REITs Explained: How Real Estate Investment Trusts Work

TL;DR. A real estate investment trust (REIT) is a company that owns or finances income-producing real estate and is required by the IRS to pay out at least 90% of its taxable income to shareholders as dividends. In exchange, the REIT itself owes no corporate income tax on the distributed profits. That structure turned a previously inaccessible asset class — institutional-grade commercial property — into something an individual can buy in one trade on the NYSE, and it explains why REIT dividend yields tend to run far above the broader stock market.

Where REITs came from

REITs were created by an act of Congress called the Cigar Excise Tax Extension of 1960, signed by President Eisenhower. The goal was democratic: let ordinary investors share in the cash flows of commercial real estate the same way mutual funds let them share in the cash flows of public companies.

The category has since grown into a $1.6 trillion U.S. asset class. According to Nareit’s REIT Industry Financial Snapshot, the FTSE Nareit All REITs Index contained 188 constituent REITs as of April 2026, owning more than $4.5 trillion of commercial real estate and distributing roughly $66.2 billion of dividends in 2024.

What actually makes a REIT a REIT

The label is not a marketing one. To qualify for the pass-through tax treatment that defines the structure, a company has to satisfy a tight set of IRS tests. The most important ones (summarized from U.S. tax code via Nareit/IRS):

The 90% distribution rule. At least 90% of taxable income must be paid out as shareholder dividends each year.
The 75% asset test. At least 75% of total assets must be real estate, cash, or U.S. Treasuries.
The 75% income test. At least 75% of gross income must come from rents, mortgage interest on real property, or sales of real estate.
The 100-shareholder rule. The REIT must have at least 100 shareholders after its first taxable year.
The 5-or-fewer rule. No five individuals can together own more than 50% of the shares during the last half of a taxable year.
The 25% TRS limit. No more than 25% of assets can sit in taxable REIT subsidiaries used for ancillary, non-qualifying business lines.

Fail any of these and the company loses its REIT election — which means it suddenly owes corporate income tax on its profits like any other C-corp. That punitive consequence is why management teams obsess over the tests and why REITs are typically built to push every spare dollar of cash flow back out the door as a dividend.

Equity, mortgage, and hybrid

REITs split into three economic types and three trading types. The economic split is what an investor should care about first:

Equity REITs own the actual real estate — the office tower, the warehouse, the apartment complex — and earn rent. This is the dominant flavor and what people usually mean when they say “REIT.”
Mortgage REITs (mREITs) own the loans, not the buildings. They borrow short, lend long, and earn the net interest spread. They behave less like real estate and more like a leveraged fixed-income fund, which is why they are vastly more rate-sensitive.
Hybrid REITs own a mix of both, although the pure hybrids have largely faded.

The trading split — from the SEC’s investor.gov — is whether the REIT is publicly traded on an exchange, registered but non-traded, or fully private. For a beginner, publicly traded equity REITs are by far the most straightforward exposure: same price discovery, same liquidity, same disclosure regime as any large-cap stock. Non-traded REITs come with serious caveats the SEC explicitly flags: shares may not be tradable for years, valuations can lag by 18 months or more, and upfront sales commissions on offerings frequently run 9–10%.

Where REITs invest: the sub-sectors

An “equity REIT” is not one asset class — it is at least ten, each with a different demand driver and a different rate sensitivity. The table below maps the major U.S. sub-sectors and gives a recognizable example for each.

Sub-sector	What it owns	Example U.S. REIT
Residential	Apartments, single-family rentals	AvalonBay, Equity Residential
Retail	Malls, strip centers, net-lease single-tenant	Simon Property Group, Realty Income
Industrial / logistics	Warehouses, distribution centers	Prologis
Data centers	Wholesale and colocation server halls	Equinix, Digital Realty
Infrastructure	Cell towers, fiber, energy pipelines	American Tower, Crown Castle
Healthcare	Senior housing, medical office, hospitals	Welltower, Ventas
Self-storage	Climate-controlled storage units	Public Storage, Extra Space
Office	CBD and suburban office buildings	Boston Properties
Lodging / resorts	Hotels and resorts	Host Hotels, Park Hotels
Timber / specialty	Commercial forests, billboards, gaming	Weyerhaeuser, Gaming & Leisure Properties

Source: sub-sector taxonomy per Nareit. Representative tickers are illustrative, not recommendations.

How the cash actually flows

The mechanics that make a REIT’s dividend possible are simpler than they sound. Tenants pay rent. The REIT pays its operating costs, its interest expense, and a modest capital reserve. Almost everything that’s left becomes a dividend, because anything not distributed gets taxed at the corporate level. The diagram below traces that flow.

Source: structure per U.S. REIT tax code and SEC investor.gov.

Why net income lies about a REIT — and FFO doesn’t

The single biggest mistake a new REIT investor makes is reading the bottom of the income statement. GAAP net income forces a REIT to deduct depreciation on its buildings every year, even though a well-maintained office tower or warehouse generally does not economically depreciate the way a car or a server does. The result is a reported earnings figure that looks dramatically lower than the actual cash the property is throwing off.

The industry-standard fix is FFO — Funds From Operations. Nareit defines FFO as net income, plus depreciation and amortization of real estate, minus gains (or plus losses) on sales of properties and certain impairment charges. In plain English, FFO is what net income would look like if you stopped pretending that the building was wasting away. A further refinement, AFFO (Adjusted FFO), subtracts the recurring maintenance capex needed to keep the asset rentable. AFFO is the closest thing to “true” distributable cash flow per share.

For valuation, REIT analysts use Price / FFO and Price / AFFO multiples rather than P/E ratios, and dividend coverage is measured as payout ratio against FFO or AFFO — not against GAAP earnings.

Why REITs care so much about interest rates

REITs combine two characteristics that make them unusually rate-sensitive: they finance their properties with substantial debt (industry-wide debt ratio of 36.0% per the most recent Nareit snapshot), and they trade largely as a yield instrument. When the U.S. 10-Year Treasury yield rises, two things happen at once: a REIT’s new debt becomes more expensive to roll, and its dividend yield must rise (i.e., its price must fall) to stay competitive with the now-higher risk-free rate. That is the simple mechanical reason REITs underperform during rate-hike cycles and tend to outperform when the curve is being cut.

The chart below compares the most recent dividend yield on the FTSE Nareit All REITs Index against the dividend yield on the S&P 500.

Source: Nareit REIT Industry Financial Snapshot, April 2026.

The roughly 3-percentage-point spread is the “extra” income an investor is paid for accepting REIT-specific risks: rate sensitivity, sub-sector cyclicality (an office REIT in 2024 looked nothing like an industrial REIT), tenant credit quality, and the fact that REITs cannot easily retain cash to weather a downturn because they are forced to distribute most of it.

A worked example

Consider a simplified, hypothetical apartment REIT. Annual rent collected: $200 million. Operating expenses: $80 million. Depreciation: $50 million. Interest expense: $30 million. GAAP net income works out to $40 million. But the building hasn’t actually lost $50 million of value — that depreciation is an accounting fiction. FFO, which adds depreciation back, equals $90 million. If the REIT then spends $10 million on recurring maintenance, AFFO is $80 million.

The 90% rule applies to taxable income, not to FFO — but in practice management teams target a dividend that consumes 70–90% of AFFO, leaving a modest buffer for unexpected vacancies. An investor who only looked at the $40 million net income would conclude the dividend was unaffordable. An investor who looked at the $80 million AFFO would conclude the dividend was comfortably covered. Same company, completely different verdict.

Common mistakes

Reading P/E instead of P/FFO. A REIT with a P/E of 60 can have a perfectly reasonable P/FFO of 15. Use the right multiple.
Treating all REITs the same. Industrial REITs and office REITs have lived through completely different decades. Sub-sector matters more than the “REIT” label.
Ignoring debt maturities. A REIT with most of its debt rolling in the next 18 months in a rising-rate environment is a fundamentally different risk than one that termed out in 2021 at 3% for 10 years.
Forgetting the tax treatment. REIT dividends are largely ordinary income, not qualified dividends. The SEC explicitly notes they don’t get the reduced corporate dividend tax rates. Many investors hold REITs in tax-advantaged accounts for that reason.
Buying non-traded REITs without reading the fine print. The SEC has issued repeated warnings about illiquidity, stale valuations, and 9–10% upfront sales fees that erode capital before a single dollar of return is earned.

What to learn next

If REITs interest you, the most useful adjacent concepts are bond duration and convexity (because REITs trade like long-duration bonds with growth optionality on top), buybacks vs dividends (REITs are a clean case study in why dividends are sometimes structurally required), and the yield curve (because REIT performance is highly correlated with the shape and level of the curve).

Sources

Disclosure: This article was produced with AI assistance and reviewed before publication. It is for informational purposes only and is not investment advice.