Real Estate Income Trusts (REITs): Owning Property Without Owning a Building

Real-world analogy

What is it?

A REIT — real estate investment trust, often searched as a 'real estate income trust' — is, in Nareit's own words, "a company that owns, and in most cases operates, income-producing real estate." You buy shares in the company rather than a property. In exchange for special tax treatment under Internal Revenue Code sections 856-859, a REIT must meet strict asset, income, ownership and distribution tests — most famously, it must distribute at least 90% of its taxable income to shareholders each year.

Real-world relevance

REITs are how ordinary people end up owning slices of data centres, warehouses, cell towers, hospitals, self-storage, apartments and shopping centres — asset classes almost nobody can buy directly. They also sit inside most target-date retirement funds. Two very different products share the name: LISTED REITs, which trade on a stock exchange and can be sold in seconds, and NON-TRADED REITs, sold through advisors, which are hard to exit and carry higher upfront fees. The SEC has published investor bulletins specifically warning about the second kind.

Key points

• The 90% distribution rule is the whole bargain — A REIT must pay out at least 90% of its taxable income as shareholder dividends. In return, it deducts those dividends and largely escapes corporate-level tax. That is why REIT dividend yields tend to run higher than typical stocks — the payout is not generosity, it is a statutory condition.
• There are asset and income tests too — At least 75% of a REIT's assets must be real estate, cash or government securities, and at least 75% of its gross income must come from real estate sources such as rents and mortgage interest. A company cannot call itself a REIT and mostly do something else.
• Ownership must be genuinely spread out — A REIT needs at least 100 shareholders after its first taxable year, and no more than 50% of its shares may be held by five or fewer individuals during the last half of the year — the '5/50 rule'. It is designed to be a public pooling vehicle, not a family holding company in disguise.
• Equity REITs and mortgage REITs are different animals — An equity REIT owns buildings and collects rent. A mortgage REIT owns loans and mortgage-backed securities and earns the interest spread — which makes it far more sensitive to interest rate moves. Same three letters, very different risk.
• ⚠️ Common misconception: 'REIT dividends are qualified dividends taxed at 15%' — Mostly no. Because the REIT deducted them, ordinary REIT dividends are generally taxed at your ordinary income rate, not the lower qualified-dividend rate. Part of a distribution may instead be return of capital or capital gain, and part may qualify for the Section 199A deduction. Your Form 1099-DIV breaks it out — check the current rules before you assume a rate.
• Liquidity is the biggest split between REIT types — A listed REIT can be sold on an exchange during market hours. A non-traded REIT often has no ready market, limited redemption windows that can be suspended, and higher upfront fees. The SEC's investor bulletin on non-traded REITs exists precisely because investors have discovered this at the worst possible time.

Code example

HOW THE 90% RULE TURNS INTO YOUR DIVIDEND
==========================================
(Illustrative arithmetic, simplified.)

A REIT owns 12 warehouses.

  Gross rents collected ......... $50,000,000
  Operating expenses ............ -$14,000,000
  Property taxes + insurance .... -$ 6,000,000
  Interest on debt .............. -$12,000,000
  Depreciation (paper expense) .. -$ 8,000,000
  ----------------------------------------
  REIT taxable income ........... $10,000,000

  Must distribute at least 90% .. $ 9,000,000

  Shares outstanding ............  10,000,000
  Dividend per share ............ $      0.90

YOU OWN 200 SHARES bought at $18.00:
  Your cost ..................... $ 3,600.00
  Your annual dividend .......... $   180.00
  Yield = $0.90 / $18.00 ........      5.0%

WHAT THIS DOES *NOT* TELL YOU:
  - whether the buildings are
    gaining or losing value
  - whether the debt reprices next year
  - whether the dividend is covered by
    cash flow or funded by borrowing
  Yield alone is not a verdict.

Line-by-line walkthrough

1. 1. SETUP: a simplified equity REIT that owns twelve warehouses and collects $50 million of rent.
2. 2. Operating costs, property taxes, insurance and interest come out first — these are real cash leaving the business.
3. 3. Depreciation is subtracted next. It is a paper expense, which is why REIT investors also look at FFO (funds from operations, which adds depreciation back) rather than net income alone.
4. 4. What remains, $10 million, is REIT taxable income. The statute requires at least 90% of it to be distributed, so at least $9 million goes out to shareholders.
5. 5. Divided across 10 million shares, that is $0.90 per share. Your 200 shares pay $180 for the year, a 5.0% yield on an $18.00 purchase price.
6. 6. OUTCOME: the yield is arithmetic, not quality. It says nothing about property values, refinancing risk on that debt, or whether the dividend is covered by real cash flow. A high yield sometimes signals a market that expects the dividend to be cut.

Spot the bug

Investor's reasoning: 'This non-traded REIT is paying an 8% distribution and the listed one only pays 4%. The non-traded one is obviously the better deal, and since it does not trade on an exchange, its price does not swing around — so it is also safer.'

Explain like I'm 5

Fun fact

Hands-on challenge

More resources

• Investor Bulletin: Real Estate Investment Trusts (REITs) (SEC / Investor.gov)
• Instructions for Form 1120-REIT (IRS)
• What's a REIT? — industry primer and REIT tests (Nareit)