Real estate has long been considered one of the most reliable ways to build wealth. Traditionally, owning property required significant capital and management responsibilities. However, thanks to real estate investment trusts (REITs), regular investors now have the chance to tap into the lucrative real estate market with less capital and more flexibility. In this article, we’ll unpack in-depth how real estate investment trust works, explore their advantages and risks, and explain how to start investing in REITs.
What Is a Real Estate Investment Trust (REIT)?
A real estate investment trust, commonly referred to as a REIT, is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool money from many investors and use that capital to invest in a portfolio of real estate assets, which can include apartment complexes, shopping malls, office buildings, hospitals, hotels, warehouses, and more.
To qualify as a REIT, a company must meet several requirements established by law, which are designed to ensure the bulk of its assets and income are connected to real property. The most notable requirement is that a REIT must distribute at least 90% of its taxable income to shareholders annually in the form of dividends.
How Real Estate Investment Trust Works: The Basics
Let’s break down how real estate investment trust works step by step:
1. Pooling Investor Money
A REIT starts by gathering capital from both individual and institutional investors. This pooling mechanism allows even small investors to participate in large-scale property investments that would typically be out of reach.
2. Acquiring or Financing Real Estate
Once funded, the REIT uses the pooled capital to invest in a diversified portfolio of properties. Some REITs own the real estate (equity REITs), some only finance properties through mortgages or loans (mortgage REITs), and some do both (hybrid REITs).
3. Generating Income
Properties owned or financed by the REIT generate income, usually in the form of rent payments from tenants or mortgage interest payments from borrowers.
4. Distributing Dividends
By law, a REIT must pay at least 90% of its taxable income to investors as dividends. This is one of the primary reasons why investors are drawn to REITs: their potentially high and regular dividend payments.
5. Trading Like Stocks
Most REITs are publicly traded on major stock exchanges, which means investors can buy and sell shares just like any other company. This liquidity is a key advantage over direct property investments, which can take months to buy or sell.
Types of REITs: How Does Each Work?
To fully understand how real estate investment trust works, it’s essential to distinguish between the main types:
Equity REITs
- They own and operate income-producing properties (think malls, apartments, hotels).
- Revenue primarily comes from leasing space and collecting rents.
- Most REITs fall into this category.
Mortgage REITs (mREITs)
- Instead of owning properties, they provide financing through mortgages or invest in mortgage-backed securities.
- Their income stems from interest earned on these financial assets.
Hybrid REITs
- Combine aspects of both equity and mortgage REITs.
- They own properties and invest in real estate loans.
Key Advantages of Investing in REITs
- Diversification: Because REITs typically own a portfolio of properties, investors reduce their risk compared to owning a single building.
- Regular Income: With a legal obligation to distribute the bulk of earnings, REITs are attractive for investors seeking steady income through dividends.
- Liquidity: Publicly traded REITs can be bought and sold easily through brokerage accounts, offering much greater liquidity than direct real estate holdings.
- Accessibility: Individuals can start investing in real estate with relatively little money. Many REITs have low entry points, sometimes less than $100.
- Professional Management: Properties are managed by experienced professionals, removing the headaches of being a landlord.
Risks and Considerations
Like all investments, real estate investment trusts carry risks. Here are some to consider:
- Market risk: REITs can fluctuate with the stock market and real estate market cycles.
- Interest rate risk: Rising interest rates may hurt REIT share prices as borrowing costs increase and other income investments become more competitive.
- Property-specific risk: The success of a REIT depends on the occupancy rates, tenants’ financial health, and property location.
- Tax implications: REIT dividends are usually taxed as ordinary income rather than qualified dividends.
How to Invest in a REIT
If you’re interested in how real estate investment trust works for your portfolio, you have several options:
- Buy Individual REITs: Purchase shares of companies listed on the stock market that are structured as REITs.
- REIT Mutual Funds & ETFs: Invest in funds that hold a collection of different REIT stocks for easy diversification.
- Non-Traded REITs: These are not listed on public exchanges and can be illiquid but may offer different risk/reward profiles.
Most investors start with publicly traded REITs or REIT ETFs, as they’re easy to buy and sell and provide transparency.
How REITs Are Taxed
A critical aspect of how real estate investment trust works is taxation. The IRS requires REITs to pay out most of their income, allowing them to avoid corporate taxes. However, the dividends you receive are typically subject to ordinary income tax rates, not the lower qualified dividend rates.
Some REIT dividends may qualify for the 20% pass-through deduction under the Tax Cuts and Jobs Act, so consulting with a tax advisor is recommended.
Bottom Line: Should You Invest in REITs?
Understanding how real estate investment trust works helps you decide if this asset is right for your investment goals. REITs offer a unique combination of liquidity, diversification, and income potential—making them an attractive choice for investors who want exposure to real estate without the hassle of direct property management.
Whether you’re a seasoned investor or just starting, REITs provide a way to participate in one of the world’s largest asset classes — the real estate market — with comparatively low capital, low effort, and often steady returns.
Want to learn more about investment strategies? Explore our latest guides on real estate, stocks, and alternative assets!