Real Estate Investment Trusts (REITs) offer a way to invest in real estate without buying physical property. They provide regular income through dividends, portfolio diversification, and exposure to various property types. This guide explains how REITs work and how to invest in them effectively.
What Are REITs?
REITs are companies that own, operate, or finance income-producing real estate. By law, they must distribute at least 90% of their taxable income to shareholders as dividends, making them attractive for income-focused investors.
Key benefit: REITs allow you to invest in large-scale real estate like shopping malls, office buildings, and apartment complexes with as little as the cost of a single share.
Types of REITs
Equity REITs
The most common type, equity REITs own and operate income-producing properties:
- Residential: Apartments, single-family rentals, manufactured housing
- Retail: Shopping centers, malls, freestanding retail
- Office: Corporate office buildings, business parks
- Industrial: Warehouses, distribution centers, data centers
- Healthcare: Hospitals, senior housing, medical offices
- Hospitality: Hotels and resorts
Mortgage REITs (mREITs)
These REITs invest in mortgages and mortgage-backed securities rather than physical properties:
- Higher dividend yields but more volatile
- Sensitive to interest rate changes
- Income from interest spread between borrowing and lending rates
Hybrid REITs
Combine elements of both equity and mortgage REITs, providing diversification within a single investment.
Benefits of REIT Investing
1. High Dividend Yields
REITs typically offer yields of 3-8% or higher, significantly more than the average stock dividend.
2. Diversification
Real estate often has low correlation with stocks and bonds, improving overall portfolio returns.
3. Liquidity
Unlike physical real estate, publicly traded REITs can be bought and sold instantly on stock exchanges.
4. Professional Management
REIT management teams handle property selection, maintenance, tenant relations, and financing.
5. Inflation Protection
Real estate values and rents tend to rise with inflation, providing a natural hedge.
How to Evaluate REITs
Funds From Operations (FFO)
FFO is the REIT equivalent of earnings per share:
- Net income plus depreciation minus gains from property sales
- Better reflects actual cash flow than traditional earnings
- Used to calculate price-to-FFO ratio (similar to P/E)
Adjusted Funds From Operations (AFFO)
AFFO is even more refined:
- FFO minus capital expenditures needed to maintain properties
- Better indicator of sustainable dividend-paying ability
- AFFO payout ratio shows dividend sustainability
Valuation Example
REIT XYZ has:
- Share price: $50
- FFO per share: $4.00
- Price-to-FFO: 12.5x
- Annual dividend: $3.00
- FFO payout ratio: 75%
A payout ratio below 80% is generally sustainable for equity REITs.
Net Asset Value (NAV)
NAV estimates what properties would sell for minus liabilities:
- Premium to NAV: Stock trades above estimated property value
- Discount to NAV: Potential value opportunity
- Compare price-to-NAV ratio across similar REITs
Occupancy Rates
Higher occupancy generally means more stable income. Watch for trends in occupancy over time.
Debt Levels
REITs use significant leverage. Check debt-to-equity and interest coverage ratios. Lower leverage is safer but may mean lower returns.
REIT Sectors to Consider
Industrial and Logistics
E-commerce growth drives demand for warehouses and distribution centers. Companies like Prologis dominate this space.
Data Centers
Cloud computing and digital transformation fuel data center demand. These specialized REITs have strong growth potential.
Cell Towers
Infrastructure REITs like American Tower and Crown Castle benefit from 5G rollout and increasing mobile data usage.
Residential
Apartment REITs benefit from housing affordability challenges that keep people renting. Sun Belt markets have shown strong growth.
Healthcare
Aging populations drive demand for senior housing, medical offices, and healthcare facilities.
Risks of REIT Investing
Interest Rate Sensitivity
REITs often decline when interest rates rise:
- Higher rates increase borrowing costs
- Dividend yields become less attractive compared to bonds
- Property values may decline
Economic Sensitivity
Some REIT sectors are cyclical:
- Hotels and retail REITs suffer in recessions
- Office REITs face work-from-home challenges
- Industrial and essential-use properties are more defensive
Concentration Risk
Many REITs focus on specific property types or geographic areas, increasing concentration risk.
Tax Considerations
REIT dividends have unique tax treatment:
- Most dividends taxed as ordinary income (not qualified dividends)
- Pass-through deduction may reduce tax by up to 20%
- Consider holding REITs in tax-advantaged accounts
- Portion of dividend may be return of capital (tax-deferred)
Ways to Invest in REITs
Individual REITs
Pick specific companies based on your research. Offers highest customization but requires more work.
REIT ETFs
Diversified exposure to multiple REITs in one investment. Examples include VNQ, SCHH, and IYR.
REIT Mutual Funds
Actively managed funds selecting REITs. Higher fees but professional management.
Private REITs
Non-traded REITs offering higher yields but with limited liquidity. Suitable for accredited investors with long time horizons.
Track Your REIT Portfolio
Pro Trader Dashboard helps you monitor dividend income and track REIT performance across your portfolio.
Summary
REITs offer accessible real estate investment with high dividend yields and diversification benefits. Evaluate REITs using FFO, AFFO, NAV, and occupancy metrics. Consider sector trends like industrial growth and data center demand. Be aware of interest rate and economic sensitivity. Hold REITs in tax-advantaged accounts when possible, or use REIT ETFs for broad diversification. With proper due diligence, REITs can be a valuable part of an income-focused portfolio.
Learn more about real estate investing with our guides on real estate sector investing and dividend investing strategies.