What is a Real Estate Investment Trust?

You know there are lots of ways to invest your money and build wealth. Stocks, bonds, mutual funds, art, rental property….these are just a few of them. Of course, rental property is my personal favorite, and it’s the bread and butter for nearly all of the investors I work with. But that doesn’t mean you shouldn’t explore other types of investments, and one of them is the real estate investment trust.

This is a type of investment that operates similarly to a mutual fund, but has some unique characteristics that set it apart. In a nutshell, real estate investment trusts, or REITs, own large portfolios of properties. These are typically commercial properties, such as office buildings, hospitals, shopping malls, or apartment complexes. From the REIT, investors can purchase shares and acquire ownership. The investment pays off when lessees pay rent each month, and that money is divided and passed on to investors in the form of dividends.

To qualify as an REIT, there are certain guidelines that a company must meet. First, at least 75% of their assets must be invested in real estate, cash or U.S. Treasuries. Second, at least 75% of the company’s gross income must be derived from rent, mortgage interest payments, or real estate sales. Third, 90% minimum of the company’s taxable income must be paid out to investors each year. Those are the primary guidelines that define an REIT, but there are a few others that must be met as well. The REIT must have at least 100 shareholders, and it also must be an entity that is taxable as a corporation, to name a couple more.

Once these criteria are met, REITs are categorized into one of three classes: equity, mortgage, or a combination of both. Equity REITs are the most common, and these are the ones that invest in real properties which produces income that is then passed onto shareholders. As the name implies, mortgage REITs invest in mortgages, and dividends are paid to shareholders through the interest that is received off these notes. The third type of REIT is a hybrid of the other two, where both real property and mortgages are owned.

So what are the pros and cons of investing in an REIT? Some of the advantages include: the 90% minimum payout I mentioned earlier, which means that the REIT’s board of directors can’t decide to cut dividends and take a bunch of money for themselves; diversity in your investment portfolio; higher yields than traditional stocks; liquidity; REITs own tangible assets that usually appreciate in value; and, ownership in real estate without the hassles of ownership.

Disadvantages of REITs include: limited control over investments (i.e., you don’t have the power to make changes to properties that could affect your profits); you may pay more in taxes as some dividends may be taxed as ordinary income; and, vacancies and/or falling property prices will negatively affect dividend payouts.

If you do decide to invest in an REIT, it’s fairly simple to do so. Many are traded on major exchanges, just like traditional stocks and other securities. You can choose to invest in REITs directly, or through mutual funds that include public real estate. Your financial advisor can also help connect you with resources and investment options.

So, that’s basically what you need to know about real estate investment trusts. They can make a good addition to a diversified portfolio, so if that’s one of your investment goals, you should definitely look into them further. If you’re more of a “get your hands dirty” type of person, then owning your own properties using a turnkey provider or another strategy might be a better option for you. But remember, it never hurts to explore everything that’s out there, and the most successful investors are the ones who do this.