantages.

On the plus side, REITs are easy to buy and sell, trading as they do on public exchanges. This mitigates some of the traditional drawbacks of real estate—its notorious illiquidity (buildings can take a long time to unload or purchase) and its lack of transparency. REITs are regulated by the SEC and must file audited financial reports.

Performance-wise, they offer attractive risk-adjusted returns and stable cash flow. And a real estate presence can be good for a portfolio, diversifying it with a different asset class that can act as a counterweight to equities or bonds.

On the downside, REITs don't offer much in terms of capital appreciation: They must pay 90% of income back to investors, so only 10% of taxable income can be reinvested. Dividends are taxed as regular income. REITs do carry a risk: They're subject to real-estate market slumps and, like most investments, don’t guarantee a profit or ensure against losses. Some have high management and transaction fees.

You can invest in publicly traded REITs—as well as REIT mutual funds and REIT exchange-traded funds (ETFs)—by purchasing shares through a broker. You can buy shares of a non-traded REIT through a broker or financial advisor who participates in the non-traded REIT’s offering. REITs are also included in a growing number of defined-benefit and defined-contribution investment plans. An estimated 80 million U.S. investors own REITs through their retirement savings and other investment funds, according to Nareit, a REIT-investment research firm based in Washington, D.C. 

There are more than 225 publicly traded REITs in the U.S., which means you’ll have some homework to do before deciding which REIT to buy. Be sure to consider the REIT’s management team and track record, and find out how they’re compensated. If it’s performance-based compensation, odds are they’ll be working hard to pick the right properties and choose the best strategies. Of course, it’s also a good idea to look at the numbers, such as anticipated growth in earnings per share and current dividend yields. A particularly helpful metric is the REIT’s funds from operations (FFO), which measures the cash flow generated by the REIT's assets.

Another consideration when choosing REITs: what sectors of the real estate market are hot or what booming sectors of the economy in general can be tapped into via real estate. A case in point is healthcare, one of the fastest-growing industries in the U.S.—especially medical buildings, outpatient care centers, and elder care facilities and retirement communities.

Several REITs focus on this sector. HCP Inc. (HCP) is one such. With a market cap of nearly $15 billion, it's a large company—large enough to be part of the S&P 500, in fact—and very liquid: Some 2.56 million shares trade daily. At $31.25 per share, as of April 5, 2019, it's trading near its 52-week high, and offering a dividend yield of 4.32%. Its recently restructured portfolio focuses on life sciences facilities (diagnostic centers, labs, etc.), medical office buildings, and senior housing.