REITs Explained: How to Invest in Real Estate Without Buying Property

Real estate has long been one of the most popular ways to build wealth, but buying property comes with big hurdles: large down payments, mortgages, maintenance, tenants and the responsibilities of being a landlord. Real estate investment trusts, or REITs, offer another path. They let everyday investors own a piece of large, income-producing properties without buying a building or answering a tenant's late-night call about a broken water heater.

What a REIT is

A REIT is a company that owns, operates or finances income-producing real estate. REITs own an enormous variety of properties, including apartment buildings, shopping centers, office towers, warehouses, hotels, hospitals and senior housing, self-storage facilities, data centers and even cell towers.

When you buy shares of a REIT, you own a small piece of that company and, indirectly, the properties it holds. As the properties generate rent and other income, the REIT passes much of that income on to shareholders.

Why REITs pay dividends

REITs are known for paying regular dividends, and there's a specific reason. To qualify as a REIT under federal tax law, a company generally must distribute at least 90% of its taxable income to shareholders as dividends each year. In exchange, REITs generally don't pay corporate income tax on the income they distribute, which avoids the double taxation that applies to many other corporations.

This structure makes REITs attractive to investors who want income, such as retirees, as well as those who want exposure to real estate as part of a diversified portfolio.

Types of REITs

REITs come in several varieties. Equity REITs, the most common type, own and manage properties and earn money mainly from rent. Mortgage REITs don't own properties directly. Instead, they lend money to real estate owners or buy mortgages and mortgage-backed securities, earning income from interest. Mortgage REITs can be more sensitive to changes in interest rates.

REITs also differ in how they're traded. Publicly traded REITs are listed on major stock exchanges and can be bought and sold throughout the trading day, just like stocks. Non-traded REITs are registered with the SEC but aren't listed on exchanges. The SEC has warned investors that non-traded REITs can be difficult to sell, may have limited opportunities to redeem shares and can charge high upfront fees. For most individual investors, publicly traded REITs offer more flexibility and transparency.

Ways to invest in REITs

There are several ways to add REITs to your portfolio. You can buy shares of individual REITs through a brokerage account, which lets you choose specific property types or companies. But picking individual REITs concentrates your risk in a few companies.

For broader diversification, many investors use REIT index funds or exchange-traded funds, which hold many REITs at once across different property types and regions. It's also worth knowing that many total stock market index funds already include some REITs, so you may already own some real estate exposure without realizing it.

Risks to understand

Like any investment, REITs carry risks. REIT prices can rise and fall with the broader stock market, sometimes sharply. They can also be sensitive to interest rates. When rates rise, REITs can face higher borrowing costs, and their dividends may look less attractive compared with bonds and other income investments, which can weigh on prices.

Certain property types can struggle when the economy or society changes. For example, office buildings and shopping malls have faced challenges as work and shopping habits have shifted. Dividends aren't guaranteed, either. REITs can reduce or suspend dividends if their income falls.

How REIT dividends are taxed

Taxes are an important consideration with REITs. Because REITs generally don't pay corporate tax on distributed income, much of their dividend income doesn't qualify for the lower tax rates that apply to many regular stock dividends. Instead, REIT dividends are often taxed as ordinary income, though some may receive other tax treatment depending on their source.

Because of this, some investors prefer to hold REITs in tax-advantaged accounts, such as IRAs or 401(k)s, where dividends can grow without being taxed each year. Tax rules can be complex and change over time, so check IRS guidance or consult a tax professional about your situation.

Where REITs fit in a portfolio

REITs can play a useful role in a diversified portfolio, offering exposure to real estate, potential income and diversification beyond traditional stocks and bonds. Many investors keep REITs as a modest portion of their overall investments rather than a large concentration. As with any investment, consider your goals, time horizon and risk tolerance, and remember that diversification across many types of investments is one of the most reliable ways to manage risk.