What Is a Real Estate Investment Trust (REIT)?

Your 401(k) is maxed out. You’ve got your Roth IRA humming along. Your retirement is looking pretty sweet, but you want more. You’ve heard that investing in real estate is a good idea, and maybe you read somewhere that a real estate investment trust (REIT) is a great way to get into that space.

But what is a REIT? How does it work? Well, buckle up, and we’ll take you through it.

What Is a REIT?          

A real estate investment trust—the cool kids call it a REIT, pronounced “reet”—is basically a mutual fund that buys real estate instead of stocks. REITs have a special tax status that requires them to pay 90% of their profits back to the shareholders.¹ This payment is called a dividend. If they follow this rule, then they aren’t taxed at the corporate level like every other type of business.

All REITs have to meet certain requirements to qualify:

• Must be a trust, association or corporation
• Must be managed by at least one official trustee or director
• Must have at least 100 shareholders
• No five of these shareholders may own more than 50% of the shares²

There are also rules around how much of a REIT must be invested in actual real estate properties and how much of the gross income from the REIT must be generated by real estate.

Is your head spinning yet? Well, REITs are actually one of the easiest ways to invest in real estate, but they can certainly get pretty complicated. There’s a lot to learn here.

What Types of REITs Are There?

There are a handful of different types of REITs out there, which can make things feel even more complicated. So let’s unpack the differences below.

Equity REITs

Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.

Some of these types may be:

• Apartment complexes
• Single-family homes
• Malls
• Big-box retail space (a shopping center featuring at least one big store like Best Buy or Home Depot)
• Hotels and resorts
• Health care buildings and hospitals
• Long-term care facilities
• Self-storage facilities
• Office buildings
• Industrial buildings
• Data centers
• Mixed-use developments

Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.

Now, equity REITs make money for their investors in several ways:

• Rent: They make the most money by collecting rent from tenants on the property they own.
• Appreciation: As the property values go up, the values of the shareholders’ investments grow too.
• Strategic purchasing: They make money by buying low and selling high.

Mortgage REITs

Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates. To maximize returns, mortgage REITs tend to use a lot of debt—like $5 of debt for every $1 in cash, and sometimes even more.

Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates.

Okay, this gets complicated, so let’s put it in numbers to try to simplify it. Let’s say a mortgage REIT raises $1 million from investors. It then borrows $5 million at a 2% short-term interest rate. This gives it $100,000 in annual expenses that it has to pay back. But it takes the $6 million in cash it now has to buy a bunch of mortgages owing 4% interest, which produces $200,000 in interest income for the REIT. This difference ($100,000 in our example) is the profit.

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Because you’re smart, you may be asking yourself, What happens if the short-term interest rate goes up?

Any increase in the short-term interest rate eats into the profit—so if it doubled in our example above, there’d be no profit left. And if it goes up even higher, the REIT loses money. All of that makes mortgage REITs extremely volatile, and their dividends are also extremely unpredictable.

Non-Traded REITs

Now, some REITs aren’t publicly traded on national stock exchanges. Non-traded REITs might still be registered with the Securities and Exchange Commission (SEC), but you won’t find them available for trade on the stock market.

A big risk here is that it can be very hard to know the value of a non-traded REIT until years after you’re invested.³ So if it’s a dud that’s losing your money, you won’t know for a long time. Another knock on these REITs is that they usually come with higher up-front fees—sometimes totaling around 10% of your investment—that can significantly lower the value of your investment.⁴ Yikes!  

Private REITs

A private REIT is neither registered with the SEC nor available for trade on stock exchanges.⁵ If you invest in one, be prepared to forget you had that money. They’re usually illiquid—a fancy term that means an investment can’t be easily turned back into cash. To get the best returns, you probably won’t have access to the money for a long time. That makes it very difficult to get out of a private REIT once you’re in one. It’s not as easy as selling a mutual fund.

For a private REIT to work for you, you’d need to be in a group that isn’t milking the REIT for their profit and driving up management fees—leaving nothing on the table for investors. Beware! This is risky stuff.

Hybrid REITs

A hybrid REIT is basically a combination between an equity REIT and a mortgage REIT—meaning the fund has company-owned properties and mortgage loans as well.

This might sound like a smart and balanced way to invest in REITs. But in many cases, hybrid REITs will lean more heavily toward one type of investment over the other. This means you need to be very careful when looking at hybrid REITs—especially if they look more like those mortgage REITs we talked about earlier that borrow a lot of money to try to generate profits for investors. That’s a dangerous game—one you should try to avoid.  

Pros and Cons of Investing in REITs

Just like with most investments, investing in REITs comes with both risks and benefits—and it’s important to know what those are before you even think about investing your hard-earned money in them. Let’s walk through those together:

Pros

• They can help you diversify your investments. REITs give you the chance to add real estate to your investment portfolio—without the headaches that come with owning rental properties.  

• Some offer higher dividends than other investments. Dividends are payments made to investors to reward their investment and share the profits with them. Since REITs are required to pay out most of their taxable incomes to shareholders, that means you could receive more in dividend income from REITs than other types of investments.

• They pay no corporate tax. Since REITs don’t pay corporate income taxes, investors don’t have to worry about “double taxation.” (But you’ll still pay ordinary income taxes on the dividends you get and capital gains when you sell your REITs at a profit—it’s a good idea to talk to a tax pro before you invest in REITs.)

• They are professionally managed. Like actively managed mutual funds, REITs are usually managed by a team of professionals who know the real estate industry inside and out and can make sure that the properties inside of the fund are being maintained and managed for high returns.

Cons

• Interest rates can be volatile. Since real estate values tend to go up and down depending on what the interest rates are, the same rule applies to REITs. Rising interest rates can jack up the cost to take out a mortgage loan and put a damper on demand for real estate—and that could negatively affect the value of a REIT in the process.
   
• Some REITs use debt to invest in real estate. If you remember nothing else, remember this: debt equals risk. And mortgage REITs almost exclusively use debt to build their fund, which means they are very risky. That’s a no-no.
   
• Some REITs are hard to sell quickly. Since non-traded REITs can’t be sold on the open market, they’re considered “illiquid investments”—which is just a fancy way of saying they can be hard to get rid of if you want to sell.

• They don’t give you any control. When you invest in a REIT, you’re giving up control over to the REIT's management team. They’ll be the ones deciding which properties to invest in and how to manage those properties—you’re just along for the ride.

How Do I Invest in a REIT?

There’s no secret formula here—anyone can invest in a REIT by simply purchasing shares through a broker, a REIT exchange-traded fund (ETF) or a REIT mutual fund. Basically, it’s the same process you would go through buying mutual funds or single stocks.  

But that’s only if the REIT is publicly traded. For a non-traded or private REIT, you’d have to purchase shares through a broker that’s associated with a non-traded REIT.⁶

Is a REIT a Good Investment?

It depends. REITs have come a long way over the past decade, and now they’re a legitimate way to invest in real estate if you have no interest in being a landlord. But they’re not for everyone, and there might be better ways for you to invest in real estate. 

First off, you should only consider investing in REITs once you reach Baby Step 7 and you’ve maxed out your tax-advantaged retirement accounts—like your 401(k) and Roth IRA. Until then, stick with the four types of growth stock mutual funds we recommend for retirement investing, which offer the most balanced growth over time.

Second, REITs run the spectrum from really bad to awesome, so you have to do your homework before you invest in one.

Mortgage REITs, for example, are a terrible idea. They use debt to buy debt, and they’re so risky you don’t want to come within 50 miles of one. What happens when interest rates go up? You lose money. What happens when people stop making their house payments? A REIT can probably withstand one or two homeowners who bail on their mortgages. But if we get into a situation similar to 2008 when millions of people lost their homes? Forget it.

If you are going to invest in a REIT, an equity REIT is probably the way to go. Since they own and manage the properties inside the fund, they aren’t as risky as mortgage REITs, they’re registered with the SEC (unlike private REITs), and they offer more transparency than non-traded REITs. Plus, you might find a handful that perform as well as good growth stock mutual funds.

Ultimately, you want to choose a fund with a long track record of strong returns that’s run by a competent group of investors. And remember that your REIT investments should be no greater than 10% of your net worth.   

But before you dive headfirst into real estate investing with REITs, make sure you talk to an investment professional first. One of our SmartVestor Pros can walk you through all the pros and cons and help you find REITs that might be a good fit for your investment portfolio.

Investing in Real Estate the Old-Fashioned Way

When you invest in a REIT, you don’t have any control over which properties they buy, how the properties are managed, or any decisions made about those properties. If you want more control over the real estate you own, then you should just buy your own properties.

Real estate is a great investment, but you need to know what you’re doing, and you should be passionate about it. Start by learning about real estate from a pro who has earned the right to be called RamseyTrusted—like one of our real estate Endorsed Local Providers (ELPs).

A RamseyTrusted real estate agent can educate you about the types of properties you can buy and what types of renters you can expect. They can help you get a deal. In real estate, money is made at the buy. Our agents can teach you to be patient so you can buy real estate like a pro—for pennies on the dollar.

To invest in real estate the smart way and keep your financial risk low, you need to answer yes to the following questions before you start investing:

• Are you completely debt-free?
• Do you have an emergency fund of at least 3–6 months of expenses?
• Are you contributing 15% of your income to retirement?
• Are you able to pay cash for your investment property?

And because HVACs break down and garbage disposals stop working, it’s a good idea to have money set aside for upkeep and repairs. As a landlord, that’s up to you.

How Traditional Real Estate Investing Makes Money

Just like with REITs, you’ll make money several ways as the owner of an investment property. You’ll make money over the long term as the value of your property increases—especially when you buy a house at a low price, then ride out any downturns in the market, and sell it when the value has gone up. And if you reinvest your profits into another similar property within a certain period of time, the 1031 exchange allows you to avoid paying capital gains tax.

You also make money with rental income. This is why most investors buy property. Once you get a quality renter, your property will generate monthly income without too much effort on your part. Heck, you can even hire a property management company to handle repairs and maintenance for you, although that will cut into your profits.

Just keep in mind that dealing with renters can sometimes be unpleasant and time-consuming. And they can cost you a lot of money if they damage the property. Evicting a renter can be a headache too. Depending on the laws in your area, it may require you to hire a lawyer. But if you’re prepared, the long-term benefits can be pretty sweet.

Are You Ready to Buy Some Real Estate?

Whether you want to explore the possibility of adding REITs to your investment portfolio or want to invest in real estate the old-fashioned way, you’re going to need some pros in your corner who can guide you through all your options.

Our SmartVestor program can help you find a financial advisor or investment professional who can answer all your questions about REITs so you can decide whether they have a place in your investment strategy or not. 

Or if you’re passionate about owning investment property, now is a great time to talk to one of our RamseyTrusted real estate agents. They’re experts at buying property in your area, they put serving you above commission, and they’ll educate you on all of the ins and outs of buying real estate.

Find a top real estate agent near you!