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A little clarity for your next decision.
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Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
A real estate investment trust, or REIT, is a company that owns or finances real estate and meets special federal tax rules. Investors buy an interest in that company, which can provide income and changes in value without requiring them to manage buildings. This guide explains what you own, where the money comes from, and the questions to ask before investing.
Buying a REIT is different from buying the apartment building down the street. The company may own buildings through several subsidiaries. You own shares in the company. Its managers decide which assets to buy, how to finance them, and when to sell them. You usually do not get a vote on each lease or roof repair. That can remove work from your life, but it also means giving up direct control. [1]
I start with a basic question: what will this business do with your money? A photo of a beautiful property does not answer it. I want to know whether the company owns occupied buildings, makes loans, builds new projects, or combines several activities. Each approach needs different skills and has different ways to lose money.
Think about an apartment REIT that owns properties in several cities. Residents pay rent to its property businesses. Those businesses pay employees, repairs, insurance, taxes, and other costs. Lenders receive interest. The REIT also has company expenses. What remains can support distributions, reserves, or new investments. The rent collected is not the same as the cash available to shareholders.
A REIT shareholder does not own a reserved apartment that can be taken out of the company later. Nor does the word “trust” mean the investment is a bank trust account or a government guarantee. It describes a tax and business structure, not a promise about safety.
A company must elect REIT treatment and satisfy ongoing requirements. These include tests for its assets, income, ownership, and distributions. Section 856 includes a quarterly test requiring at least 75% of asset value to consist of qualifying real estate assets, cash and cash items, and government securities. It also has separate 75% and 95% gross-income tests. Not every dollar a business earns from a building meets those definitions. [2]
There are ownership rules as well. For example, the law generally calls for at least 100 owners, subject to timing and first-year provisions. A company cannot simply put “REIT” in its name and skip these requirements. Management and tax professionals must track compliance as the business changes.
The familiar distribution test generally requires dividends equal to at least 90% of REIT taxable income, calculated before the dividends-paid deduction and excluding net capital gain. The statute also includes adjustments for foreclosure income and certain noncash income. That is a tax calculation, not a rule that 90% of rent must be sent to investors. [3]
The dividends-paid deduction can reduce the REIT's federal corporate taxable income. It does not make every REIT transaction tax-free. A REIT can owe tax on retained taxable income and under special rules. Its taxable subsidiaries may owe corporate tax, too. Investors may owe tax on the distributions they receive.
These rules help explain why REITs distribute income. They do not establish whether a particular company buys good properties, uses sensible debt, or charges fair fees. Tax qualification is only one part of the review.
The first question is how the REIT invests. An equity REIT mainly owns real estate. A mortgage REIT mainly invests in real estate loans or mortgage-backed securities. A hybrid combines property ownership and real estate lending. The word “equity” here refers to the property-owning strategy; it does not tell you whether its shares trade on an exchange. [4]
The second question is how its shares are offered and traded. These categories describe access, disclosure, and liquidity. They do not replace the first question.
| Share structure | What it means | First question to ask |
|---|---|---|
| Exchange-listed REIT | Shares trade on a securities exchange. | What price and trading costs apply when I buy or sell? |
| Public non-traded REIT | A public offering and public reporting do not include exchange trading. | What limits apply to any share repurchase program? |
| Private REIT | Shares are offered under an exemption from registration, with no regular exchange market. | What eligibility, reporting, and transfer terms apply? |
A private offering still falls under applicable securities laws, including antifraud rules. Exempt from registration does not mean exempt from all regulation. Eligibility depends on the offering's exemption and terms. Many private offerings target accredited investors; that does not make accreditation a universal requirement for every REIT. [5]
A publicly offered REIT can still be hard to sell. I would never shorten “public non-traded” to “public” in a conversation about access to your money. That missing word changes the practical answer.
For a property-owning REIT, start with tenants. Who pays the rent? How much space is vacant? When do leases end? Who pays repairs and taxes under those leases? A long lease may provide a useful stream of contracted rent, but the tenant still needs the ability to pay.
A simple hypothetical building collects $1 million in annual rent and other property income. Operating expenses total $400,000. Its net operating income is $600,000 before financing and company costs. If interest is $200,000, company costs are $75,000, and cash needed for repairs and leasing is $100,000, only $225,000 remains in this simplified cash budget. Debt principal payments or additional reserves could reduce it further.
That example is not a forecast or a tax-income calculation. It shows why “the properties produce a 6% cap rate” does not tell you what shareholders receive. The price paid for the buildings, the borrowing terms, share count, and other costs all matter.
For a mortgage REIT, ask about borrowers and financing instead. A lender may earn interest on loans while paying interest on its own borrowing. The difference must cover expenses and credit losses. Loan maturity dates, collateral values, and the lender's rights in a default matter. Mortgage-backed securities add their own features, such as repayment patterns and price changes.
The same interest-rate change can affect different businesses in different ways. Floating-rate loans may pay more when rates rise, while borrowers face higher payments. A property owner may have fixed-rate debt today but face a higher rate when it refinances. I want the actual balance sheet and loan terms, not a one-line claim that all REITs benefit or suffer in the same way.
Suppose a REIT has $10 million of taxable income for the distribution test, before the relevant deduction, with no net capital gain or special adjustments. A $9 million qualifying distribution meets the basic 90% amount. That does not mean an investor gets a 90% return. The amount per share depends on the shares entitled to that distribution. It also does not mean $9 million is the most the company can distribute. [3]
The board can change distributions as conditions change, subject to the governing rules. A regular payment history does not make future payments certain. A distribution may come from operating cash, a property sale, borrowing, or capital raised from investors. Those sources have different implications for future cash flow and value. [1]
Imagine buying shares for $100,000, collecting $6,000 during a year, and ending the year with shares worth $90,000. Your simple total return is negative $4,000, or negative 4%, before personal taxes and transaction costs. The 6% cash payment did not prevent a loss.
Now assume the ending shares are worth $104,000 instead. The same $6,000 payment produces a $10,000 gain in total value, or 10%, on those assumptions. These are illustrations, not expected returns. They show why I keep the cash payment and the change in share value on the same page.
REIT shareholders in taxable accounts commonly receive Form 1099-DIV. A payment can include ordinary dividends, capital gain distributions, or nondividend distributions. The final tax classification may differ from the label used during the year. Use the tax form and supporting information, not just the amount that reached your bank account. [6]
A nondividend distribution generally reduces your tax basis. Once basis reaches zero, additional nondividend distributions generally create capital gain. “Return of capital” is therefore not a promise that the money will never be taxed. It also does not, by itself, prove the property business is failing. The tax classification and the economic source of a payment answer different questions.
Under current federal law, eligible noncorporate taxpayers may deduct up to 20% of qualified REIT dividends under Section 199A, subject to its rules and overall limitation. A qualified REIT dividend for this purpose excludes capital gain dividends and qualified dividend income. This deduction is not a tax credit worth 20% of the cash you receive. [7]
For a simplified illustration, a fully eligible $5,000 qualified REIT dividend could support a $1,000 deduction. It would not produce a $1,000 refund by itself. Your tax benefit depends on your tax rate, limitations, and other facts. State treatment and any net investment income tax need separate review.
Retirement accounts have different tax rules. Do not assume the taxable-account treatment above applies inside an IRA. I would have your CPA compare the account choices before making tax savings a reason to choose a particular investment.
Start with the financial statements. Net income, operating cash flow, debt, and changes in equity each tell you something different. Property depreciation is an accounting expense that can reduce net income even when no cash leaves the business for that expense during the period. Yet buildings still wear out and require cash for repairs.
Funds from operations, or FFO, is a supplemental performance measure used by equity REITs. Nareit's definition adjusts GAAP net income for specified real estate depreciation and amortization, certain property gains and losses, and other defined items. FFO should accompany the financial statements rather than replace them. It is not simply the cash left in the checking account. [8]
Adjusted funds from operations, or AFFO, makes further adjustments. Those may address recurring capital work and accounting rent differences. There is no single standard AFFO definition across all issuers. Read each company's calculation before comparing two reported figures. [9]
Look for a reconciliation showing how management gets from the closest GAAP measure to its adjusted measure. SEC guidance addresses those disclosures and the prominence of GAAP results. An attractive adjusted number deserves more questions when the adjustments repeatedly remove costs that keep returning. [10]
Net asset value, or NAV, estimates the assets' value after liabilities and other relevant claims. Dividing the equity value by the applicable share count can produce a per-share estimate. Assumptions about rents, required returns, and property sales affect it. An appraisal or published NAV does not promise that a buyer will pay that amount, or that a repurchase request will be accepted. [11]
Listed shares usually offer a practical path to sale through a brokerage account. The market determines the sale price. Being able to sell is useful, but it is different from being able to sell without a loss. Order type, market conditions, trading volume, and costs can affect execution.
For a non-traded or private REIT, obtain the current repurchase or redemption terms. A program may set request windows, holding requirements, discounts, and limits on how much the company will buy. It may allow the board to reduce or suspend purchases. There is no one redemption percentage that applies to all REITs.
I would ask a practical question: if every investor wanted money back during a difficult period, what would happen? A fund holding buildings cannot always sell enough property quickly at reasonable prices. A rule allowing requests is not an obligation to honor every request on time.
For example, a hypothetical company might accept only half the shares requested during a particular window. If you need $40,000 and only $20,000 is paid, you still need another source for the bill. Plan from what the documents permit, rather than from the assumption that the program will always run at full capacity.
REIT shares generally are not qualifying replacement real estate in a Section 1031 exchange. Treasury's real-property regulation excludes stock and other specified interests, with narrow exceptions that do not create a general REIT-share exchange route. Selling a rental property and buying ordinary REIT shares does not, by itself, defer the property's gain. [12]
A qualifying Delaware statutory trust can be different. In Revenue Ruling 2004-86, the IRS treated the interests in a trust with specific facts and restricted powers as ownership of the underlying real estate for federal tax purposes. That ruling does not make every trust labeled “DST” eligible. The structure and your exchange still need review. [13]
A property contribution to a partnership under Section 721 can be another separate transaction. Some structures offer a possible later move from a DST into a REIT's operating partnership. Partnership units are not the same thing as REIT shares. Whether that move is available, optional, and tax-deferred depends on the documents and facts. It is not an automatic second step in every DST investment. [14]
For an owner leaving property management, those differences are central. Ask whether the priority is exchange deferral, access to cash, current income, control, or simpler administration. A structure that helps one goal may limit another. The right comparison begins with your needs rather than the product name.
Owning shares without a personal margin loan does not mean the investment has no debt. The REIT may borrow at the company level, through its property entities, or both. The business must meet those obligations before common shareholders receive the remaining value. Read its debt disclosures alongside the property descriptions.
Consider a simplified company with $100 million of assets, $50 million of debt, and no other claims. Its equity value is $50 million. If asset value falls to $80 million while debt remains $50 million, equity falls to $30 million. The assets lost 20% of their value, but equity lost 40%. This example excludes costs and does not predict a share price. It shows how borrowing can magnify a loss.
Timing matters as much as the debt total. A sound building can still create a problem when a large loan comes due and the company cannot renew it on workable terms. Ask how much debt matures soon, whether rates are fixed or floating, and how much cash or borrowing capacity remains available.
Also check which security you are buying. Common shares, preferred shares, and a company's bonds have different rights. A payment priority does not remove credit risk. A familiar REIT name on all three securities does not make their terms interchangeable. The prospectus and financial statements explain the claims ahead of your investment. [1]
A REIT mutual fund or exchange-traded fund adds another layer: you own fund shares, and the fund holds its portfolio. Review its holdings, costs, and trading rules separately. It may spread company exposure, but a fund focused on one sector can still be concentrated. It also will not give you direct ownership of the buildings in those companies.
Before choosing a REIT, write a short description of what it owns, how it earns money, and how you can exit. Then check that description against the current prospectus or private offering documents. For public reporting companies, read the annual report, latest quarterly report, and important later filings. The SEC's guide to a 10-K explains how the business discussion, risk factors, management discussion, and financial statements fit together. [15]
Next, list costs in dollars. Include any purchase charge, ongoing advisory or servicing costs, company-level expenses, incentive fees, and exit charges that apply. Some are paid directly; others reduce what remains inside the investment. Avoid adding a fee twice when it is already reflected in reported net results. [16]
Check how the new holding fits beside what you already own. Several funds can own similar buildings, lend to similar borrowers, or rely on the same markets. More account statements do not necessarily mean more diversification. Concentration can exist through property type, geography, tenant, manager, or debt exposure. [17]
Finally, decide what would make you pass. It might be an exit restriction, a large near-term debt maturity, unclear fees, or too much exposure to one tenant. Writing that down before looking at projected income helps keep the decision grounded.
No. Listed shares trade on exchanges, but public non-traded and private REIT shares do not have that same market. Read the actual sale, transfer, and repurchase terms. Even listed shares can fall in price when you need to sell.
No. It is a tax qualification calculation tied to taxable income, with specific adjustments. It does not guarantee a fixed amount, a monthly payment, or a positive investment return. Income and distributions can fall.
Yes. A company may focus on a property sector or market. A REIT label does not ensure broad diversification. Review the actual holdings and sources of revenue rather than assuming every REIT owns a little of everything.
No. They are performance measures with defined or company-specific adjustments. The board's distribution decision is separate. Compare the measures with financial statements, cash needs, and the source of distributions before judging payment coverage.
Ordinary REIT shares generally do not qualify. A qualifying DST interest or a separate Section 721 property contribution involves different rules. Have your tax adviser review the specific structure before committing exchange funds.
Bring your income needs, time horizon, cash reserve needs, current holdings, and any property-sale plans. Bring the prospectus or offering documents for a REIT you are considering. Those facts make it possible to discuss the actual tradeoffs instead of comparing advertised yields alone.
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
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