Buying and renting out a property can help you grow your wealth, but the costs associated with startup and maintenance can make this type of real estate investment prohibitive. Rental properties also begin to veer into active-income territory when you factor in the common challenges of being a landlord, such as late payments, delinquent tenants, lease breakage, and property damage.
Fortunately, there’s an easier, more accessible option for generating real estate passive income. It’s called a real estate investment trust (REIT), and you only need around $100 to start.
Key Takeaways:
- REITs are companies that use investor capital to purchase or finance properties.
- REIT properties generate income that gets distributed as dividends to the investors.
- An Act of Congress broadened the population of investors who could benefit from commercial real estate.
- Most REITs generate income through rent payments from the tenants who lease properties. Mortgage REITs generate income through the interest earned on the mortgages or mortgage-backed securities they purchase or originate.
- A steady dividend stream, easy accessibility, and liquidity, and diversification are key benefits of investing in REITs.
What Is a REIT?
A REIT is a company that owns, operates, or finances real estate that generates income. You can think of a REIT as a mutual fund but with real estate. Investors pool their money into buying a portfolio of assets — in this case, properties — and in return, they receive dividends on the income the assets yield.
The History of REITs: A Boon for Small Investors
The history of REITs is tied to making real estate passive income accessible to a larger population. In 1960, Congress enacted the REIT Act to authorize REITs to allow large and small investors to access the advantages of income-generating real estate. Such benefits were previously only for large financial organizations and the wealthy. Later, the Tax Reform Act of 1986 broadened the scope of REITs by allowing them not only to own and finance properties but also to manage them.
Malls and shopping centers were the first property types to get packaged into REITs. The 70s and 80s saw the addition of lodges, resorts, apartments, warehouses, distribution and storage facilities, office buildings, and racetracks. Since then, REITs have come to own or manage all types of commercial properties. According to the National Association of Real Estate Investment Trusts, approximately 45% of American households directly or indirectly own REIT stocks via mutual, exchange-traded, or target-date funds. REITs have expanded beyond American borders and are now available in 40 countries.
Types of REITs
The two main categories of REITs are equity REITs and mortgage REITs. Equity REITs fit the fundamental definition of REITs: companies that own or operate income-generating real estate. In contrast, mortgage REITs don’t directly own income-generating real estate but provide financing.
You can also classify REITs by sector, as they tend to specialize in particular property types. The primary REIT sectors are as follows:
- Retail: Large commercial operations, such as malls, outlets, and shopping centers, are the purview of retail REITs. Most such establishments are likely REIT-owned or operated.
- Residential: A residential REIT specializes in properties such as multifamily apartment buildings, single-family homes, manufactured homes, and student housing.
- Health care: The property types you may find in the portfolio of a health care REIT are hospitals, skilled nursing facilities, senior living facilities, and medical office buildings.
- Office: Office REIT portfolios include a diverse range of office properties, including office parks and skyscrapers.
- Lodging: A lodging REIT might own or manage hotels or resorts or rent specific spaces within such properties.
- Self-storage: A REIT that specializes in self-storage owns and manages storage facilities.
- Industrial: With industrial REITs, the properties are primarily facilities associated with manufacturing and production, such as distribution centers and warehouses.
- Infrastructure: Examples of properties that an infrastructure REIT might own are telecommunications towers, energy pipelines, fiber cables, and wireless infrastructure.
- Datacenter: In addition to owning or managing facilities for data storage, data center REITs might also specialize in products and services for protecting that data and the servers that store it.
- Specialty: A specialty REIT specializes in properties that don’t quite fall under other sectors, such as casinos, movie theaters, advertising sites, and farmland.
Aside from sector-specific trusts, there are also diversified REITs, whose portfolios combine property types. Rather than focus their holdings in a particular sector, they own and manage real estate across various sectors.
How Do REITs Generate Income?
Broadly speaking, a REIT generates income the same way a landlord does. After purchasing or leasing a property, the REIT leases it to a tenant, and the tenant pays regular rent to the REIT. A single REIT can own or finance many properties and receives money from many renters across multiple property types. The REIT then pays out at least 90% of its taxable income to its investors through dividends.
Mortgage REITs are an exception to the general model. Because mortgage REITs have no direct real estate ownership, they generate income by purchasing or originating mortgages and mortgage-backed securities and then earning interest on such investments.
What Are the Advantages of Owning REIT Stock?
There are several good reasons to include REITs in your stock investment portfolio:
- A steady cash flow: REITs tend to be stable and consistent, so you can expect to receive a reliable stream of annual dividends for as long as you remain an investor.
- Diversification: Though you purchase shares of a REIT through a stock exchange, every share you own gives you a larger presence in the real estate market. The diversification benefits arise from the tendency of REITs to follow the typical 10-year real estate cycle, which offsets the shorter terms of the bond and real estate markets.
- Accessibility and liquidity: Most REITs trade on public exchanges, so buying and selling shares is simple. And you can buy a share for around $100. Camden Property Trust, for example, is a residential REIT that has traded for as low as $99 in 2023. Such accessibility and liquidity aren’t typical of other forms of real estate investment.
Are There Any Downsides to Investing in REITs?
Yes. REITs, like any investment, carry some risks and opportunity costs. One major issue of all REITs is their limited capital appreciation. Remember, REITs pay out at least 90% of their taxable income to their investors, so only 10% is available for reinvestment, putting a tight belt on their potential to buy new income-generating holdings. Additionally, the dividends you receive as an investor are taxed as regular income, and you may have to pay steep management and transaction fees.
How To Invest in REITs
Investing in a REIT is no more complicated than buying public stock. You can look at major stock exchanges and purchase shares of a publicly traded REIT through a broker. There are also non-traded REITs, which aren’t available through the major stock exchanges. You’ll need to consult with a broker or financial adviser specializing in non-traded investments.
REITs are accessible as mutual, exchange-traded, or target-date funds. Many investors invest in REITs through such funds via their 401(k)s, individual retirement accounts, pension plans, and Thrift Savings Plans.
Gain Both Knowledge and Passive Income
That’s a lot to take in about REITs, but there’s much more to learn. If you’re interested in growing your understanding of how REITs can fit into your investment strategy, give some thought to signing up for our 360 Pro membership. With it, you’ll gain a wealth of resources that can help you generate more income, including group coaching, summit attendance, and access to turnkey rental properties. Earning passive income from real estate is within your reach. Let us help you grasp it.
