What Is a REIT, and Is It a Good Retirement Investment?

Find out the meaning and benefits of a REIT

Commercial real estate in a city.
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Real estate investment trusts (REITs) offer a hands-off opportunity to own property. Understanding what a REIT is and its impact on your retirement portfolio can help you determine whether it's the right choice for you.

REIT Meaning

REITs are companies that own or fund income-generating properties. Individuals can earn a portion of this income by investing in REITs, which share their income with shareholders through dividends.

You can invest in REITs in a few ways:

  • Stocks: Purchase stock in a REIT. This offers a direct method of investment in a REIT.
  • Mutual funds: Buy mutual funds that invest in REITs and real estate companies. This is an indirect method of investment that offers greater diversification in the types of REITs you hold. But you would have to purchase the fund through a mutual fund company.
  • Exchange-traded funds (ETFs): Buy ETFs that own shares of REITs and real estate companies. With ETFs, you also gain indirect ownership of properties and benefit from diversification. You can buy an ETF on the secondary market on which the fund trades.

As investments, REITs resemble mutual funds. What is different about a REIT is that it holds individual properties rather than stocks or bonds. A REIT's management team takes responsibility for acquiring and managing the properties that it owns.

Types of REITs

REITs fall into one of two main categories: equity REITs or mortgage REITs.

Equity REITs, which make up the bulk of REITs, typically own large commercial buildings, retail storefronts, or apartment buildings, although specialty REITs might own hotels or other properties in the hospitality industry. Some REITs focus on long-term care facilities and other properties in the medical industry.

Examples of commercial real estate owned by REITs are large, multi-floor office buildings used as headquarters for medium- to large-sized companies. Many companies lease their store locations rather than owning them.

Rather than own properties, mortgage REITs finance and collect interest on mortgages or mortgage securities related to properties. These REITs may specialize in residential or commercial markets, but some invest in mortgages in both markets.

Pros and Cons of REITs in a Retirement Portfolio

Adding REITs to your investment mix offers several advantages.

You get exposure to a diverse portfolio of properties. Adding real estate can diversify the asset classes in your retirement portfolio without having to manage physical properties yourself. Plus, REITs generally don't correlate with price fluctuations of stocks or bonds. For example, in a falling market, REITs won't necessarily drop at the same rate as stocks.

You can receive income on the underlying real estate. Regulations governing REITs require that a REIT distribute at least 90% of its taxable income to shareholders, which can result in substantial income to shareholders. In addition, U.S. REITs have outperformed other income-producing securities in recent years.

You can reap returns when the properties in the REIT appreciate in value. Domestic REITs performed better than stocks for most of the last decade.

You may be able to hold REITs longer. While stocks and bonds tend to follow business cycles of six years, REITs tend to move with real estate markets that often last a decade or longer. This can make REITs a good option for an investor with a long time horizon until retirement.

They can serve as a hedge against inflation. Research shows that REITs can weather rising prices better than stocks in the medium-term (five years).

You don't have to pay current taxes on REITs in a non-taxable account. If you hold REITs in a tax-deferred retirement account, such as a traditional 401(k) or IRA, you won't be taxed in the current year on the income or gains from a REIT. You will, however, have to pay taxes on distributions you later take from a tax-deferred account. Hold the REIT in a Roth account, and you won't have to pay tax on the distributions in the current year or in later years.

However, investing in real estate through REITs is not without its downsides.

They can be riskier than stock. REITs can be more volatile than U.S. large-cap stocks. And if a REIT primarily holds properties in a certain area that experiences a real estate downturn, the REIT can drop in value, as can the overall value of a retirement portfolio that is heavily invested in REITs. For this reason, it's important to determine what underlying assets a REIT holds before you invest. In addition, REITs work best when they make up no more than 5% of a diversified retirement portfolio; they're not recommended as a single investment that makes up all or a large part of the portfolio.

Current taxes apply to income from REITs in a taxable account. REIT dividends are generally considered non-qualified dividends, which means they are taxed at ordinary income tax rates. These rates are considerably higher than the long-term capital gains tax rates at which qualified dividends from stocks are taxed. For this reason, REITs aren't ideal for inclusion in taxable accounts. In addition, you would incur a short- or long-term capital gain or loss on the REIT when you sell it, which can further increase your taxable income and your overall tax bill that year.

Dividend payouts may fall or stop completely. In tough economic times, a REIT's portfolio of properties may not produce enough rental income. As a result, its dividend payout may be reduced or eliminated.

How to Invest in REITs

You can buy REITs in the same way you would other stocks or funds. That is, you would need to purchase REITs as stocks, mutual funds, or ETFs in the retirement account where you want to hold them.

Publicly traded REITs have a ticker symbol, and you can easily find their share price and dividend yield on the internet through online financial sites such as Yahoo Finance.

In contrast, privately held REITs do not trade on any exchange. Although they are still registered securities, private REITs do not have a ticker symbol. You must buy shares directly from the real estate company offering them or through one of their sales representatives. In addition, they often present a challenge if you need to sell your shares, as no public market for the REIT exists with other buyers and sellers.

Think carefully before investing in private REITs. Many private REITs will have a strategy for when they plan to go public, but it doesn't always pan out. As a result, during an economic downturn, you may not be able to sell an investment for an extended period. Your money would essentially be trapped in the investment.

The Bottom Line

Learning about what a REIT is affords you the opportunity to invest in real estate without managing it. REITs reward you with dividends, which can make them an effective income-producing retirement investment. REIT funds and ETFs promote even greater diversification in your portfolio.

Given that dividends from REITs are usually taxed at a higher rate than stock dividends, it's not wise to include REITs in a taxable account unless you're prepared to foot the tax bill. In a retirement account, the ability to defer taxes in the current year (or avoid them both now and in the future in the case of a Roth account) can make REITs an attractive option.

Moreover, REITs should represent one component in a diversified portfolio. Because of their volatility, they should ideally make up no more than 5% of the portfolio. This allows you to gain exposure to real estate in your portfolio but also minimize risk.