Real estate investment trusts, or REITs, are companies that focus the majority of operations in real estate. These companies are usually in the business of owning and acquiring properties or acting as landlords. It is beneficial for a company to become a REIT as it results in no income tax obligations on the corporate level. Instead, these taxes are passed on to the individual investors. In return, these companies distribute at least 90% of earnings to shareholders in the form of dividends, resulting in very high yields.
The two main kinds of REITs are equity and mortgage. Equity REITs focus on property management. Although these firms do finance their properties, they increase income by making acquisitions and managing properties. In contrast to equity REITs, mortgage REITs do not own or manage their properties. They earn their income by investing in real estate loans.
REITs are often categorized depending on the specific type of property that they invest in. Approximately two thirds of REITs are in offices, apartments, shopping centers, malls, and industrial facilities. The remaining REITs own properties such as hotels, health care properties, and self-storage facilities.
Many investors invest in REITs for their high yields. Since the companies are mostly tax exempt and are obligated to pay out the vast majority of their earnings in dividends, REIT yields are typically much higher than other types of stocks (averaging about an 8% annual yield for a 15-year investment). REITs also attract investors since their dividends are often secured by ongoing rent and long term leases. Other benefits include simple tax implications, diversification, and the ease of trading on an exchange.
Like most investments, REITs carry risk. Many investors are attracted to high yield REITs, but those investments can sometimes include the most risk. Unlike other dividend paying companies that pay the same dividend every quarter, mortgage REITs often cut their dividends when there is an increase in interest rates and mortgage defaults. Although the long term returns are typically successful for investors, REITs largely depend on real estate prices. Thus, these investments often go through cycles of boom and bust.
REITs are popular instruments for income investors due to their high yields and relatively steady cash flow. As with an investment, these stocks still include a certain degree of risk, and careful research is needed to separate high-quality names from those in decline.