REITs explained: how real estate investment trusts work

A real estate investment trust, or REIT, is a company that owns, and usually operates, income-producing real estate such as apartments, warehouses, offices, data centers or cell towers, or that finances real estate through mortgages. Buy a share of a listed REIT and you own a slice of a property portfolio that would cost hundreds of millions of dollars to assemble yourself, with a share price that updates every second the market is open.

REITs exist because of a deal written into the US tax code. A company that meets a set of tests about what it owns and earns, and that pays out at least 90% of its taxable income as dividends, generally pays no corporate income tax on the income it distributes. That bargain explains almost everything that is distinctive about REITs: the high payouts, the special earnings measure the industry uses, the way the shares respond to interest rates, and the tax bill shareholders receive. This guide covers each of those, then looks at how a broad REIT fund, VNQ, has actually performed against the S&P 500 since 2004.

What makes a company a REIT

The rules are in sections 856 and 857 of the Internal Revenue Code. In outline, a REIT must:

• be managed by directors or trustees and have its ownership held by 100 or more persons;
• hold at least 75% of the value of its total assets in real estate assets, cash and cash items, and government securities, tested at the end of each quarter;
• earn at least 75% of its gross income from real-estate sources such as rents from real property and interest on mortgages, and at least 95% from those sources plus other passive income such as dividends and interest; and
• pay dividends at least equal to 90% of its REIT taxable income, computed without the deduction for dividends paid and excluding net capital gain.

A REIT that pays out 90% but less than 100% owes corporate tax on what it keeps, so most aim to distribute close to all of their taxable income. The SEC's investor page notes that most REITs pay out at least 100% of their taxable income.

There is one more structural point. Unlike a homebuilder or developer, a REIT is meant to buy or develop property to operate it as an investment, not to build and resell it.

The kinds of REIT

By what they own. The SEC's bulletin notes that most REITs specialize in one property type: office, industrial (warehouses and distribution), retail, residential, healthcare, self-storage, data centers and more. The type matters because rents follow different customers. Office and industrial rents depend on business spending; retail and residential rents depend more on consumers.

Equity versus mortgage. Equity REITs own buildings and collect rent. Mortgage REITs make real estate loans or buy mortgage-backed securities and earn the difference between the interest they receive and their cost of funding. The SEC bulletin notes they tend to use more borrowed money than property REITs and often hedge interest-rate and credit risk with derivatives. Their returns behave more like a leveraged bond portfolio than like property ownership.

By how they trade.

Everything else on this page is about publicly traded REITs and the ETFs that hold them.

How REIT earnings are measured: FFO

Under standard accounting, a REIT deducts depreciation on its buildings every year, as if they steadily wear out in value. Real estate values often do the opposite over time, and depreciation is a non-cash charge, so net income can understate what a property portfolio actually earns. The industry body Nareit created funds from operations (FFO) in 1991 as a supplemental measure. Its definition starts from net income and excludes depreciation and amortization related to real estate, gains and losses on sales of certain real estate, gains and losses from a change in control, and impairment write-downs of certain real estate.

Two cautions. FFO is not a GAAP measure, and Nareit itself says it is not a measure of cash flow or of a REIT's ability to pay a dividend. Many REITs also report adjusted FFO (AFFO), which subtracts recurring capital spending such as roof replacements and tenant improvements. AFFO definitions vary by company, so compare them with care. For general valuation tools see Valuation methods: intrinsic, relative and asset-based compared.

Why REITs react to interest rates

REITs have a reputation as rate-sensitive stocks. There are three channels.

1. Competition for income. Investors who buy REITs for their dividends can switch to Treasuries, CDs or money-market funds when those yields rise. The SEC's bulletin makes this point directly.
2. Financing costs. REITs borrow heavily to buy property. Higher rates raise interest expense when debt is refinanced.
3. Property values. Buyers value buildings by dividing their net operating income by a capitalization rate, and cap rates tend to move with long-term interest rates.

Rates are not the whole story, though. The SEC's bulletin also notes that rising rates can come with rising rents for some REITs, and property demand depends on the economy. The data shows both.

• December 2021 to October 2023. VNQ's monthly close fell from $116.01 to $72.92, down 37%, while the 10-year Treasury yield rose from 1.47% to 4.80%. This is the rate channel at full strength.
• January to March 2020. VNQ fell from $93.93 to $69.85, down 26%, while the 10-year yield fell from 1.76% to 0.87%. Here the driver was the economic shock of the pandemic, not rates.
• Over the whole period, the monthly correlation between VNQ's price return and the change in the 10-year yield was −0.22 (140 months, January 2015 to September 2026, our calculation). That is a real but loose link: rate moves explain only a small part of REIT returns month to month.

By September 2026, with the 10-year yield at 4.99%, VNQ closed the month at $89.63, only about $3 above its January 2015 close of $86.55. How interest rates affect stocks: discount rates and equity duration covers the rate channels for stocks in general, and The 10-year Treasury yield: why it matters and what drives it covers the yield itself.

VNQ against the S&P 500

On price alone, $100 put into VNQ in October 2004 was worth about $177 in October 2026, a compound rate of about 2.6% a year, while $100 in SPY grew to about $680, or 9.1% a year. In the financial crisis VNQ's monthly close fell from $83.76 in January 2007 to $23.89 in February 2009, a 71% decline, deeper than SPY's 52% fall from October 2007 to February 2009. (Real estate sat at the center of that crisis; see The 2008 financial crisis: housing, Lehman, TARP and the 57% fall.)

Taxes on REIT dividends

Because the REIT itself generally pays no corporate tax on what it distributes, its dividends do not carry the corporate tax that ordinary companies' dividends have already borne. The trade-off is that, as the SEC bulletin notes, REIT dividends typically do not count as qualified dividends and so do not get the lower long-term capital gains rate; they are generally taxed as ordinary income. Part of a REIT's distribution can also be classified as a capital gain or a return of capital, which the REIT reports on Form 1099-DIV. Holding REITs in a tax-advantaged account defers the issue. How dividends and interest are taxed: qualified, ordinary, muni covers the general rules.

Pitfalls and limitations

Chasing yield. A high dividend yield can mean the market expects a cut. Check that FFO or AFFO covers the dividend.

Treating "real estate" as one thing. Office, data-center and self-storage REITs have had very different results, because their tenants are different. A broad fund averages them; a single REIT is a bet on one property type.

Ignoring leverage. Mortgage REITs and heavily indebted equity REITs can cut dividends quickly when funding costs rise.

Non-traded REIT fees and illiquidity. The SEC warns that non-traded REITs often carry large up-front fees, may pay distributions out of offering proceeds or borrowings, and may not publish a value per share for 18 months after their offering closes.

Expecting a bond substitute. VNQ's 71% fall in 2007–09 and 37% fall in 2022–23 are stock-like drawdowns. REITs pay income, but they are equities.

REITs compared with other ways to own real estate

How Finabase does it

The real estate sector page lists the S&P 500's real estate stocks, most of which are REITs (AMT, CCI and AVB among them), with their returns alongside the sector index, and the sector overview shows how real estate ranks against the other ten sectors over periods from a day to a year. Every REIT and REIT ETF has a symbol page; VNQ's Dividends & splits tab lists the fund's payouts, which is where the income missing from the price-only charts above shows up.

Finabase does not flag which stocks are REITs, and it does not compute FFO or AFFO; REITs appear as ordinary stocks in the Real Estate sector. The charts on this page are ours, built from Finabase's monthly price data and the Federal Reserve's 10-year yield series.

Frequently asked questions

Why do REITs pay such high dividends?

Because the tax code requires it. To keep its status, a REIT must distribute at least 90% of its taxable income each year, and in return the income it distributes is not taxed at the company level.

Are REIT dividends qualified dividends?

Generally no. Most REIT dividends are taxed as ordinary income rather than at the lower qualified-dividend rate, although part of a distribution may be a capital gain or a return of capital.

What is the difference between an equity REIT and a mortgage REIT?

An equity REIT owns properties and earns rent. A mortgage REIT lends money for real estate or buys mortgage-backed securities and earns the interest spread, usually with more leverage, so it behaves more like a leveraged bond portfolio.

Why do REITs fall when interest rates rise?

Higher yields make other income investments more attractive, raise REITs' borrowing costs and push up the cap rates buyers use to value buildings. The link is loose, though: in early 2020 VNQ fell 26% while the 10-year yield dropped.

What is FFO?

Funds from operations is the REIT industry's supplemental earnings measure. It adds real estate depreciation back to net income and removes gains and losses on property sales, so it reflects recurring property earnings better than net income does.

Summary

A REIT is a real estate company that meets the tax code's asset, income and ownership tests and distributes at least 90% of its taxable income, in exchange for paying no corporate tax on what it distributes. Equity REITs own property and collect rent; mortgage REITs finance it with more leverage. The industry measures earnings with FFO because depreciation understates what buildings earn. REIT dividends are generally taxed as ordinary income. Share prices respond to interest rates through income competition, financing costs and cap rates, as VNQ's 37% fall in 2022–23 showed, but the economy matters too. On price alone VNQ trailed the S&P 500 badly from 2004 to 2026, and its 71% drop in the financial crisis was deeper; a fair comparison has to add back its larger dividends.