Investors earn money on a REIT by receiving regular dividends from rental income and property sales, and potentially profiting from increases in share price. REITs are required by law to distribute at least 90% of taxable income to shareholders annually, making them a primary source of passive income.
REITs, or Real Estate Investment Trusts, are companies that own, operate, or finance income-producing real estate. They allow individuals to invest in large-scale properties such as shopping centers, apartment complexes, and data centers without buying physical property. To qualify as a REIT under U.S. tax law, a company must distribute at least 90% of its taxable income each year to shareholders in the form of dividends.
The Internal Revenue Service (IRS) mandates this distribution rule to ensure investors receive a steady flow of income. As a result, REITs often have high dividend yields compared to other equities. For example, in 2023, the average dividend yield for equity REITs was 5.2%, according to the National Association of Real Estate Investment Trusts (NAREIT).
Dividends from REITs come primarily from rental income generated by their underlying properties. A REIT that owns office buildings in major cities collects rent from tenants and uses that revenue to pay dividends. These payments are typically distributed monthly or quarterly, offering predictable income streams.
For instance, Realty Income Corporation (O), a retail-focused REIT, paid $2.64 in dividends per share in 2023, distributed monthly. Shareholders who owned 100 shares received $264 in dividends over the year. This consistent payout structure makes REITs attractive to retirees and income-focused investors.
Unlike most corporations, which retain earnings for reinvestment, REITs pass nearly all profits to shareholders. This structure reduces corporate-level taxation because REITs avoid paying federal income tax if they meet distribution requirements. Instead, the tax burden shifts to individual investors.
There are three main categories of REITs, each with distinct income generation methods:
| Type | Focus | Income Source | Example |
|---|---|---|---|
| Equity REITs | Own and manage physical properties | Rental income and property appreciation | Simon Property Group (SPG) |
| Mortgage REITs (mREITs) | Lend money to real estate developers and homeowners | Interest from loans and mortgages | Annaly Capital Management (NLY) |
| Hybrid REITs | Combine ownership and lending activities | Rents and interest income | Various private and public hybrid structures |
Equity REITs generate income through leases and long-term contracts. Mortgage REITs earn returns by collecting interest on real estate-backed loans. These mREITs are sensitive to changes in interest rates-rising rates can compress profit margins due to higher borrowing costs.
A non-obvious distinction: while both types pay dividends, mREITs often have higher yields but greater volatility. In 2022, NLY's dividend yield reached 10.5%, but its share price dropped 32% due to rising Treasury yields. Equity REITs like O maintained more stable returns during the same period.
Beyond dividends, investors can make money on a REIT through capital gains when the share price rises. This occurs when the market values the underlying real estate assets higher, either due to improved performance, location demand, or favorable economic conditions.
For example, in 2021, Digital Realty Trust (DLR) saw its share price increase by 28% over 12 months. This growth stemmed from rising demand for data center space driven by cloud computing expansion. Investors who bought DLR shares at $100 and sold at $128 earned a 28% return, to annual dividends totaling $3.20 per share.
Not all REITs grow in value. Some trade at a discount to net asset value (NAV)-the estimated market value of their properties. In 2020, several REITs traded below NAV due to pandemic-related uncertainty. Investors who bought then benefited from both dividends and eventual price recovery.
Dividends from REITs are taxed differently than those from regular stocks. Most REIT dividends are classified as ordinary income, subject to the investor's marginal tax rate. However, a portion may be labeled as "qualified" or "non-qualified," depending on the REIT's earnings source.
Under IRS rules, up to 20% of qualified REIT dividends may be eligible for a deduction under the Qualified Business Income (QBI) deduction, available to pass-through entities. This benefit applies only to taxpayers earning below $445,850 (single filers) or $518,400 (married filing jointly) in 2023.
I once held a REIT in my taxable brokerage account during a market downturn. Despite a 15% drop in share price, the dividend kept flowing. After six months, the stock recovered, and I realized a 12% total return including dividends. That experience reinforced the importance of holding REITs for income, not just speculation.
Many assume REITs are low-risk investments because of their high yields. This is incorrect. High yields can signal underlying issues-such as declining property values or over-leveraged balance sheets. For example, in 2020, Realty Income's yield spiked above 6% briefly due to investor panic, but the company maintained its dividend with strong cash flow.
Another misconception is that all REITs are publicly traded. While most are listed on exchanges, private REITs exist and are not accessible to retail investors. Public REITs offer liquidity and transparency, but private ones may offer higher returns with less volatility-though they require accredited investor status.
Finally, investors often confuse REITs with real estate funds. While both involve property, REITs are legally structured entities with specific tax rules. Mutual funds and ETFs that hold real estate stocks are not REITs unless they meet the IRS criteria.
To build wealth using REITs, combine dividend reinvestment with long-term holding. Reinvesting dividends compounds returns over time. An investor who reinvests $1,000 annually in a REIT with a 6% dividend yield and 5% annual growth will accumulate approximately $115,000 in 30 years, assuming no taxes.
For those starting with $10,000, allocating 20% to REITs offers diversification. A portfolio with 20% REIT exposure historically delivered higher income than broad stock indices. Over 10 years, the S&P 500 returned 8.5% annually, while the FTSE NAREIT All Equity REIT Index returned 9.1% with higher dividend income.
Consider using a tax-advantaged account like an IRA to hold REITs. Since dividends are taxed annually, placing them in a retirement account defers tax liability until withdrawal. This strategy improves net returns over decades.