REITs: Owning Real Estate for the Rent

Most people will never own an office tower, a shopping center or a network of cell towers. But anyone with a brokerage account can own a slice of all three through a REIT, and collect a share of the rent. That’s exactly what REITs were created for.

What a REIT is

A real estate investment trust (REIT, pronounced “reet”) is a company that owns, and usually operates, income producing property. In 1960 Congress created the REIT structure so that ordinary investors could own big commercial properties the way mutual funds let them own a basket of stocks.

The deal Congress offered was simple. If a company meets the REIT rules, it pays no corporate income tax on the profit it hands to shareholders. The biggest rule is the payout.

The rules

That 90% rule is why REIT yields are usually well above the market. A typical company might pay out 40% of its profit. A REIT pays out at least 90% of its taxable income, and taxable income is often far below the cash its buildings produce, thanks to depreciation. More on that in How to Analyze a REIT: FFO, AFFO and More.

How REITs earn their rent

A REIT’s income comes from leases, and the type of lease matters a lot:

• Net leases (often “triple net”): the tenant pays the property taxes, insurance and maintenance. The landlord collects a steady, predictable rent, usually rising a little each year, often on leases of ten years or more. Realty Income, which rents buildings to drugstores, grocers and convenience stores, works this way.
• Gross or short leases: apartments, hotels and self-storage units re-price often, sometimes monthly. Rent can rise quickly when demand is strong and fall quickly when it isn’t.

How REITs grow

Here’s the catch with paying out almost everything: there’s little left to buy new buildings. So REITs grow by raising money, issuing new shares and borrowing, and buying properties whose rent yields more than that money costs.

This is the deeper reason REITs are so sensitive to interest rates. Higher rates don’t just make their dividends look less attractive next to bonds; they make growth itself harder. We explore that in Interest Rates and Dividend Investing.

Listed, non-traded, equity and mortgage

Some well known REITs, live

Notice the range. Fast growing REITs that own data centers or medical buildings can yield under 2%, while slower growing landlords yield 5% to 8%. The same logic you learned for stocks applies: a lower yield often comes with faster growth, and an unusually high one deserves a question. The next lesson tours the property types: The Different Kinds of REITs.