REIT Investing for Beginners: What Are They & How Do They Work?

Choosing where and how to invest your money can be difficult, particularly if you are new to investing or have only limited experience. How can you know which real estate investments will match your risk comfort level and earn you a good return that makes your investment worthwhile?

At Addition Financial, we always want our members to have the information and support they need as they invest in their futures. REIT investing is something that allows investors to earn passive income by investing in residential or commercial real estate. To help you understand whether investing in the real estate market is right for you, here’s our overview of REIT investing for beginners.

What is a REIT?

A Real Estate Investment Trust or REIT is an investment vehicle that allows individuals to invest in real estate trusts of income-generating properties. People who may not have enough money to invest in real estate directly by purchasing properties to rent can take advantage of the financial benefits of real estate ownership by purchasing shares in REITs.

A lot of Americans have put some of their investment funds into REITs. There are approximately 150 million people in total living in households that have invested in REITs. People may purchase REIT shares through mutual funds, exchange-traded funds (EFTs) and by purchasing company shares directly. There are over 225 publicly traded REITs in the United States, with a combined market capitalization of more than $1 trillion.

How do REITs work?

REITs are income-producing investments, giving them a lot in common with dividend stocks. By law, REITs are required to pay out 90% of their taxable income to their shareholders in the form of dividends. Income may be earned by renting the properties financed and/or owned by the REIT.

Most REITs are traded on public stock exchanges, something that makes them far easier to buy than real estate. They’re accessible to investors at every level.

As stated above, REITs pay dividends. Legally they are required to pay dividends once every year, but many REITs pay them on a monthly or quarterly basis. As a result, REITs are a better source of passive income than they are of long-term gains. With only 10% of taxable income available to reinvest, REITs don’t have the same growth potential as other investments.

What are the different types of REITs?

Before you add REITs to your investment portfolio, you should understand how REITs are classified. Here are the primary types of REITs:

Equity REITs are the most common type of REIT. They own and manage income-producing real estate, with most revenues coming from rent.
Mortgage REITs loan money to real estate owners and operators, and may do so either through mortgage loans or with the acquisition of mortgage-backed securities. Unlike equity REITs, mortgage REITs may be negatively impacted by increases in interest rates.
Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs.

There are some other classifications that may apply to REITs, as follows:

Publicly traded REITs are listed on a national securities exchange, bought and sold by individuals, and regulated by the SEC.
Public non-traded REITs are less liquid than publicly traded REITs. They are registered with the SEC but do not trade on a national exchange.
Private REITs are not registered with the SEC and don’t trade on a national security exchange. They are sold primarily to institutional investors.

Most individual investors purchase shares of publicly traded equity REITs. REIT shares may be purchased on the exchange directly, through a broker, or through a retirement account such as a 401(k) or an IRA.

What are the returns for REIT investments?

Historically, REITs have proven to be a good investment. While payouts can and do fluctuate from year to year, the data shows that over time, REITs have outperformed the S & P 500 index. In fact, over the past 20 years, REITs have earned an average return of 12.7% compared to just 9.5% for the S & P 500.

The type of REIT you invest in will impact how much money you earn from your investment. Here are the average returns for REITs based on the real estate properties they contain:

Self-storage facilities: 18.8%
Industrial real estate: 15.8%
Residential real estate: 14.4%
Healthcare real estate: 12.7%
Office/retail: 12.1%

Only diversified REITs and REITs of resort properties underperformed the S & P 500, so you should keep that in mind when choosing your investments.

How do you invest in REITs?

93% of all target date funds, including most retirement plans, have REIT allocations. If you have a 401(k) or an IRA, you can choose to invest in REITs as part of your retirement planning. 83% of financial advisors recommend REIT investments to their clients because of their steady returns.

How can you buy REIT shares?

You have several options if you want to purchase REIT shares. The first is to buy the shares directly on the stock exchange. Examples of publicly traded REITs that have performed well include the following:

Avalon Bay Communities, Inc. (AVB)
Boston Properties Inc. (BXP)
Mid-America Apartment Communities Inc. (MAA)
Prologis Inc. (PLD)
W.P. Carey Inc. (WPC)

Another way to purchase REITs is to do so through REIT mutual funds or EFTs.

What is the right portfolio allocation for REITs?

Asset allocation is an important part of choosing investments. As a rule, you want to limit high-risk investments. Younger investors can generally afford to take more risks compared to those who are close to retirement age because they’ll have time to recoup any losses before they retire.

Most experts advise making REITs between 5% and 15% of your investment portfolio unless you are planning to retire soon. Beginning investors with 40 or more years to go until retirement can go as high as 18% if they choose. Those who are approaching retirement may want to decrease their REIT allocation to 3% at retirement.

Keep in mind that REITs are a better source of ongoing passive income than they are of long-term growth. Keeping some REIT shares in your portfolio after retirement may provide a supplement to your other retirement income.

What are the pros and cons of investing in REITs?

Now, let’s review the pros and cons of investing in REITs.

Pros of investing in REITs

Portfolio Diversity. Investing in REITs adds tangible property to your investment portfolio because REITs are a separate class from stocks, bonds, or money market accounts.
Passive Income. As we mentioned above, REITs are required by law to pay out 90% of their taxable income as dividends. That means that adding REITs to your portfolio can provide you with passive income. You may choose to spend or reinvest your dividend income.
Zero corporate tax. One thing that sets REITs apart from most corporations is that they are not required to pay a corporate tax. The result is that they have more of their income to pay out as dividends, meaning larger returns for you.
Liquidity. REITs are a more liquid investment than traditional real estate, which can take a lot of time to sell and is subject to market fluctuations. If you decide you want to liquidate your REIT shares, you can do so quickly and easily.
Access to commercial real estate. Most of us don’t have access to commercial real estate investments as individuals. If you invest in the right REIT, you can invest in commercial property including things like self-storage facilities or industrial property, both of which deliver higher-than-average returns.

Cons of investing in REITs

Interest rates. The value of your REIT investments may rise and fall depending on interest rates. The value of an REIT is tied to the Treasury yield, so an increase in interest rates may lead to a decrease in the value of the REIT.
Real estate trends can impact REITs’ value. While real estate tends to appreciate over time, there are exceptions. If a particular type of property or business sector falls out of favor, there’s the possibility that your REIT investment could lose value as a result.
REIT dividends are taxable income. When you receive dividends from REIT investments, they are reported to the IRS as income and you must pay taxes. The tax percentage you pay depends on a variety of factors. If the REIT has owned a property for less than a year, dividends will be taxed at the ordinary rate. Proceeds from properties owned for more than a year will be taxed at a capital gains rate of 0%, 15% or 20% depending on your annual income. You may potentially be able to defer paying taxes if you reinvest the money you earn in a traditional IRA or another pre-tax retirement plan.
Fees may be high. Some REITs come with higher-than average fees hidden in the fine print of the purchase agreement. These may include transaction fees and trust management fees, so make sure to read everything before you buy.
Not good short-term investments. As a rule, REITs make better long-term investments than they do short-term investments. Thanks to market fluctuations that may impact their value, there’s a possibility that an REIT could lose a significant amount of its value, so you’re better off thinking of them as a long-term investment.

Diversify your portfolio with REITs

If you’re just starting out as an investor, adding REITs to your portfolio can help with diversification while providing a source of passive income. The information we’ve provided here can help you make the right choices for your portfolio and eventual retirement.

Do you need assistance choosing investments for your portfolio? Addition Financial is here to help! Click here to read about our MEMBERS Financial Services program and book an appointment with a Financial Professional today.