What You'll Learn
- What REITs are and how they generate income
- Different types of REITs and their characteristics
- How to evaluate and choose REITs
- Tax implications of REIT investing
- How to build a diversified REIT portfolio
What is a REIT?
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. REITs allow everyday investors to invest in real estate without buying property directly. According to Investopedia, REITs own approximately $4 trillion in gross real estate assets in the U.S.
Think of REITs as mutual funds for real estate. When you buy shares of a REIT, you own a piece of a diversified real estate portfolio that might include:
- Apartment buildings
- Shopping centers and malls
- Office buildings
- Healthcare facilities
- Data centers
- Cell towers
- Warehouses and logistics centers
Key Benefit
REITs are required by law to distribute at least 90% of their taxable income as dividends to shareholders. This is why REITs typically offer higher yields than regular stocks - often 3-6% or more.
Why Invest in REITs for Passive Income?
REITs offer several advantages for passive income seekers:
High Dividend Yields
REITs typically yield 3-6%, significantly higher than the S&P 500's average dividend yield of around 1.5%.
No Property Management
Unlike owning rental properties, you don't deal with tenants, maintenance, or repairs. The REIT handles everything.
Liquidity
Publicly traded REITs can be bought or sold instantly on stock exchanges, unlike physical real estate.
Low Minimum Investment
Start with as little as one share (often $20-100) versus the down payment needed for property.
Diversification
One REIT may own hundreds of properties across multiple markets, spreading your risk.
Inflation Protection
Real estate and rents typically rise with inflation, protecting your purchasing power over time.
According to Nareit (the National Association of Real Estate Investment Trusts), REITs have historically delivered competitive long-term returns, outperforming the broader stock market over certain periods.
Types of REITs
REITs come in different categories based on what they invest in:
Equity REITs (Most Common)
Own and operate income-producing real estate. They make money primarily through collecting rent from tenants.
Residential REITs
Own apartment buildings and rental housing. Examples: AvalonBay, Equity Residential
Typical Yield: 3-4%Retail REITs
Own shopping centers, malls, and retail properties. Examples: Realty Income, Simon Property
Typical Yield: 4-6%Industrial REITs
Own warehouses, distribution centers, and logistics facilities. Examples: Prologis
Typical Yield: 2-4%Healthcare REITs
Own hospitals, nursing facilities, and medical office buildings. Examples: Welltower
Typical Yield: 4-6%Data Center REITs
Own facilities that house servers and data. Examples: Digital Realty, Equinix
Typical Yield: 2-4%Cell Tower REITs
Own wireless communication infrastructure. Examples: American Tower, Crown Castle
Typical Yield: 2-3%Mortgage REITs (mREITs)
Don't own property directly. Instead, they provide financing for real estate by purchasing mortgages or mortgage-backed securities. They often offer higher yields (8-12%) but carry more risk.
Beginner Tip
Start with equity REITs rather than mortgage REITs. Equity REITs are more stable and easier to understand. Mortgage REITs are more complex and sensitive to interest rate changes.
How to Evaluate REITs
Unlike regular stocks, REITs use different metrics for valuation:
Key Metrics to Analyze
Funds From Operations (FFO)
The REIT equivalent of earnings. FFO adds depreciation back to net income since real estate typically appreciates, not depreciates. Higher FFO per share indicates better earnings power.
FFO Payout Ratio
Dividend divided by FFO. A ratio below 80% is generally healthy, leaving room for dividend growth and reinvestment.
Occupancy Rate
Percentage of property that's rented out. Higher is better - look for REITs with 90%+ occupancy in their portfolio.
Debt-to-Equity Ratio
Measures financial leverage. REITs often carry debt, but too much (above 1.0) can be risky during downturns.
Dividend Yield
Annual dividend divided by share price. Compare to peers in the same sector. Be wary of yields that seem too high.
Net Asset Value (NAV)
The estimated value of the REIT's properties minus liabilities. REITs trading below NAV may be undervalued.
Tax Considerations
REIT dividends are taxed differently than regular stock dividends. According to NerdWallet, understanding these differences can help you optimize your returns:
Ordinary Income Portion
Most REIT dividends are taxed as ordinary income (your regular tax rate), not the lower qualified dividend rate. However, you may qualify for a 20% deduction on this income under the 199A tax provision.
Capital Gains
A portion of REIT dividends may be classified as capital gains, taxed at lower rates.
Return of Capital
Some distributions may be return of capital (ROC), which reduces your cost basis and isn't immediately taxed.
Tax Strategy
Consider holding REITs in tax-advantaged accounts (IRA, 401k, Roth IRA) to shelter the income from taxes. This is especially beneficial since most REIT dividends are taxed at ordinary income rates.
Building a REIT Portfolio
Here's how to create a diversified REIT portfolio for passive income:
Option 1: REIT ETFs (Easiest)
For instant diversification, consider REIT ETFs:
- VNQ (Vanguard Real Estate ETF): Largest REIT ETF, holds ~170 REITs
- SCHH (Schwab U.S. REIT ETF): Low expense ratio, broad coverage
- RWR (SPDR Dow Jones REIT ETF): Tracks the Dow Jones REIT index
- XLRE (Real Estate Select Sector SPDR): S&P 500 real estate companies
Option 2: Individual REITs
For more control, build a portfolio of individual REITs across sectors:
Sample Diversified REIT Portfolio
- 20% Industrial: Prologis (PLD) - e-commerce warehouse growth
- 20% Residential: AvalonBay (AVB) - apartment rentals
- 20% Healthcare: Welltower (WELL) - senior housing
- 20% Net Lease: Realty Income (O) - monthly dividends
- 20% Technology: Digital Realty (DLR) - data centers
Monthly Dividend REITs
Some REITs pay monthly dividends instead of quarterly, providing more frequent income:
- Realty Income (O) - "The Monthly Dividend Company"
- STAG Industrial (STAG)
- Agree Realty (ADC)
- LTC Properties (LTC)
REIT Income Projections
Here's how much passive income you could generate from REITs at various investment levels (assuming 4% average yield):
| Investment | Annual Income | Monthly Income |
|---|---|---|
| $10,000 | $400 | $33 |
| $50,000 | $2,000 | $167 |
| $100,000 | $4,000 | $333 |
| $250,000 | $10,000 | $833 |
| $500,000 | $20,000 | $1,667 |
*Based on 4% average dividend yield. Actual yields vary by REIT.
Risks to Consider
Interest Rate Sensitivity
REITs often decline when interest rates rise, as higher rates increase borrowing costs and make bonds more competitive.
Sector-Specific Risks
Different REIT types face different challenges. Retail REITs struggle with e-commerce; office REITs face remote work trends.
Economic Downturns
During recessions, occupancy rates may drop and tenants may struggle to pay rent, affecting dividend payments.
Dividend Cuts
While rare for quality REITs, dividends can be cut if the company faces financial difficulties.
Getting Started Today
Ready to add REITs to your passive income portfolio? Here's your action plan:
- Open a brokerage account if you don't have one (Fidelity, Schwab, Vanguard)
- Start with a REIT ETF like VNQ for instant diversification
- Allocate 10-25% of your portfolio to real estate/REITs
- Reinvest dividends to compound your returns
- Consider holding REITs in tax-advantaged accounts
- Research individual REITs as you learn more
Diversify Your Passive Income
REITs are just one piece of a diversified income portfolio. Explore our other investment guides to build multiple income streams.
View All Investment Guides