Buying real estate investment trust (REIT) shares provides investors with a convenient way to invest in land and buildings while receiving income and capital appreciation. AEEAPs own and finance real estate and pay out 90% of their rental, interest and capital gains income as dividends. While REITs tend to generate reliable income, they are subject to real estate boom and bust cycles and are also sensitive to changes in interest rates. A financial advisor can help you decide if a REIT fits your goals and risk profile, and which type of REIT would be best for you.
The first REITs appeared in the 1960s after the US Congress authorized them as a way to allow investors to participate in the real estate business. In exchange for agreeing to pay out 90% of taxable income as dividends and meeting other restrictions, REITs are allowed to avoid paying the double federal income tax imposed on corporations. Instead, dividends pass tax-free to investors, who usually pay taxes on the income at their normal individual rates.
Advantages of REITs
Diversification is one of the main benefits of REIT investing. Real estate generally has a low correlation with other financial assets, such as stocks and bonds, and holding them can help portfolios weather market conditions. However, many investors are reluctant to take on the responsibility of directly owning and managing real estate. REITs allow them to diversify without the burden of collecting rents, maintaining and repairing residential and commercial properties.
Beyond that, REITs are valued for their high dividend payouts. REITs provide some of the highest dividends available in the stock market. The average REIT dividend payout in May 2021 was 3.16%, according to the National Association of Real Estate Investment Trusts (NAREIT), compared to the average S&P 500 stock dividend of 1.34%.
Types of REITs
REITs are divided into two types: equity and mortgage. Equity REITs own and typically manage real estate. Mortgage REITs are involved in real estate financing but do not own real estate. Equity REITs are divided into the types of properties in which they specialize. Most REITs operate in apartments, manufactured homes, office buildings, shopping centers and industrial properties. Others own healthcare facilities, self-storage projects, hotels and other types of real estate. Equity REITs derive much of their income from long-term leases. They also create capital gains when they sell properties at a profit.
Mortgage REITs, also known as mREITs, do not own property. Instead, they buy mortgages from lenders and generate income by collecting the mortgage payments. MREITs tend to have higher payouts than equity REITs, but are also considered riskier as they are more sensitive to interest rate trends.
About a quarter of equity REITs are in retail, with malls, stores and shopping centers, as well as properties that house restaurants and other service businesses. The number of indoor shopping centers is in a long-term decline, which is expected to continue. Competition from online sellers has also put pressure on many other brick-and-mortar retailers. As a result, with the exception of REITs specializing in convenience stores, discount stores, and service providers such as auto repair shops, retail is considered one of the riskiest REIT sectors.
Disadvantages of REITs
One of the disadvantages of REIT investing is that dividends received by shareholders are generally taxed as ordinary income. Other dividends from regular companies are usually taxed at the capital gains rate, which for most people is 15%. Ordinary income tax rates are usually higher, meaning that most REIT dividends create a greater tax liability than other dividends. About three-quarters of REIT dividends are considered ordinary income, according to NAREIT.
While REIT dividends tend to be stable over the long term, overall performance, including price changes, can vary significantly. Sometimes REITs can reduce a portfolio’s performance. In 2020, for example, equity REITs experienced an average loss of 5.1%, according to NAREIT. The Russell 1000 market index, meanwhile, returned 21%. And when interest rates rise, mortgage REITs often cut their dividends.
How to buy REITs
REITs are listed on major exchanges, including the New York Stock Exchange and Nasdaq. They trade just like common stocks and are easy to buy using a traditional or online brokerage or online trading platform. Unlike owning real estate, which can be illiquid, owning a REIT offers the same liquidity as other stocks
Choosing a REIT to invest in can involve significant research, including evaluating the rental income and length of leases on the underlying property. Another way to go is to invest in a REIT fund or an exchange-traded fund. These provide a high degree of diversification along with the same liquidity advantages of REIT shares. Because of the substantial income generated by REIT shares, investors may choose to hold them in a tax-advantaged account, such as an IRA, in order to defer taxes.
REITs are widely valued by investors looking for convenient real estate diversification and reliable income. Shares are easy to buy and sell and offer some of the highest dividend payouts of all stocks. However, investors typically pay their individual income tax rates on REIT dividends, and REITs are also subject to the boom and bust cycle of the overall real estate industry. It’s also important to understand the different types of REITs to ensure that whichever one you invest in fits your goals and risk profile.
REITs are taxed and valued differently than other stocks, and making a smart REIT investment requires knowledge of the industry and its many variables. That’s where a financial advisor can be instrumental in your success. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors to help you reach your financial goals, get started now.
Before you start investing, you should choose securities that suit your risk tolerance. You can determine your risk tolerance by assessing your comfort level in certain investments.
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