A REIT is a Real Estate Investment Trust. REITs are an investment class similar to mutual funds that invest primarily in real estate. There are two kinds of REITs Mortgage and Equity. A Mortgage REIT invests in mortgages and makes its money on the interest paid by the mortgage holders. An Equity REIT directly owns property and earns money primarily by leasing property to tenants. Some folks will split hairs and say that there is a third type, the hybrid that does a bit of both Equity and Mortgage.
There are a couple of things that a company must do to qualify as a REIT:
- Has to have at least 100 owners.
- No more than 50% of shares held by 5 or few individuals.
- Invests at least 75% of assets in real estate.
- Earns at least 75% of gross income from rents or mortgage interest.
- Pay at least 90% of the REIT’s taxable income as dividends.
When REITs were signed into law as part of the Cigar Excise Tax Extension of 1960 the purpose was to give investors the opportunity to invest in real estate through a security. That is to say an investor can buy a share of a REIT and add real estate exposure to their portfolio and it was just that quick and easy. By requiring at least 100 owners and stipulating that no more that half of the shares can be owned by five or fewer individuals the investment vehicle is inherently designed to be owned by a large group. This increases the availability of the asset class to investors. And the requirements that a REIT must earn three quarters of its income from rents and mortgage interest keeps the company honest in focusing on what it is designed to focus on: real estate.
One of the big draws of a REIT is the last bullet point. Since a REIT has to pay 90% of its taxable income as dividends to its shareholders the dividend yield of REITs tends to be high compared to other asset classes. There are some REITs that pay out a 10% dividend yield. If a stock pays a dividend it is generally in the 2-3% range, though there are outliers.
Various investment ideas come and go into fashion over time. Not too long ago Growth investing was the popular idea. Buying fast growing companies that were going to appreciate in value was seen as the ideal. That has shifted over the last few years to dividend yield investing in which investors seek out investment vehicles that pay a steady stream of dividends. With REITs paying such high dividends compared to other asset classes they have been exceedingly popular since they mesh so well with the flavor of the week investing philosophy.
An interesting thing to note is that as of August 31st 2016 real estate is now the 11th tracked sector in the S&P 500 Index. Mortgage REITs are still listed under the financial sector in the index. But Equity REITs along with Real Estate Management & Development companies are now in their own Real Estate sector. REITs have been a part of the S&P 500 index since 2001 when they were first lumped into the financial sector. Since REITs are represented in the S&P 500 index buying an index fund that tracks the S&P 500 index is most probably going to include REIT’s in its holdings without having to go purchase a REIT directly.