What is a REIT, and what makes a company qualify?
REITs let individual investors earn a share of the income from large commercial properties without buying or managing them, and most trade on stock exchanges like any other share. Unlike a property developer, a REIT does not build properties to resell them; as the SEC’s Investor.gov explains, it buys and develops properties mainly to operate them as part of its own portfolio.
The conditions are set in sections 856 and 857 of the US Internal Revenue Code. Among them, the company must be managed by trustees or directors, have transferable shares, be taxable as a domestic corporation if it were not a REIT, be owned by 100 or more persons and not be closely held, and pass tests showing that most of its assets and income come from real estate. The best known condition is the payout rule.
- Real estate investment trust (REIT)
- A company that owns, operates or finances income-producing real estate and, by meeting tax-code conditions including paying out at least 90% of its taxable income, avoids most corporate income tax.
The 90% rule: why REITs pay large dividends
Under section 857, a REIT must pay dividends equal to at least 90% of its REIT taxable income, measured before the deduction for dividends paid and excluding net capital gain. Taxable income it keeps is taxed at the corporate rate, so many REITs pay out close to 100%; Nareit, the industry association, says most do.
Two consequences follow. REITs keep little of their income to fund growth, so they issue new shares and borrow more often than most companies. And their dividends look large next to their profit: the usual payout ratio of dividends ÷ net income can make a healthy REIT look as if it pays out more than it earns, because net income is reduced by large depreciation charges on buildings.
- REIT distribution requirement (90% rule)
- The US rule that a REIT must pay dividends of at least 90% of its REIT taxable income, excluding net capital gain, each year to keep its tax treatment.
Types of REITs: equity, mortgage, listed and non-traded
By what they invest in, there are two main kinds. Equity REITs own properties and earn mostly rent. Mortgage REITs (mREITs) lend on real estate or buy mortgage-backed securities and earn interest; they borrow heavily and are especially sensitive to interest rates and credit losses. Equity REITs usually specialize by property type: apartments and single-family rentals, warehouses and logistics, offices, shopping centers, hotels, self-storage, healthcare buildings, data centers and cell towers.
By how they are held, there are three. Publicly traded REITs are registered with the SEC and listed on an exchange; you can buy them, or a REIT fund or ETF, like any share. Public non-listed REITs are registered with the SEC but not listed: according to Investor.gov, they are hard to sell, may not estimate their value per share until 18 months after their offering closes, often pay distributions partly from offering proceeds and borrowing, and charge sales commissions and upfront fees that usually total about 9% to 10% of the investment. Private REITs are exempt from SEC registration and can generally be sold only to institutional investors.
- Equity REIT
- A REIT that owns properties and earns most of its income from rent, often specializing in one property type such as warehouses, apartments or data centers.
- Mortgage REIT (mREIT)
- A REIT that lends on real estate or buys mortgages and mortgage-backed securities, earning interest rather than rent. Usually more leveraged and more rate-sensitive than an equity REIT.
- Non-traded REIT
- A REIT registered with the SEC whose shares are not listed on an exchange. It is illiquid, its value per share is hard to know, and it typically carries high upfront fees.
How to analyze a REIT: FFO instead of EPS
Accounting rules depreciate buildings every year, even though well-kept property often holds its value. That makes net income and earnings per share understate what an equity REIT earns from its properties. To address this, Nareit created funds from operations (FFO) in 1991: net income excluding depreciation and amortization related to real estate and gains and losses from the sale of certain real estate, among other adjustments. FFO is a supplemental, non-GAAP performance measure, not a cash figure; for cash, read the cash flow statement. Many REITs also report an adjusted FFO (AFFO) that subtracts recurring spending to maintain the buildings, with no standard definition.
In the drawing below, a hypothetical REIT reports net income of $60 million, with $50 million of real estate depreciation and a $10 million gain on selling a building. FFO = 60 + 50 − 10 = $100 million. With 50 million shares, EPS is $1.20 and FFO per share $2.00. A dividend of $1.60 a share is 133% of EPS but 80% of FFO, which is how REIT payouts are usually judged. At a share price of $32.00, the dividend yield is 1.60 ÷ 32 = 5.0% and the price-to-FFO ratio 32 ÷ 2 = 16.0, the REIT counterpart of the P/E ratio.
- Funds from operations (FFO)
- A REIT performance measure defined by Nareit: net income excluding real estate depreciation and amortization and gains and losses on sales of certain real estate, among other adjustments.
- Price-to-FFO (P/FFO)
- A REIT’s share price divided by its FFO per share, used in place of the P/E ratio.
Why are REIT prices sensitive to interest rates?
Investors buy REITs largely for their income, so REITs compete with bonds. When Treasury yields rise, investors tend to demand a higher yield from REITs too, which means a lower price for the same dividend. REITs also borrow a lot, so higher rates raise their interest costs as debt is refinanced, and property values tend to fall when the rates used to value them rise. The bond yields and stocks lesson explains the general mechanism.
In the simplified drawing below, a hypothetical REIT pays $2.00 a year and investors want a yield 2 percentage points above the 10-year Treasury. With the Treasury at 3%, the REIT must yield 5%: a price of 2.00 ÷ 0.05 = $40.00. At 4% it must yield 6%: $33.33. At 5% it must yield 7%: $28.57, 28.6% below $40.00. Real REITs can raise rents over time, especially when inflation is high, so the link is looser and varies by property type, but the direction of the pressure is the same.
How are REIT dividends taxed?
In general terms, for a US taxpayer, most REIT dividends are taxed as ordinary income, not at the lower rates for qualified dividends that apply to many corporate dividends, as Investor.gov notes. Part of a REIT’s distribution may be reported as a capital gain distribution, taxed as a long-term capital gain, and part as a return of capital, which is not taxed when received but lowers your cost basis in the shares. The REIT reports the split each year on Form 1099-DIV.
Qualified REIT dividends may also be eligible for the qualified business income deduction under section 199A, which the IRS describes as up to 20% of qualified REIT dividends, subject to its conditions. Investors outside the US are generally subject to US withholding tax on REIT dividends, at rates that depend on the type of distribution and any tax treaty, and may owe tax in their own country as well. Holding REITs in a tax-advantaged account changes the picture again, so check your situation with a tax adviser.
- Return of capital (nondividend distribution)
- The part of a distribution that is not paid out of earnings. It is generally not taxed when received but reduces the cost basis of the shares, so it raises the taxable gain when they are sold.