How to Invest in REITs

Real Estate Investment Trusts (REITs) offer a simple and accessible way for investors to invest in the real estate market without the hassle of directly owning or managing a property.

Legally codified in 1960, REITs are investment trusts (or corporations) specializing in buying, selling or operating income-producing real estate. REITs possess many of the same characteristics as mutual and exchange-traded funds (ETFs) but there are a few key differences.

In order to qualify as a REIT, the trust must satisfy specific criteria under U.S. tax laws. Trusts must follow a 75 / 75 / 90 rule by investing at least 75% of total assets in real estate, cash or cash equivalents, by generating at least 75% of gross income from real estate-related activities and by distributing at least 90% of their taxable income to shareholders. REITs do not pay federal income tax on dividends distributed to their shareholders, avoiding “double taxation.”

When a REIT is first formed, it typically issues shares to investors to generate capital for investments. Trusts can issue shares in public offerings, private placements or direct stock purchase plans. Public offerings are typically done through an initial public offering (IPO), in which the REIT issues shares to the public for the first time. Private placements are offered to a select group of investors, such as institutional investors or accredited investors. Direct stock purchase plans allow individual investors to purchase shares directly from the REIT, bypassing a brokerage firm. Like mutual funds and ETFs, most REIT shares are typically traded on exchanges following the initial offering.

Since REIT shares are securities, dedicated mutual and exchange-traded funds are provided by companies such as BlackRock (NYSE: BLK) and State Street (NYSE: STT) dedicated to tracking different REIT indexes. These funds allow investors to diversify their REIT investments.

In addition to issuing shares, REITs can issue debt securities in bonds or notes. Trusts can also obtain financing from banks or other financial institutions, as well as through mortgage-backed securities (MBSs). REITs employ debt to finance the acquisition or development of real estate properties.

Although all REITs must follow the 75 / 75 / 90 rule detailed above, not all REITs follow the same investment strategy. Equity REITs, the most common type, buy, sell and manage real estate directly. Mortgage REITs (mREITs) follow a different strategy, choosing instead to invest in MBSs, commercial mortgage loans and other real estate debt instruments. Hybrid REITs implement a mixture of both strategies.

REITs can also be split into agency and non-agency categories. Agency REITs only invest in federally insured mortgages, typically through government-sponsored entities such as Fannie Mae and Freddie Mac. Non-agency REITs have no restrictions, opening investors to higher risk and returns.

Individuals typically invest in REITs to hedge against risk and volatility and to receive higher dividend payments. The 75 / 75 / 90 helps provide investors with a consistent cash flow stream. REITs also correlate less with the stock market compared to other asset groups. A low correlation with the stock market allows investors to reduce their losses when the equity markets perform poorly. Combined with physical real estate serving as collateral to a REIT’s value, REITs are often viewed as a safer investment than most other securities.

For most investors, equity REITs and mREITs are the preferred way to go. Their ability to trade on exchanges makes it easy for investors to buy and sell their shares and get real-time pricing. However, some REITs, private and public non-listed (PLNRs), are not found on exchanges.

Private REITs do not require US Securities & Exchange Commission (SEC) registration but can only be sold to institutional investors. PLNRs are registered with the SEC but intentionally avoid their shares being listed on exchanges. PLNR investors must buy and redeem their shares from the fund through brokers, and many funds have a minimum investment requirement between $1,000 and $2,500.

In conclusion, REITs have become a popular investment vehicle for those interested in the real estate market without the burden of directly owning or managing a property. The 75 / 75 / 90 rule and specific U.S. tax laws provide investors with consistent cash flow streams and tax advantages. REITs are divided into different categories based on investment strategies and can issue shares or debt securities to raise capital. The correlation between REITs and the stock market is low, making them an excellent option for investors seeking diversification and reduced risk. Whether through publicly traded REITs or PLNRs, individuals can invest in REITs to hedge against volatility and receive higher dividend payments.

Want more? Read our related articles:

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Investing in REITs: Pros and Cons 

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