What's a REIT? And Should You Invest in One?

Real estate investing, simplified.

Real estate is a popular investment. The traditional way to do it is to buy a property that you either use for rental income or sell for a profit, but this isn't an option for everyone. It's time-consuming, it's expensive, and it's risky, since you'll be tying up a lot of your money in the property you buy.

The good news is that there's a much more accessible option. It's called a real estate investment trust (REIT), and if you want to get into real estate investing, one of these could be a great addition to your portfolio.

What's a REIT?

A REIT is a company that owns, and in many cases operates and finances, income-producing real estate. REITs have been around since 1960, when Congress established them so that any investor would have the opportunity to invest in commercial real estate.

Investing in REITs is similar to investing in stocks. They're bought and sold in shares, and most REITs are publicly traded, meaning you can invest in them through a brokerage account.

There are many types of REITs available, including residential REITs, office REITs, retail REITs, and healthcare REITs. If you have a specific type of property or market sector you want to invest in, you can focus on that type of REIT.

Pros and cons of investing in REITs

There are several benefits of investing in REITs:

• They pay high dividends, making them great for earning passive income. REITs are required by law to pay at least 90% of taxable income as dividends.
• They make it convenient to invest in real estate. You don't need to worry about coming up with a big down payment to buy a property. Since REITs are bought and sold like stocks, it's also much easier and faster to sell them.
• They diversify your portfolio. Real estate also tends to be less volatile than the stock market.

Like any investment, REITs have their drawbacks. They often decrease in value when interest rates rise. Performance will also depend on the REITs you invest in.

The biggest drawback to be aware of with REITs is how they increase your tax liability. They pay nonqualified dividends, which are dividends that get taxed as ordinary income. So, while you can earn lots of passive income from REITs, you'll also owe more in taxes.

Fortunately, there's a way around this. If you invest in REITs through an individual retirement account (IRA), you won't owe dividend taxes each year. Here's how REIT taxation works with each type of IRA:

• With traditional IRAs, you don't owe taxes until making withdrawals, and contributions are tax deductible.
• With Roth IRAs, withdrawals are tax free, but you make contributions with after-tax income.

Should you invest in a REIT?

REITs are a good investment that have performed well over the years. Over the last 45 years, they've had an average compound annual return of 11.4%. That's nearly identical to the S&P 500, an index tracking 500 of the largest publicly traded companies on U.S. stock exchanges, which had a return of 11.5%.

It may not be an absolute must-have, but a REIT is worth considering to diversify your portfolio. REITs are a good fit, in particular, if any of the following are true:

• You'd like to invest in real estate.
• You want to earn more passive income from your investments.
• You have a stock-heavy portfolio and you want to reduce volatility.

If you decide you want to invest, you can pick individual REITs. Or, you can look into REIT ETFs. These invest your money across multiple REITs and real estate stocks, which comes with lower risk than only investing in a single REIT.