REITs Explained: Property Income Without the Property

A REIT owns income-producing property and hands almost all of its profit to shareholders. The law requires it. In exchange for distributing at least 90% of its taxable income every year, a real estate investment trust pays no corporate income tax on what it passes through, which is why the yield on a REIT looks nothing like the yield on an ordinary operating company and why the dividend does most of the work in your total return.

The bargain that creates the yield

The US REIT structure dates from 1960. The idea was to let someone with a few hundred dollars own a slice of commercial property that had until then been reachable only by institutions and wealthy families.

The trade is clear enough. A company electing REIT status accepts three main constraints: at least 75% of its assets must sit in real estate, cash or government securities, at least 75% of its gross income must come from rent, mortgage interest or property sales, and at least 90% of taxable income must leave as dividends each year. Meet all of that and corporate tax disappears. Fail it and the company is taxed like any other corporation, which erases the reason anyone bought the shares.

That 90% floor explains almost everything odd about REITs. A REIT cannot retain much cash, so it cannot fund a new warehouse out of profit the way a software company funds new engineers. It raises money by issuing shares and by borrowing. When the share price is high, issuing equity is cheap and the company builds; when the price is low, the tap closes and expansion stops, which means a REIT’s growth depends on the market’s opinion of it in a way that a self-funding business never has to worry about.

Two different animals wearing one label

Equity REITs own buildings. They collect rent, pay for maintenance, manage leases, and sell assets when the price is right. Almost every large, familiar REIT is one of these.

Mortgage REITs own the debt. They buy mortgages and mortgage-backed securities, borrow short-term against them, and keep the difference between what the assets yield and what the borrowing costs. The business is a leveraged interest rate spread wearing a property costume.

The distinction matters far more than the shared name suggests, because a mortgage REIT’s book value can fall hard when short-term funding costs rise faster than the yield on the assets it holds, and the dividend that looked so generous on the screener gets cut in the same quarter the share price collapses.

	Equity REIT	Mortgage REIT
What it owns	Buildings and land	Mortgages and mortgage-backed securities
Where the income comes from	Rent	The spread between asset yield and funding cost
Main risk	Occupancy, rent levels, property values	Rate moves, funding costs, prepayments
Leverage	Moderate	High
Behavior in a rate shock	Painful	Severe

Yield screeners sort high to low. Mortgage REITs sit at the top of that list, and beginners meet them first.

Why the earnings line is wrong

Accounting depreciates buildings. Every year a property’s book value drops by a set amount, the charge runs through the income statement, and reported earnings per share comes out far below the cash the building actually produced. The building itself may have gained value over the same twelve months.

So the industry uses funds from operations. FFO starts with net income, adds back real estate depreciation and amortization, and subtracts gains on property sales, since a one-off disposal says nothing about the repeatable stream of rent.

Work it through. A REIT reports net income of $100 million. Depreciation for the year was $80 million. It sold a building at a $15 million gain.

FFO = $100m + $80m - $15m = $165m

Across 100 million shares that is $1.65 of FFO per share against $1.00 of EPS. Now look at a $1.40 annual dividend. Against earnings it is 140% of profit and looks reckless. Against FFO it is about 85% and looks ordinary.

AFFO goes one step further. Adjusted funds from operations subtracts the money a REIT has to spend every year simply to keep the buildings rentable: roof replacements, tenant improvements, leasing commissions. Say that comes to $25 million, and a straight-line rent adjustment removes another $5 million.

AFFO = $165m - $25m - $5m = $135m

That is $1.35 a share, below the $1.40 being paid out. The gap is being funded from somewhere other than operations.

What you are actually renting out

REITs are not one asset class. The sectors behave differently enough that owning two of them can feel like owning two unrelated businesses.

Sector	What it owns	What drives it
Residential	Apartments, single-family rentals, manufactured housing	Household formation, wages, local supply
Industrial	Warehouses, distribution centers, cold storage	Goods volumes, online retail, access to ports and highways
Retail	Malls, strip centers, standalone stores	Consumer spending, tenant credit, online substitution
Data center	Server halls, power and cooling capacity	Computing demand, electricity supply, land near fiber
Healthcare	Hospitals, medical offices, senior housing	Demographics, operator solvency, reimbursement rules
Office	Towers and business parks	Occupancy, lease expiries, how many days staff come in

Lease length is the number to find. A residential REIT re-prices its entire portfolio every year because the leases run twelve months, so rising prices feed through quickly and so does a recession. A REIT holding fifteen-year leases with hospital operators has locked in its cash flow and locked itself out of raising rents. Both of those are real positions, and the brochure calls both of them stability.

The same logic drives the sector funds covered in sector ETFs, where concentration is the feature and the risk at once.

Rates, and why they matter this much

Property is priced the way a bond is priced: a stream of income divided by the return a buyer demands. That divisor is the cap rate.

A building produces $500,000 of net operating income a year. Buyers pricing that risk at a 5% cap rate pay $500,000 / 0.05 = $10,000,000. Let required returns rise so the same building trades at a 6% cap rate, and the price becomes $500,000 / 0.06 = $8,333,333. Nothing changed inside the building. The tenants are the same, the rent is the same, and one percentage point on the cap rate still took 16.7% off the value.

Two other channels run alongside it. REITs carry mortgages and bonds, so higher rates raise refinancing costs as maturities roll. And income buyers compare a REIT yield against a Treasury yield, so when the safe alternative pays more, the REIT has to get cheaper before anyone will take the risk. The general mechanism sits in how interest rates affect stocks, amplified here by leverage and by the fact that income is the entire pitch.

This is why REITs disappointed people who bought them as inflation protection during a rising rate cycle. Rents did go up. The discount rate went up faster.

The dividend is taxed as ordinary income

Here is the other side of the corporate tax exemption. Income that was never taxed at the company level generally fails the qualified dividend test, so most of what a REIT pays you is taxed at your marginal ordinary income rate, the same rate as your salary.

Take a $20,000 position yielding 5%, which is $1,000 of dividends in a year. At a 24% marginal rate the tax is $240. The identical $1,000 arriving as a qualified dividend from an ordinary company, taxed at 15%, would cost $150. Brackets and rates change, so check the current figures before you plan around them.

Three details soften or complicate that.

Part of a REIT distribution is often classified as return of capital. You pay no tax on it now, your cost basis falls by that amount, and the bill arrives as a larger capital gain when you sell.

US law has allowed a deduction on qualified REIT dividends under Section 199A. The size and the expiry of provisions like that move with legislation, so treat it as a question to look up.

Placement does the rest of the work. A REIT held inside an IRA or a 401(k) produces no annual tax bill at all, which makes it one of the clearest cases in the whole of tax-efficient investing: put the high, ordinary-income yield in the sheltered account and keep the tax-favored holdings outside. The wider mechanics of yield, payout ratios and dividend safety are in dividend investing.

One REIT, or a basket

A single REIT is a concentrated bet on one management team, one debt stack, one property type and usually one region. Tenants leave. Debt comes due in bad years. A REIT ETF spreads that across dozens or hundreds of companies, charges a fee for doing so, and removes the possibility that one bad capital allocator ruins your position. The creation and pricing machinery behind those funds is covered in what an ETF is, and the fee is worth running through the expense ratio calculator before you buy.

One thing gets missed constantly. A broad US index fund already holds REITs, since they are listed companies inside the index like any other. Adding a dedicated REIT fund increases weight in something you own already, which is a decision worth making on purpose. Diversification arrives from assets that behave differently, and a REIT fund and a stock fund have plenty of overlap in how they trade.

Where REITs let you down

They trade like stocks when it counts. The pitch describes property, steady rent and a long horizon, and then a panic arrives and REIT shares fall with everything else, as they did in 2008 and again in the March 2020 selloff. Correlation with equities tends to rise exactly when you wanted it to fall.

Buildings can go obsolete. A mall loses its anchor tenant, the smaller tenants discover they hold exit clauses tied to that anchor, and the whole rent roll unwinds across two or three years while the property still sits on the balance sheet near its old carrying value, which is how a REIT can report stability right up to the quarter it writes the asset down. An office tower keeps its lease income long after the desks empty, and the reckoning waits for the expiry date.

Leverage cuts both ways, and the debt sits under an asset class most people bought for safety. A REIT that has to refinance a large maturity in a market that has repriced can find the new rate consumes the cash that used to be the dividend.

And the yield screen is a trap all by itself. The highest yields on the list belong to the companies the market expects to cut, so screening on yield alone reliably selects for the next round of cuts.

Pick one REIT or REIT fund you are considering, find its dividend per share and its AFFO per share in the latest quarterly release, and divide one by the other. If the payout is running above AFFO, you have learned something no yield figure was going to tell you. Then decide which account it belongs in.