What Are REITs and How Do They Work?

Most Americans know that real estate is one of the most reliable wealth-building assets in history. But the barriers to direct property ownership — large down payments, mortgages, maintenance costs, tenant management, and illiquidity — put traditional real estate investing out of reach for many people. Real Estate Investment Trusts, known as REITs, solve that problem. They allow anyone with a brokerage account to invest in income-producing real estate for the price of a single share.

This guide explains what REITs are, how they are structured, how they generate returns, the major types available, and how to decide whether REITs belong in your portfolio.

Table of Contents

1. What Are REITs?
2. How REITs Generate Returns
3. Types of REITs
4. Publicly Traded vs. Non-Traded REITs
5. Pros and Cons of REIT Investing
6. How to Invest in REITs
7. Tax Treatment of REIT Dividends
8. The Role of REITs in a Diversified Portfolio

What Are REITs?

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Congress created the REIT structure in 1960 to give ordinary investors access to large-scale, diversified real estate portfolios — the same type of investments previously available only to wealthy individuals and large institutions.

To qualify as a REIT under IRS rules, a company must meet several requirements:

• Invest at least 75% of its total assets in real estate, cash, or U.S. Treasuries
• Derive at least 75% of its gross income from real estate-related sources (rent, mortgage interest, property sales)
• Pay at least 90% of its taxable income to shareholders as dividends each year
• Have at least 100 shareholders and be owned by no fewer than those shareholders (with limits on concentration)
• Be structured as a taxable corporation managed by a board of directors or trustees

The 90% dividend distribution requirement is the most consequential for investors. Because REITs must pay out the vast majority of their taxable income as dividends, they tend to offer significantly higher dividend yields than the average stock market dividend. The trade-off is that REITs retain little cash for reinvestment, so they frequently issue new stock or take on debt to fund acquisitions and growth.

In exchange for meeting these requirements, REITs themselves pay no corporate income tax on the income they distribute to shareholders — the tax obligation passes through to individual investors. This eliminates one layer of taxation compared to regular corporations, which pay corporate tax before distributing after-tax dividends.

How REITs Generate Returns

REITs generate returns for investors through two primary channels:

Dividend Income

Because REITs distribute at least 90% of taxable income as dividends, they typically pay substantially higher yields than the broad stock market. The average REIT yield has historically ranged from 4% to 6%, compared to roughly 1.5%–2% for the S&P 500. For income-focused investors — retirees, for example — this high yield is the primary attraction.

REIT dividends come from the rents collected on the properties the REIT owns. An apartment REIT collects monthly rent from thousands of tenants across hundreds of buildings; a retail REIT collects rent from stores and restaurants in shopping centers; a data center REIT collects rent from technology companies that lease server space. As long as the underlying properties are occupied and generating rent, the REIT distributes that income to shareholders.

Capital Appreciation

Beyond dividends, REIT share prices can rise over time as the underlying real estate appreciates in value and as the REIT grows its portfolio. REITs that consistently grow their revenue and distributions tend to see their share prices rise alongside their fundamentals. However, REIT share prices are also influenced by interest rates — when rates rise sharply (as in 2022), REIT prices typically fall because the yield differential between REITs and risk-free alternatives like Treasury bonds narrows.

Historically, REITs have delivered total returns (dividends plus price appreciation) competitive with the broader stock market over long periods, while providing meaningful diversification benefits due to their low correlation with other equity sectors.

Types of REITs

The REIT universe spans a wide range of property types. Understanding the major categories helps you invest in the sectors with the most favorable outlook for your time horizon.

Residential REITs

These REITs own apartment communities, single-family rental homes, manufactured housing communities, and student housing. Residential REITs benefit from fundamental demand driven by population growth, household formation, and the long-term trend of renters delaying homeownership due to affordability constraints. Major players include AvalonBay Communities (AVB), Equity Residential (EQR), and American Homes 4 Rent (AMH).

Commercial REITs

Commercial REITs include office buildings, retail shopping centers, regional malls, and mixed-use properties. Office REITs faced significant headwinds from the remote work trend following COVID-19, while regional mall REITs struggled with the shift to e-commerce. Well-located, high-quality commercial properties with strong anchor tenants have proven more resilient than generic suburban offices and lower-tier malls.

Industrial REITs

Industrial REITs own warehouses, distribution centers, and logistics facilities. This sector has been one of the strongest performers in recent years, driven by the explosive growth of e-commerce and the need for fulfillment centers near major population centers. Prologis (PLD), the largest industrial REIT, operates globally and benefits from long-term leases with major e-commerce companies. Industrial REITs have delivered exceptional total returns over the past decade.

Healthcare REITs

Healthcare REITs own hospitals, medical office buildings, senior housing, skilled nursing facilities, and life science laboratory space. They benefit from demographic tailwinds — the aging of the large Baby Boomer generation creates long-term demand for healthcare real estate. Welltower (WELL) and Ventas (VTR) are the two largest healthcare REITs.

Data Center and Technology REITs

These REITs own the physical infrastructure of the digital economy: data centers, cell towers, and fiber networks. Equinix (EQIX) and Digital Realty (DLR) own data centers leased to major technology companies. American Tower (AMT) and Crown Castle (CCI) own cell towers leased to wireless carriers. These REITs have benefited enormously from the growth of cloud computing, streaming, and mobile data consumption.

Specialty REITs

Beyond the major categories, specialty REITs own a diverse range of property types: self-storage facilities, casinos, timberland, farmland, billboard signs, prisons, and student housing. Public Storage (PSA) is the dominant self-storage REIT; Weyerhaeuser (WY) owns timberland; Farmland Partners (FPI) owns agricultural land. These niche REITs can provide very specific real estate exposure for investors with particular convictions or diversification goals.

Publicly Traded vs. Non-Traded REITs

Not all REITs are equal in terms of investor accessibility and risk profile. The critical distinction is between publicly traded and non-traded REITs.

Publicly Traded REITs

Publicly traded REITs are listed on major stock exchanges (NYSE, NASDAQ) and can be bought or sold during market hours at market prices, just like individual stocks. They are subject to SEC disclosure requirements, must file regular financial reports, and are subject to market pricing that reflects real-time investor sentiment. This transparency and liquidity make publicly traded REITs the appropriate choice for most individual investors. All the REITs mentioned in this guide are publicly traded.

Non-Traded REITs

Non-traded REITs (also called private REITs) are not listed on stock exchanges. They are sold through broker-dealers, financial advisors, or directly by the REIT sponsor. They have several characteristics investors should carefully evaluate:

• Illiquidity: There is no secondary market for most non-traded REIT shares. Your investment may be locked up for 5–10 years, or until the REIT conducts a liquidation event.
• High fees: Non-traded REITs often carry sales commissions and fees of 10–15% of the investment amount — a significant drag on returns before the investment earns a single dollar.
• Less transparency: Valuations are not determined by market prices but by periodic internal appraisals, which may not reflect true market values.
• Potentially higher yields: Some non-traded REITs offer higher stated yields to attract investors, though this does not always translate to superior total returns after fees and illiquidity costs.

The SEC has published investor alerts about non-traded REITs warning of their complexity and risks. For most investors, publicly traded REIT ETFs provide superior liquidity, transparency, and often competitive performance at far lower cost.

Pros and Cons of REIT Investing

Like any investment, REITs come with a specific set of advantages and disadvantages worth understanding before investing:

Advantages of REITs:

• High dividend yields relative to other equity investments, providing substantial current income
• Real estate exposure and inflation protection without the hassles of direct property ownership
• Liquidity — buy or sell shares on the exchange at any time during market hours
• Professional management of large, diversified property portfolios
• Low or negative correlation with other equity sectors, providing genuine portfolio diversification
• Access to property types (data centers, cell towers, industrial parks) unavailable to individual investors
• No minimum investment beyond the price of one share or fractional share

Disadvantages of REITs:

• Interest rate sensitivity — REIT prices typically fall when rates rise, because higher-yielding bonds become relatively more attractive
• REIT dividends are generally taxed as ordinary income (not at the lower qualified dividend rate), which can significantly reduce after-tax returns in taxable accounts
• Limited retained earnings for internal growth, requiring frequent equity or debt issuance to fund expansion
• Sector-specific risks — retail REITs face e-commerce headwinds; office REITs face remote work trends; healthcare REITs face reimbursement policy risks
• Share prices can be significantly more volatile than physical real estate, making it psychologically harder to hold through downturns

How to Invest in REITs

Individual REIT Stocks

You can buy shares of individual publicly traded REITs just like any other stock through your brokerage account. This approach allows you to concentrate in specific property sectors you find most compelling — industrial REITs for e-commerce growth exposure, healthcare REITs for demographic tailwinds, data center REITs for technology infrastructure demand. The downside is concentration risk; a single REIT's performance depends heavily on its specific property portfolio, management quality, and leverage levels.

REIT ETFs

REIT ETFs provide instant diversification across dozens of REITs in a single purchase. The most widely held option is the Vanguard Real Estate ETF (VNQ), which holds over 160 REITs across all property types with an expense ratio of just 0.12%. Other options include the iShares Core U.S. REIT ETF (USRT) at 0.08% and the Schwab U.S. REIT ETF (SCHH) at 0.07%. For most investors, a broad REIT ETF is the simplest and most cost-effective approach to real estate exposure.

REIT Mutual Funds

Many mutual fund families offer real estate sector funds. Vanguard's Real Estate Index Fund (VGSLX) is the mutual fund equivalent of VNQ and charges 0.12%. These work well for investors who prefer mutual fund structures or are investing within a 401(k) plan that includes a real estate fund option but not ETF trading.

Through a Broader Index Fund

The real estate sector constitutes roughly 2–4% of the S&P 500 and total market indexes. If you hold a broad U.S. stock market index fund like VTI, you already have some REIT exposure. Some investors choose to overweight real estate beyond its natural index weight by holding a dedicated REIT ETF alongside their broad market fund — effectively tilting their portfolio toward the real estate sector.

Tax Treatment of REIT Dividends

Understanding how REIT dividends are taxed is critical to optimizing your after-tax returns, and this is an area where many investors are surprised.

Most dividends paid by REITs are classified as ordinary income — not qualified dividends — because REITs pass through rental income rather than corporate profits. Ordinary REIT dividends are taxed at your regular marginal income tax rate, which can be as high as 37%. This is significantly higher than the 0%, 15%, or 20% rate that applies to qualified dividends from most regular corporations.

However, the Tax Cuts and Jobs Act of 2017 introduced the Section 199A deduction, which allows most investors to deduct 20% of qualified REIT dividends received in a taxable account (subject to income limits and other rules). This partially offsets the ordinary income rate disadvantage, effectively reducing the top tax rate on REIT dividends to about 29.6% for investors in the highest bracket.

The most tax-efficient account for holding REITs is a Roth IRA — all dividend income accumulates and can be withdrawn in retirement completely tax-free, eliminating the ordinary income tax concern entirely. Holding REITs in a traditional IRA or 401(k) defers taxes until withdrawal. For REITs held in taxable accounts, the higher ordinary tax rate on dividends reduces returns; investors in higher tax brackets may prefer to hold REITs in tax-advantaged accounts and keep more tax-efficient index funds in taxable accounts.

The Role of REITs in a Diversified Portfolio

REITs serve several distinct functions in a well-constructed portfolio:

Income generation: Their high dividend yields make REITs valuable for income-seeking investors — retirees living off portfolio income, or younger investors who want to see tangible cash flows from their portfolio while still in the accumulation phase.

Inflation protection: Real estate has historically been a reasonable inflation hedge. Property values and rents tend to rise with inflation over time, and many commercial leases include annual rent escalation clauses tied to inflation indexes. In inflationary environments, REITs can maintain purchasing power better than fixed-rate bonds.

Diversification: REITs have a relatively low long-term correlation with other equity sectors, reducing portfolio volatility when added to a stock-and-bond portfolio. They are driven by real estate fundamentals — occupancy rates, rental growth, property valuations — rather than purely by corporate earnings expectations.

Most financial advisors suggest allocating between 5% and 15% of a portfolio to real estate exposure through REITs, depending on the investor's income needs, tax situation, and overall portfolio construction. Given their sensitivity to interest rates and their unfavorable tax treatment in taxable accounts, REITs are generally best held in tax-advantaged accounts like Roth IRAs and 401(k)s, where their high dividends compound tax-free.

REITs are a genuinely powerful tool for building real estate exposure without the complications of property ownership. Whether through individual REIT stocks, a diversified REIT ETF like VNQ, or a combination, they can add income, diversification, and inflation protection to almost any long-term investment portfolio.