A real estate investment trust (REIT) is a company that owns or invests in major types of real estate or related assets. A REIT can be a publicly traded or privately held as long as it is directly held by at least 100 investors. Many REITs are publicly traded on a major stock exchange. According to the National Association of Real Estate Investment Trusts (Nareit), the equity market capitalization of U.S. listed REITs is more than $1.3 trillion.

REITs may own and manage certain categories of property, such as offices, residential buildings, warehouses, hospitals, and retail centers. REITs that focus on a particular class of property are sometimes referred to as sector REITs. For example, a healthcare REIT would focus on owning and operating properties in the healthcare industry such as hospitals, nursing homes and medical centers. There are also mortgage REITs, which invest in mortgages and generate income from interest payments. In addition, there are equity REITs, which own direct or indirect equity interests in real estate.

REIT status confers a number of benefits to investors. In particular, REITs receive special tax consideration. Certain U.S. federal income tax requirements must be satisfied in order to qualify for taxation as a REIT. There is no entity-level taxation for REITs and qualifying REIT dividends are subject to a reduced tax rate. The favorable tax treatment in turn helps attract tax-exempt and foreign investors.

A REIT is typically formed as a corporation, although it can also be formed as an LLC or state law trust. A company must make a REIT election by filing its income tax return on Form 1120-REIT with the Internal Revenue Service.

REITs usually offer investors high dividend yields, since REITs are required to pay out 90% of their annual taxable income as dividends. Therefore, REIT investors generally receive a higher rate of dividends than investors in equity securities or fixed income investments.

A number of organizational requirements govern REITs. Most importantly, a REIT must invest in real estate assets and derive the majority of its income from real estate activities. In addition, the following requirements must be satisfied:

• A REIT must be beneficially owned by 100 or more persons.
• No more than 50% of the value of a REIT’s outstanding stock can be held by five or fewer people. This is referred to as the closely held test.
• A REIT must be managed by one or more trustees or directors. This is usually a straightforward requirement to satisfy.

There are two annual income tests that a REIT must satisfy—the 75% gross income test and the 95% gross income test. At least 75% of the REIT’s gross income must be derived from real estate-related income. The categories of income items considered to be real estate-related include rents from real property, interest on real estate secured obligations, and real property gains. In addition, at least 95% of the REIT’s gross income must be passive income.

REITs are also subject to quarterly asset tests. On a quarterly basis, a REIT must demonstrate that at least 75% of the value of its total assets is composed of real estate assets, cash or government securities. Real estate assets may include real property, shares in other REITs, and debt instruments of publicly traded REITs.

REITs can provide investors with portfolio diversification and the potential for higher yields. However, investors should be cautioned that REITs face many similar risks to the overall real estate market, including interest rate, occupancy, and geographic risk.