REITs Explained

Most people think real estate investing means buying a rental property, dealing with tenants, and getting a call at 2 AM about a broken water heater. There’s another way. You can own hospitals, warehouses, cell towers, and data centers through your regular brokerage account. No tenants. No maintenance calls. Just quarterly income checks.

That’s what a REIT does. And if you’re serious about income investing, you need to understand how they work.

The Basics: What a REIT Actually Is

A Real Estate Investment Trust is a company that owns, operates, or finances income-producing real estate. Congress created the REIT structure in 1960 to give everyday investors access to commercial real estate. Before that, you basically had to be wealthy enough to buy an office building.

Here’s the key rule that makes REITs special. To qualify as a REIT, a company must distribute at least 90% of its taxable income to shareholders as dividends. That’s not a suggestion. It’s a legal requirement.

This is why REITs tend to have high yields. They’re forced to pay out most of their income. A typical REIT might yield 4-7%, which is well above the S&P 500 average of around 1.3%.

The tradeoff? Because they’re paying out 90%+ of income, REITs have less cash to reinvest internally. When they need capital for new acquisitions or development, they often issue new shares or take on debt. That’s just how the structure works.

Three Flavors of REIT

Equity REITs are the most common type. They own and operate physical properties. Think office buildings, apartment complexes, shopping malls, warehouses. Revenue comes primarily from rent. When you buy a share of Prologis, you’re effectively owning a tiny slice of 1.2 billion square feet of industrial warehouse space around the world.

Mortgage REITs (mREITs) don’t own physical property. They own mortgage-backed securities and make money on the interest rate spread, borrowing short-term at low rates and lending long-term at higher rates. Annaly Capital and AGNC are the big names here. These tend to have very high yields (often 10%+) but come with significantly more risk. When the yield curve inverts or rates spike, mREITs can get destroyed.

Hybrid REITs do a bit of both. They’re less common and I wouldn’t spend too much time on them.

For most income investors, equity REITs are where you want to focus.

The Metrics That Matter

You can’t value a REIT the way you value a regular stock. Earnings per share is basically useless here because depreciation (a non-cash charge) makes REIT earnings look artificially low. The properties aren’t actually losing value the way the accounting suggests.

FFO (Funds From Operations) is the standard REIT metric. It takes net income, adds back depreciation and amortization, and removes gains from property sales. This gives you a much better picture of actual cash generation. If a REIT has an FFO of $3 per share and trades at $45, that’s a 15x P/FFO multiple. Reasonable for a quality name.

AFFO (Adjusted Funds From Operations) goes one step further by subtracting recurring capital expenditures needed to maintain the properties. Think of it as “true free cash flow” for a REIT. This is the number that tells you how well the dividend is covered.

NAV (Net Asset Value) estimates what the REIT’s properties are worth if sold on the open market, minus liabilities. If a REIT trades below its NAV, you’re theoretically buying real estate at a discount. If it trades above NAV, you’re paying a premium for management quality or growth expectations.

Occupancy rate matters too. A REIT with 97% occupancy is in a very different position than one at 82%. Empty space means no rent.

Sector REITs: Not All Real Estate Is the Same

This is where it gets interesting. REITs cover a wide range of property types, and each sector has its own dynamics.

Data Center REITs like Equinix and Digital Realty have been massive beneficiaries of cloud computing and AI infrastructure demand. These facilities house the servers that run the internet. Demand is growing faster than supply in many markets.

Healthcare REITs own hospitals, medical office buildings, senior living facilities, and life science labs. Welltower and Ventas are major players. Demographics favor this sector as the population ages, but operator quality matters enormously.

Industrial REITs own warehouses and distribution centers. Prologis is the giant here. E-commerce growth has made logistics real estate one of the strongest-performing property sectors of the past decade.

Residential REITs own apartment buildings. AvalonBay and Equity Residential focus on high-cost coastal markets. These benefit when home prices are so high that more people rent.

Retail REITs own malls and shopping centers. This sector got hit hard by e-commerce disruption. Simon Property Group survived and adapted, but plenty of mall REITs didn’t. Be selective here.

Cell Tower REITs like American Tower and Crown Castle own the physical infrastructure that wireless networks run on. Every carrier needs tower space, which gives these REITs pricing power.

When REITs Shine (and When They Don’t)

REITs are interest-rate sensitive. Full stop. When rates are falling or expected to fall, REITs tend to outperform. Lower rates mean cheaper financing for acquisitions, and REIT yields become more attractive compared to bonds.

When rates are rising? REITs struggle. That’s exactly what happened in 2022-2023 when the Fed hiked aggressively. The Vanguard Real Estate ETF (VNQ) dropped over 25% from its 2022 high. Not because the properties were suddenly worth less, but because higher rates made the yields less compelling relative to risk-free alternatives like Treasury bills.

This creates opportunities for patient investors. If you believe rates are heading lower over the next 12-18 months, buying quality REITs during a rate-hiking cycle can set up very strong total returns.

REITs also tend to do well during moderate inflation. They can raise rents, which means revenue grows with prices. But runaway inflation that forces the central bank into aggressive tightening? That’s the worst-case scenario.

The Tax Angle

One thing to know. Most REIT dividends are classified as ordinary income, not qualified dividends. That means they’re taxed at your regular income tax rate, which can be significantly higher than the 15-20% rate on qualified dividends.

The 2017 tax law added a partial offset. You can deduct up to 20% of REIT dividend income through the Section 199A deduction, which helps. But REITs are still less tax-efficient than regular dividend stocks in taxable accounts.

This is why a lot of investors hold REITs inside an IRA or 401(k). In a tax-advantaged account, the tax treatment doesn’t matter. You collect the full distribution and reinvest it.

The Bottom Line on REITs

REITs give you access to institutional-quality real estate with the liquidity of a stock. You can buy and sell them in seconds. You get monthly or quarterly income. And you get diversification into an asset class that doesn’t always move in lockstep with the broader market.

Just remember the rules. Use FFO and AFFO instead of earnings. Watch interest rates. Know what type of property you’re buying. And if you’re in a taxable account, think about where you hold them. Get those things right and REITs can be a solid piece of an income portfolio.