REIT Fundamentals: How REITs Work, Their Benefits and Risks

From lending to landlording

The bond unit was about lending. You handed money to a government or a company, they paid you interest, and at maturity you got your principal back. Everything you owned was somebody else's promise to pay.

This unit is about the other two ends of an income portfolio: property and cash. Property first.

Video coming soon

This lesson explains the idea in full without it.

What a REIT actually is

A REIT owns real estate that pays: apartment complexes, warehouses, offices, medical buildings, hotels, storage units, even portfolios of single-family rentals. Tenants pay rent. The REIT covers the costs of running the properties and pays interest on its debt. What's left flows out to shareholders as dividends.

The share trades on an exchange like any stock. You can buy one share, sell it Tuesday, and nobody asks you about a roof. That's the pitch, and it's a genuinely good one: real estate income at the price of a share instead of the price of a building.

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Most REITs specialize. One owns nothing but hospitals; another owns nothing but self-storage. The industry isn't spread evenly across property types — a handful of them carry most of the money, and which ones are largest shifts over the years as the economy changes what kind of space people need. That lopsidedness matters later, when we talk about concentration.

The rule that makes REITs pay

Here is the engine of the whole thing, and it isn't a business strategy. It's tax law.

A company only gets to be treated as a REIT if it meets a set of tests written into the tax code. It must distribute at least 90% of its taxable income to shareholders every year. It must hold at least 75% of its assets in real estate, cash and cash items, and government securities, and earn at least 75% of its gross income from real estate sources. Meet the tests and the company largely escapes tax at the corporate level — the income is taxed once, in your hands, instead of twice.

That distribution requirement is why REIT yields look the way they do. A REIT isn't being generous. It's paying you because it has to.

Now follow the consequence, because most people stop at the yield and miss it. A company that pays out nearly everything it earns keeps almost nothing. An ordinary business funds a new factory out of retained profit. A REIT can't — the profit already left. So when a REIT wants to buy another property, it has two options: issue new shares, which divides ownership among more people, or borrow, which adds debt and interest.

That's why REIT balance sheets carry more debt than most companies, and why REITs come back to the market to sell shares more often than most companies do. Neither is a scandal. It's the arithmetic of a business that isn't allowed to keep its earnings. But it does mean two things follow you through the rest of this unit: REITs are sensitive to what borrowing costs, and your slice of the company can get smaller over time even when the business does well.

Equity REITs and mortgage REITs are not the same investment

An equity REIT owns property and collects rent. It buys buildings, leases the space, maintains them, sometimes improves or develops them. When you picture a REIT, this is what you're picturing. The vast majority of REITs are equity REITs.

A mortgage REIT owns no buildings at all. It holds real estate loans — lending to property owners, or buying securities backed by mortgages. It makes money on the gap between what it pays to borrow and what it earns on the loans it holds, and it borrows heavily to widen that gap.

Read that again, because it's the trap. A mortgage REIT is not a way to own property. It's a leveraged bet on interest rates wearing a real-estate name. When short-term borrowing costs rise toward what its loan portfolio yields, the gap it lives on narrows — and because it's borrowing several dollars for every dollar of its own, a small move in that gap is a large move in its results. Someone who buys a mortgage REIT believing they've bought a piece of an apartment complex has misunderstood what they own, and they'll find out during a rate move rather than before one.

Both are real investments and neither is a fraud. But they're different asset classes sharing a label. The rest of this unit is about equity REITs, and from here "REIT" means an equity REIT. If you go looking for one, check which kind you're looking at before anything else.

Why net income lies about a REIT

This is the part that costs beginners money, so slow down here.

Accounting rules require a company to record depreciation — a yearly expense reflecting the assumption that a physical asset is wearing out and losing value. For a delivery van, that's honest. Vans do wear out. For a well-maintained office building in a good location, it often isn't true at all: the property may hold its value or gain, while the income statement insists, every single year, that a large chunk of it evaporated.

So the industry uses a different measure. Funds from operations (FFO) is the standard measure of a REIT's earnings — roughly net income with depreciation added back, and with one-time gains or losses from selling properties taken out. It asks a plainer question: how much cash did operating these buildings actually generate? Since dividends are paid out of cash and not out of accounting entries, that's the number that tells you whether the dividend is real.

Watch the two measures disagree about the same fictional company. Call it UVWXYZ Properties. Round numbers, chosen to be legible, not to be typical:

Same company, same year, same buildings. One measure says UVWXYZ lost $5 million. The other says it generated $35 million in cash — enough to comfortably fund the roughly $28 million in dividends it paid. The $40 million gap is entirely an accounting assumption about buildings decaying.

Now think about what a screener does with net income of −$5 million. It produces a negative price-to-earnings (P/E) ratio, or no P/E at all. An investor who has learned that a negative P/E means "this company loses money" will scroll past a perfectly healthy business — or, worse, will look at a REIT with a positive P/E and conclude it's the sound one, when all they've learned is something about its depreciation schedule.

FFO isn't the last word either. Buildings do need real money spent on them — roofs, elevators, parking lots, and the cost of buying the next property. Adjusted funds from operations (AFFO) subtracts those capital expenditures from FFO. FFO tells you what the buildings threw off this year. AFFO tells you what's left after keeping them standing and buying the next one — a closer read on what can actually be paid to you and sustained.

The same gap on a real company

What REITs bring to an income portfolio

Income. Because of the distribution rule, REITs generally pay, and pay consistently. The cash behind those dividends comes mostly from rent, and rent is contractual — tenants signed leases running years, which makes the revenue steadier than most businesses'. Steadier is not certain. Leases are only as good as the tenants, malls empty out, offices sit half-used, and a REIT that can't collect can cut. A dividend is never a promise.

Some diversification. Property doesn't respond to the economy on exactly the same schedule as stocks or bonds, so a REIT sleeve can behave differently from the rest of your portfolio some of the time. Be clear-eyed about the size of that benefit: REITs are stocks. They trade on exchanges, they're owned by the same funds that own everything else, and in a genuine market panic they get sold along with everything else. The diversification is partial, and it thins out exactly when you'd most want it. Real, worth having, not a hedge.

Partial inflation protection. Rents tend to rise as other prices do — leases often build in increases, and expiring leases get repriced into the current market. When it works, a REIT's income grows as your grocery bill does, which is more than a fixed bond coupon can say. When it doesn't, it's because the lease was signed at last decade's rent and doesn't come up for years, or because the same inflation raised the REIT's borrowing costs faster than it raised its rents. Lean, not a shield.

Some growth. Unlike a bond, a REIT share can appreciate. Property values rise, portfolios expand, and the shares can be worth more than you paid. Over long periods REITs have behaved like what they are — an equity, with returns driven by both the dividend and the value of the buildings, and with swings closer to a stock's than a bond's. Growth isn't the point of an income sleeve, but it isn't nothing either — especially if you're retired and the money has to outlast you.

The risks, stated plainly

Interest rates hit REITs twice. First on the business: REITs borrow to buy property, so when rates rise, new loans and refinanced ones cost more, and that comes straight out of what's available to distribute. Second on the price: REIT shares compete with bonds for the same yield-seeking money. When bonds start paying more, some of that money leaves REITs, and their prices fall — even when every tenant is paying on time. There's a third channel through the property itself: higher rates mean higher mortgage rates, which means fewer buyers, which can drag on the value of what a REIT owns.

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Real estate moves in long cycles, and you're concentrated in one slice of it. Property expands and contracts over years, not weeks, and the segments don't move together — residential can sag while industrial climbs, and a city two states over can boom while yours doesn't. A REIT that owns only one property type in one region hands you that cycle undiluted. That's concentration risk, and it's the flip side of the specialization that makes REITs easy to understand.

They're stocks, and they fall like stocks. Whatever the property is doing, the share price is set by people in a market. In a crash, REITs drop hard. Anyone who bought them expecting bond-like steadiness has been surprised, and the surprise arrived in the same month as every other one.

Management can wreck it. A REIT is a company run by people, and running one well is a live skill — buying the right buildings, at the right time, without taking on more debt than the rents can carry. A management team that overpays at the top of a cycle, or borrows heavily right before rates move, can turn a portfolio of good buildings into a bad investment. Reading what a REIT's management says about its strategy, and checking whether they did what they said last time, is the only real handle you have on this one.

The tax treatment is a real disadvantage, and it's routinely missed. A qualified dividend — one taxed at the lower long-term capital-gains rates — is what most people assume they're getting from a dividend payer. REIT distributions frequently don't qualify. Much of what a REIT pays you is taxed as ordinary income, at your regular rate, which for many people is meaningfully higher.

The reason sits in the structure you just read. A REIT largely isn't taxed on the income it distributes, so that income hasn't been taxed at the corporate level on its way to you — and the lower qualified-dividend rate exists to soften the double taxation that a REIT mostly avoids. No corporate tax, no discount. Congress has at times layered other provisions on top of that baseline, and tax law changes; the specifics that apply to you in the year you file are worth confirming rather than assuming. The practical shape of it is that a REIT's yield looks better before taxes than after, and that the account you hold it in matters more than it does for most investments. What that means for your situation depends on your income and your accounts, and it's a fair thing to take to a tax professional.

Key takeaways

• A REIT is a company that owns income-producing property and trades like a stock. It's how you get rent income without a down payment, a mortgage, or a tenant's phone number.
• REITs pay large dividends because tax law requires them to distribute most of their income. That same rule leaves them little to reinvest, so they grow by issuing shares or borrowing — which is why they carry debt and why rate moves matter so much to them.
• Judge a REIT on funds from operations (FFO), not net income. Depreciation charges a healthy building for decay that isn't happening, so a profitable REIT can show a net loss and a negative P/E ratio. Reading that as "losing money" is the classic mistake.
• Equity REITs own buildings; mortgage REITs own loans and are essentially a leveraged interest-rate bet. Same name, different investment. Know which one you're looking at.
• REITs are interest-rate sensitive, concentrated in a slice of the property market, and still stocks — they fall in crashes, so their diversification benefit is partial and weakest when you need it. Their dividends are also often taxed as ordinary income rather than at qualified-dividend rates.

• A REIT is a company that owns buildings and collects rent, and you can buy a piece of it like any other stock. It's how you get rent money without a down payment or a tenant's phone number.
• They hand out a lot of money because the law says they have to. That same rule leaves them almost nothing to save, so they grow by borrowing or by selling more pieces of themselves — which is exactly why a change in what borrowing costs hits them so hard.
• Don't judge one by whether it "made a profit." The rules make them count their buildings as wearing out even when they aren't, so a perfectly healthy one can look like it lost money. Ask how much cash the buildings actually brought in.
• Two very different things share the name. One owns buildings. The other owns loans and is really a bet on interest rates. Check which one you're looking at first.
• When borrowing gets more expensive, their prices usually fall even if every tenant is still paying rent on time. Nothing went wrong with the buildings.
• And they're still stocks, so they also fall when everything falls — which means they help less exactly when you'd want them to help most.