Real estate investment trust

REITs were born from a law that Congress enacted in 1960 to enable small investors to invest in real estate without either the large capital required to purchase single properties, or the responsibilities of property maintenance on a direct realty purchase. When holding shares of an equity REIT, an investor is an actual owner of real estate.

REITs receive special tax treatment--the deduction of dividend payments on their corporate income taxes-- as long as the primary purpose of the company is to own real estate and it pays out 90% of its dividend income (rental income) each year to shareholders. The special tax treatment REIT dividends receive means that they are deemed non-qualified dividends for the investor (ie. not subject to the lower "qualified" dividend tax rate granted to firms subject to double taxation). This makes REITs very tax-inefficient, and best held in tax-deferred accounts. If an investor has filled up available tax-advantaged space with bonds and wants to invest in REITs, placing them in a low-cost variable annuity or a Non-deductible Traditional IRA is usually more tax efficient than holding them is a taxable account. Alternately, an investor can also switch taxable bonds held in tax-advantaged accounts for REIT held in tax-advantaged and adding  municipal bonds held in taxable accounts.

Types of REITs

 * Equity REITs: REIT stocks traded on a public stock exchange. This makes REITs very liquid unlike owning real estate on your own.
 * Diversified REITs: own a diverse group of properties not tied to any specific sector or industry.
 * Industrial REITs: own industrial real estate, ie. used for industry manufacturing.
 * Office REITs: REITs that own office buildings or other similar property.
 * Residential REITs: REITs that invest in residential real estate, such as apartment complexes.
 * Retail REITs: REITs that invest primarily in retail properties such as shopping malls.
 * Specialized REITs: own property that is specialized in a single use (such as logging or storage).


 * Mortgage REITs: Invest primarily in mortgages backed by commerical real estate, and the earnings are from the mortgage loans. (Vanguard REIT Index Fund does not invest in mortgage REITs since they are not part of the MSCI REIT index).
 * Hybrid REITs: REITs that invest in both property ownership and mortgages.
 * Private REITs: Private (non-traded) REITs are not traded on a public stock exchange, and are very illiquid. These are often sold by financial advisors who receive large commissions not looking out for your best interest, and are designed to be sold and not bought.

Composition of MSCI REIT index
Below is a table of a percentage breakdown of the different types of REITs in the Vanguard REIT Index Fund which tracks the MSCI REIT Index.

REIT dividend yield
REIT dividends are composed of three different types of yield income, which are taxed at different rates:
 * Return of Capital: This is a return of your own investment and is not taxed upon distribution, it reduces your cost basis by the amount of the dividend. For more information see Vanguard REIT Index Tax Distributions.
 * Capital Gain: Results from sale of properties or other assets, taxed at either short or long term capital gains rates.
 * Dividend: Income which usually results from rental income of properties, which is non-qualified and taxed at your full marginal tax rate.

The exact breakdown of the REIT fund dividends are not known until after the calendar year, sometimes as late as late February or early March. Beware of this if you hold REIT in a taxable account. Vanguard provides a current estimate of unadjusted yield, and adjusted yield accounting for the return of capital on their Current REIT index fund yield estimate page, and they do not quote a 30-day SEC yield for the fund due to these complications.

Interest rate risk
REIT prices may decline as the interest rate rise.

Sector risk
REITs are one specific sector, there are only 97 stocks in the index. This makes REITs more volatile than broad market index funds. Some suggest that public REITs are only a small slice of the commercial real estate market, and best referred to as a separate asset class than a sector.

Role in a portfolio
Most Bogleheads allocate REITs up to 10% of their total portfolio according to a forum poll. REITs should be treated as equity, even though they have income-producing characteristics similar to bonds, due to the risks involved. REITs can act as a portfolio diversifier since they have varying correlation to stocks and bonds (either higher or lower). REITs are weakly correlated to inflation, due to the hard asset/rental income nature of the investment, however if you are looking specifically for inflation protection, use TIPS instead. One should consider what Percentages of REITs Present in Vanguard Index Funds these funds already own before adding a separate REIT fund.

Funds

 * See US Real Estate Investment Trusts for mutual funds and ETFs covering the asset class.


 * Vanguard REIT Index Fund
 * Current REIT index fund yield estimate


 * Vanguard REIT Index ETF

Definitions

 * REIT definition on Investopedia
 * Funds From Operations- FFO on Investopedia
 * Timber Investment Management Organization - TIMO on Investopedia

Sites

 * REIT.com
 * REIT Wrecks
 * MSCI REIT Index

Forum discussions

 * The Core Four is a good forum discussion thread regarding the inclusion of REITs in a portfolio.

Real Estate research journals

 * Journal of Real Estate Research
 * International Real Estate Review