Should You Invest in a Real Estate Investment Trust (REIT)?

Should You Invest in a Real Estate Investment Trust (REIT)? article image.

You might dream of owning property and sitting back collecting rent payments as a passive income. But the upfront costs and ongoing costs of maintaining a rental property create high barriers to entry. Another option could be investing in a real estate investment trust (REIT), which allows you to diversify your portfolio and profit from real estate investing without the direct responsibilities of a landlord.

What Is a REIT?

REIT pools investors' money to purchase or build and then operate income-producing real estate. There are also REITs that focus on the financing of income-producing real estate rather than owning or operating it. However, REITs don't develop properties with the intent of selling them later.

The underlying real estate could be apartments, homes, hotels, malls, warehouses, office buildings or another type of income-producing property. REITs tend to focus on a single type of real estate, and you may see a REIT called an office REIT or health care REIT depending on its specialty.

REITs also fall into three general categories:

  • Equity REITs: Most REITs are equity REITs, which means they own and operate real estate.
  • Mortgage REITs: A mortgage REIT, or mREIT, focuses on financing real estate. It may offer mortgages or buy mortgage-backed securities, and investors can earn money from the interest payments it collects.
  • Hybrid REITs: There are also hybrid REITs, which are a combination of equity REITs and mREITs.

All three types of REITs may be publicly traded, which means you can buy shares on a stock exchange. But there are also non-traded REITs, which are registered with the U.S. Securities and Exchange Commission (SEC) but aren't publicly traded. To invest in these, you may need to work with a broker, meet minimum investment requirements and pay upfront and ongoing fees.

There are also private REITs, which aren't registered with the SEC or publicly traded. These may be primarily available to institutional and accredited investors.

No matter its category or classification, a company has to meet certain requirements to become a REIT. For example, it must pay out at least 90% of its taxable income to shareholders each year. (As an investor, you'll receive these payments as dividends.) The REIT also must invest 75% or more of its assets in real estate or cash, and make most of its income from real estate activity.

How to Invest in a REIT

You can invest in publicly traded REITs through a brokerage account, including tax-advantaged individual retirement accounts (IRAs) or 401(k)s. Buying a share of a REIT is similar to buying a stock in any other publicly traded company, and its price may change throughout the day. The specific fees for trading could depend more on your investment account than the REIT you want to buy.

There are also REIT exchange-traded funds (ETFs) and mutual funds. ETFs are listed on stock exchanges and bought and sold like stocks. You can purchase mutual funds through some brokerage and retirement accounts or directly from a mutual fund company.

There may be important differences between ETFs and mutual funds. But either option lets you easily invest in different REITs, which may decrease your risk by spreading out (diversifying) your investment.

Still, as with any other investment, you're taking a risk when you buy a REIT. The company might not bring in as much profit if it's not able to keep its units full, collect rent, attract new tenants or afford its bills. Over time, it could lose money or even file for bankruptcy, and you could lose your investment.

What Are the Advantages and Risks of Buying a REIT?

REITs may have an appeal as a special type of publicly traded company, and non-traded REITs could also be attractive to eligible investors. But keep these general pros and cons in mind before investing:

Advantages

  • Accessibility: You can invest in real estate without needing to take on the upfront cost or the responsibilities that can come with being a landlord.
  • Liquidity: It's much easier and faster to buy and sell REITs than to buy and sell investment properties.
  • Income: You may receive a steady income stream through dividends, which are often paid out quarterly. Because REITs have to pay out the majority of their profits, the dividend yields on REITs may be higher than on many other stocks.
  • Diversification: The real estate market tends to have a low correlation with the performance of stocks and bonds, which means REITs could go up in value when other parts of your portfolio fall.

Disadvantages

  • Minimum investments: Non-traded, private and mutual fund REITs may have large minimum investment requirements.
  • Taxes: If you hold a REIT in a taxable brokerage account, you may need to pay taxes on all dividend income. The income could be considered ordinary income rather than long-term capital gains.
  • Difficult to understand and trade: It may be hard to buy or sell shares in non-traded and private REITs. It can also be difficult to value the REIT or identify potential conflicts of interest if the REIT has an external manager.
  • Debt and interest rate risks: Partially because REITs have to pay out so much of their earnings, they may need to borrow money to expand their real estate holdings. Rising interest rates can increase the cost of borrowing, which can hurt the REIT's profits.

Learn More About REITs and Investing

If investing in real estate by buying a REIT sounds appealing, the next step could be to take a more in-depth look at specific REITs. The National Association of REITs has a directory of publicly traded REITs that may be a useful starting point.

If you find a REIT—or REIT fund—that aligns with your goals and risk tolerance, it could be a good addition to your portfolio. However, it might still be best to speak with a financial planner who can assess your specific situation and offer you personalized advice.

Before making any investments, make sure your existing financial obligations are taken care of. This includes your retirement plan and emergency fund. Your debt should also be considered—due to interest costs, you might be better off paying down debt before making new investments.

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