Real Estate Investment Trusts (REITs): How They Work and Pay Dividends

How Landlords Became a Stock Market Asset

In 2023, U.S. REITs collectively owned $4.5 trillion in real estate assets — office towers, hospital wings, data centers, apartment complexes, and strip malls. An investor with a standard brokerage account can own a fractional share of all of them before lunch. Congress created this structure in 1960 specifically to democratize real estate ownership the same way mutual funds democratized stock ownership.

The Legal Structure Behind a REIT

A Real Estate Investment Trust is a company that owns, operates, or finances income-producing real estate. To qualify as a REIT under U.S. federal law, a company must meet several strict requirements set by the Internal Revenue Code.

At least 75% of total assets must be real estate, cash, or government securities
At least 75% of gross income must come from real-estate-related sources such as rents or mortgage interest
At least 90% of taxable income must be distributed to shareholders as dividends each year
The company must have at least 100 shareholders after its first year of existence
No more than 50% of shares may be held by five or fewer individuals

That 90% distribution requirement is the engine of REIT dividends. Because REITs pay out almost all earnings, they typically yield significantly more than broad stock indices. The average REIT dividend yield in the U.S. historically runs between 3% and 5%, compared with roughly 1.5% for the S&P 500.

Equity REITs vs. Mortgage REITs

Not all REITs do the same thing. The two primary categories differ fundamentally in how they generate income.

Type	Income Source	Risk Profile	Example
Equity REIT	Rents from owned properties	Moderate — tied to occupancy and property values	Prologis (warehouses), Simon Property Group (malls)
Mortgage REIT (mREIT)	Interest from real estate loans or MBS	Higher — sensitive to interest rate spreads	Annaly Capital Management, AGNC Investment Corp
Hybrid REIT	Both rents and interest income	Mixed exposure	Less common; many converted to pure equity

Equity REITs are by far the dominant form, accounting for roughly 90% of total REIT market capitalization in the U.S. Mortgage REITs generate income through net interest margin — the spread between what they earn on loans and what they pay to borrow — making them acutely sensitive to changes in short-term interest rates.

Property Sectors Within Equity REITs

Equity REITs specialize by property type. The FTSE Nareit All REITs Index tracks eleven distinct sectors.

Industrial — warehouses and logistics facilities (Prologis is the largest globally)
Retail — shopping malls and freestanding stores
Residential — apartment communities and single-family rental homes
Office — urban and suburban commercial office buildings
Health care — hospitals, senior housing, and medical offices
Data centers — facilities housing servers for cloud computing companies
Self-storage — Public Storage and Extra Space Storage dominate this niche
Timberland — forest land harvested for lumber

Sector specialization matters. During 2020–2021, retail and office REITs suffered significant declines as remote work and e-commerce reshaped demand. Meanwhile, industrial and data center REITs posted strong gains. Knowing a REIT's sector is the first step in assessing its risk.

How Dividends Flow from Property to Investor

The dividend mechanics follow a predictable chain. Tenants pay rent. The REIT collects rent, subtracts operating costs (maintenance, insurance, property taxes, management fees), and is left with net operating income (NOI). After debt service on any mortgages, the remaining cash becomes funds from operations (FFO).

FFO is the REIT industry's preferred earnings metric. It adds back depreciation (a non-cash charge) to net income, because real estate assets often appreciate over time even as accounting rules require depreciation. Analysts use FFO per share to evaluate whether a REIT's dividend is sustainable. A payout ratio above 100% of FFO is a warning sign.

Metric	Formula	Purpose
Net Operating Income (NOI)	Revenue − Operating Expenses	Property-level profitability
Funds from Operations (FFO)	Net Income + Depreciation − Gains on Sales	Recurring earnings benchmark
Adjusted FFO (AFFO)	FFO − Capital Expenditures − Straight-line Rent	Cash available for distribution
Payout Ratio	Dividends ÷ AFFO	Dividend sustainability check

Tax Treatment of REIT Dividends

REIT dividends are taxed differently from qualified dividends on common stocks. Most REIT dividends are classified as ordinary income, taxed at the investor's marginal rate rather than the lower 15–20% qualified dividend rate. However, the 2017 Tax Cuts and Jobs Act introduced a 20% deduction on pass-through income (Section 199A), allowing individual investors to deduct 20% of REIT dividends from their taxable income — effectively capping the top rate on REIT ordinary dividends at 29.6% rather than 37%.

Capital gains distributions from asset sales are taxed at long-term capital gains rates. Return of capital distributions reduce cost basis and defer tax until the shares are sold.

Publicly Traded vs. Non-Traded REITs

Most retail investors access REITs through publicly traded shares on the NYSE or Nasdaq. These offer daily liquidity and price transparency. Non-traded REITs are registered with the SEC but not listed on exchanges, making them illiquid and often carrying high upfront commissions of 8–12%. Private REITs are exempt from SEC registration entirely and are limited to accredited investors.

The National Association of Real Estate Investment Trusts (Nareit) reported 225 publicly listed REITs in the U.S. as of 2024, with a combined equity market capitalization exceeding $1.3 trillion.

Risks Unique to REIT Investing

Interest rate sensitivity is the central risk. When rates rise, REITs face higher borrowing costs that compress FFO margins. Rising rates also make their dividend yields look less attractive compared to newly issued bonds, pushing share prices down. The 2022 Federal Reserve rate-hiking cycle cut the FTSE Nareit All Equity REITs index by roughly 25%.

Sector-specific risks add another layer. Retail REITs depend on consumer spending. Office REITs face structural headwinds from remote work. Health care REITs are exposed to regulatory changes in Medicare reimbursement rates.

REITs in a Portfolio Context

Institutional investors have long used REITs as a distinct asset class. Academic research, including work published in the Journal of Portfolio Management, suggests a portfolio allocation of 5–15% in REITs can improve risk-adjusted returns over the long run due to partial correlation with broad equities and inflation-hedging properties. Rents tend to rise with inflation over time, particularly for leases with CPI-adjustment clauses.

This article is for informational purposes only and does not constitute financial advice.