Many investors looking to add diversification to their investment portfolio or generate passive income by getting into real estate may feel they don’t have the funds to do so.
Thankfully, real estate investment trusts (REITs) are a special type of investment that might allow everyday investors to more easily invest in this often pricey market.
If you’re looking for a way to get started in real estate investing without spending tens of thousands of dollars, here’s what you need to know about REITs.
What is a REIT?
If you’re investigating how to invest in real estate, you’ve likely come across the term REIT. According to the U.S. Securities and Exchange Commission, “A REIT is a company that owns and typically operates income-producing real estate or related assets.” The National Association of Real Estate Investment Trusts, known more simply as Nareit, expands on this definition to also include companies that finance income-producing properties.
The structure of some REITs allows individuals to invest in physical real estate they likely could not afford to invest in on their own. After all, purchasing and managing physical real estate assets could easily cost hundreds of thousands, if not millions, of dollars.
REITs can invest in different property types and typically hold multiple properties. This helps diversify the risk of a single property’s tenant failing to pay the rent or a single property’s decline in value from wrecking your investment.
REITs usually help investors earn money in two ways:
- Dividend payments from cash left over after receiving rent and paying expenses
- Capital appreciation, or an increase in the market price, of the real estate held by the REIT
Of course, each REITs works in different ways and not every REIT will experience both these types of gains. As with all investments, you could lose money investing in REITs.
How REITs work
REITs can work in different ways depending on the type of REIT you invest in. Typically, REITs invest in a specific type or multiple types of real estate. These can include single-family or multi-family residential real estate, office buildings, malls, hotels, data centers, storage facilities, and more. Some REITs focus on one segment, such as commercial real estate, whereas others invest in several areas in the real estate market.
When you invest in a REIT, you actually own part of the company that holds the physical real estate properties. One of the most common types of REITs is a publicly traded REIT. These REITs are traded on public stock exchanges where you can buy and sell a share of the REIT during market hours, as you would with shares on the stock market.
The REIT professionally manages the real estate. It looks for potential real estate to purchase and decide when to sell the real estate assets. It may also manage the tenants who lease the real estate. This management comes at a cost as the REIT has to hire contractors and pay the staff that manages the properties. Because of this, REITs typically charge expense ratios. Some may also charge upfront purchase fees.
By investing money in a REIT, you get the benefits of owning part of the company. When the REIT decides to distribute profits as dividends, you get paid. If the REIT appreciates due to the rising prices of the real estate it owns, you might be able to sell your REIT shares to lock in the gains.
Some REITs are regulated by the SEC, whereas others are not. The regulations may state what type of financial statements and other information the company must share with its investors. If you invest in a non-regulated REIT, you may not get as much information about your investment in a timely manner.
Types of REITs
Most REITs are equity REITs. These are real estate companies that own residential or commercial properties and manage them on behalf of investors. These REITs allow individual investors to purchase shares of the REIT on stock exchanges.
As an investor, you can choose between several types of REITs that invest in different kinds of real estate. Here are a few popular options you may come across.
A retail REIT owns property that is leased out to commercial businesses. These REITs may own properties such as strip malls, traditional shopping malls, grocery store shopping centers, and large big-box retailer anchored shopping centers.
Residential REITs focus on properties where people live. They make money by owning the properties and renting them out to tenants. These properties can include single-family homes, apartment buildings, manufactured homes, and even housing for university students.
These REITs may focus on just one type of residential real estate or a broad array. They may also concentrate their investments in particular locations they feel offer promising opportunities or they may have real estate diversified across several localities.
Office REITs own real estate focused on office space for businesses. They rent out this office space to tenants to earn income. Common examples of office spaces owned by these REITs include large-scale office buildings, such as skyscrapers, to small office parks in suburban areas.
As with residential REITs, these may focus on a specific classification within this type of real estate. Others may focus on office space aimed toward a particular type of tenant. Alternatively, they may focus on office space in a specific area of the country.
Health care REIT
Health care REITs purchase and rent out real estate focused on providing health care services. This can include hospitals, assisted living facilities, nursing homes, medical office buildings, and more. The tenants renting this type of real estate typically have specific requirements for their buildings that make this a unique investment opportunity.
A mortgage REIT, sometimes simply known as an mREIT, is unique compared to the above options. Instead of owning physical real estate, this type of REIT invests in mortgages. Mortgages are the debt that backs many real estate purchases.
REITs may originate mortgages themselves or purchase groups of mortgages called mortgage-backed securities. Because the REIT holds the mortgage, the mortgage borrowers repay the REIT whatever principal and interest on the loans they own.
Publicly traded vs. private REITs
In addition to the type of property invested in, REITs can be classified by how they’re traded. Here are the three major classifications of REITs you’ll likely come across:
- Publicly traded REITs: These REITs are traded on stock exchanges, such as the New York Stock Exchange or Nasdaq. This makes them more liquid, as they can be traded during trading hours. An example would be a REIT exchange-traded fund. These REITs are registered and regulated by the SEC.
- Public non-traded REITs: These REITs are not traded on an exchange. Instead, you buy these through brokers. These REITs restrict your ability to sell and might require you to keep them for a set time before redeeming the shares. These are still registered and regulated by the SEC.
- Private REITs: These REITs aren’t widely available to everyone. Instead, you must be an accredited investor to access them. These typically are less liquid and have high minimum investments. These are not registered or regulated by the SEC.
Pros and cons of REITs
Investing in REITS could have several benefits:
- Invest in real estate for less: REITs allow you to invest in real estate without purchasing physical real estate, putting down a sizable down payment, and taking out a mortgage.
- Some REITs are liquid: Publicly traded REITs can be bought and sold on the markets very quickly, unlike physical real estate, which has far less liquidity.
- Earn dividends: REITs generally pay out profits as dividends, giving you a source of income, though the actual dividend yields can vary by REIT.
- Diversify your portfolio: REITs allow you to add an alternative asset class to your portfolio other than the traditional stock and bond offerings.
REITs might not be the best investment for everyone due to the following:
- Generally a long-term investment: Real estate is historically a long-term investment that may not be suitable for short-term investors. If you’re after long-term capital appreciation, you’ll be tied up in this investment for the long haul.
- REIT dividends are taxable: Although earning dividend income can be nice, that money becomes taxable income in the year it is paid out.
- Real estate values could fall: Real estate isn’t immune to price drops, as evidenced by the real estate crash in the mid-to-late 2000s.
- Tenants could quit paying rent: Tenants may stop paying rent at any time, as happened to many landlords during the market volatility triggered by the COVID-19 pandemic.
Should you invest in a REIT?
A REIT could be a good investment option for long-term investors looking to diversify their portfolios beyond stocks and bonds. Allocating a small portion of your portfolio to alternative assets, such as real estate, might help you achieve your investing goals.
That said, REIT investing isn’t a good fit for everyone. People who have not built an extensive portfolio might find investing in REITs overcomplicates their investment plan. Instead, these investors might want to consider other investment options, such as learning how to invest in index funds, that could be a better fit.
Is a REIT a good investment?
A REIT might be a good investment if it helps you reach your investing goals. Some REITs might be less liquid than other types of investments though. REITs may also charge fees that are higher than other investment options. However, REITs might be more liquid than investing in physical real estate yourself. Keep these factors in mind when considering this type of investment and the place it might hold in your portfolio.
Can you lose money in a REIT?
As with other investments, you could lose money investing in a REIT. The value of REITs tends to follow the relevant market movements, the future cash flows of the REIT, dividend payments of REITs, and the value of the properties the REIT owns. Any of these factors or other factors not performing as expected could result in your REIT investment dropping in value.
How much money do I need to invest in REITs?
Each REIT could have a minimum investment amount required, but the actual amount will vary. REITs set up as mutual funds might have a minimum investment such as $2,500. Some private REITs might require you to more to get started.
However, some REITs trade as ETFs, which technically only require you to buy a single share to invest in them. For instance, Vanguard’s Real Estate Index Fund ETF (VNQ) would only require you to buy a single share. If you find a brokerage that allows you to buy partial shares of this ETF, you could invest with almost any amount.
Now that you can answer the question, “What is a real estate investment trust?” you can start to figure out whether investing in one may help your financial goals.
With a REIT, you don’t have to invest in real estate directly and can still benefit from the relatively passive income this class of investment often offers. Some REITs even allow you to invest in real estate with $500 or less.
Investing money in REITs doesn’t come without risks, though. Real estate can crash just like any other asset class. Tenants may quit paying rent or terminate their leases early if their businesses fail or they lose their jobs. Ultimately, you must decide if the potential rewards of investing in REITs outweigh the risks.