REITs (Real Estate Investment Trusts)

How it works

A REIT collects rent from tenants, pays the operating costs of running the buildings, interest on its debt and management fees, and distributes what remains to shareholders. The tax election is the mechanism that makes the structure work: income the REIT distributes is not taxed at the corporate level, so rent flows through to investors without a layer of corporate tax first.

To keep that status a company must pass statutory tests every year: distribute at least 90% of taxable income, hold at least 75% of assets in real estate, cash or government securities, derive at least 75% of gross income from rents and mortgage interest, have at least 100 shareholders, and avoid five or fewer individuals owning more than half the shares, the so-called 5/50 rule.

Because depreciation is a large non-cash charge against real property, REITs are analysed on funds from operations, net income plus real-estate depreciation minus gains on sales, and on adjusted FFO, which further subtracts recurring maintenance capital spending and straight-line rent adjustments. Equity REITs own buildings and collect rent directly; mortgage REITs instead hold mortgages and mortgage-backed securities and earn a spread on borrowed money, a distinct risk profile covered separately.

Sub-sectors reprice on different clocks: net-lease REITs sign long leases where the tenant covers taxes, insurance and maintenance, apartment and self-storage REITs reprice leases annually or monthly, and hotels reprice nightly. Many listed REITs are structured as UPREITs, where the public company owns an operating partnership; a property owner can contribute a building for partnership units and defer the capital-gains tax a direct sale would trigger. Non-traded and NAV REITs raise capital outside the exchanges, report a periodic appraised valuation instead of a market price, and cap redemptions to a quota per quarter.

What it pays

The payout is quoted as a dividend yield on the share price, usually distributed quarterly with a minority of REITs paying monthly. The size of the payment is set mechanically by the 90% distribution requirement acting on taxable income, and its safety is judged against AFFO, with the AFFO payout ratio serving as the standard coverage measure.

Growth in the distribution comes from three sources: contractual rent escalators built into existing leases, re-leasing space at higher prevailing market rents, and acquiring or developing property with capital that is accretive to per-share cash flow. Property itself is valued in the private market on cap rates, net operating income divided by property value, so a REIT's share price reflects both the rent stream and where cap rates sit relative to the market's implied valuation of the company.

Leverage amplifies both directions. A REIT funds acquisitions with mortgages and unsecured bonds, and the spread between the yield on the property and the cost of that debt determines whether growth adds to or subtracts from per-share cash flow. Because the 90% rule prevents retaining much cash, growth capital has to come from issuing new shares and debt, which means the share price itself becomes an input into whether the company can grow at all.

Costs and taxes

US tax treatment splits each distribution on Form 1099-DIV into three pieces: ordinary income, capital gain distributions, and return of capital. Most of the payment is typically ordinary income taxed at marginal rates rather than at the lower qualified-dividend rate that applies to many corporate dividends.

Section 199A provides a deduction for qualified REIT dividends for individual taxpayers, and the mechanics of that deduction have changed with legislation, so current-year treatment should be confirmed rather than assumed from prior years. The return-of-capital portion is not taxed when received; instead it reduces cost basis, which increases the taxable gain realized on an eventual sale, and depreciation is the accounting source of that return-of-capital component.

Because most REIT income is ordinary rather than qualified, the distributions are frequently discussed in the context of tax-deferred accounts; that is a description of tax mechanics, not guidance on where anything should be held. Listed REITs cost nothing to hold beyond the normal bid-ask spread, since the management expense sits inside the company's own income statement. Non-traded REIT programs historically carried substantial upfront selling commissions and ongoing fees disclosed in the offering document, and REIT ETFs or mutual funds add an expense ratio on top of the underlying companies' internal costs.

Liquidity and time commitment

Listed REITs trade like any other exchange-listed stock: execution is immediate during market hours, with no lock-up and no notice period required to exit a position. That is the principal structural difference from owning a building directly, where a sale typically takes months and consumes several percent of value in commissions and closing costs.

Non-traded and NAV REITs are far less liquid. Redemptions are capped, a common program structure limits repurchases to a small percentage of NAV per quarter, and that window can be suspended entirely, which has occurred during periods of heavy redemption demand.

Ongoing effort for a listed REIT holding is limited to reading quarterly results for occupancy, same-store net operating income, lease expiry schedules and debt maturities. There are no landlord duties at all, since the operating company employs its own property managers, which is what makes this the passive version of real estate income rather than direct ownership.

How it goes wrong

Rate sensitivity is the most persistent risk: rising interest rates raise both the discount rate applied to the rent stream and the cost of refinancing maturing debt, and REIT share prices have historically fallen sharply in rate-tightening cycles even when the underlying buildings kept performing. Refinancing walls compound this, since property is financed with term debt, and a REIT whose maturities land in a closed or expensive credit market can be forced into asset sales or equity issuance at a depressed price.

Dilutive equity issuance is a structural risk unique to the 90% payout rule: because a REIT cannot retain much earnings, one trading below its net asset value that keeps issuing shares to fund acquisitions destroys per-share cash flow even as the portfolio grows. Tenant and sector concentration adds another layer, a net-lease REIT dependent on a handful of large tenants, or an office REIT facing structurally lower demand, can see occupancy and re-leasing spreads deteriorate together.

Dividend cuts happen and are usually abrupt rather than gradual; the 2020 shutdowns produced cuts and outright suspensions across hotel, retail and some office REITs within a single quarter. A related and easily missed failure mode is confusing the payout with income: a distribution that is largely return of capital feels like yield while quietly reducing basis, and in a poorly covered REIT, reflects an eroding asset base rather than genuine cash flow.