How Do Reit Managers Make Money

9 Minute Read | September 27, 2021

Your 401(k) is maxed out. You've got your Roth IRA humming along. Your retirement is looking pretty sweet, but you want more. You've heard that investing in real estate is a good idea, and maybe you read somewhere that a real estate investment trust (REIT) is a great way to get into that space.

But what is a REIT? How does it work? Well, buckle up, and we'll take you through it.

What Is a Real Estate Investment Trust (REIT)?

A real estate investment trust—the cool kids call it a REIT, pronounced "reet"—is basically a mutual fund that buys real estate instead of stocks. REITs have a special tax status that requires them to pay 90% of their profits back to the shareholders.¹ This payment is called a dividend. If they follow this rule, then they aren't taxed at the corporate level like every other type of business.

All REITs have to meet certain requirements to qualify:

Must be a trust, association or corporation
Must be managed by at least one official trustee or director
Must have at least 100 shareholders
No five of these shareholders may own more than 50% of the shares²

There are also rules around how much of a REIT must be invested in actual real estate properties and how much of the gross income from the REIT must be generated by real estate.

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Is your head spinning yet? Well, this certainly isn't the easiest way to invest in real estate. But there's a lot to learn here.

How Do I Invest in a REIT?

There's no secret formula here—anyone can invest in a REIT by simply purchasing shares through a broker, a REIT exchange-traded fund (ETF) or a REIT mutual fund. But that's only if the REIT is publicly traded. For a non-traded or private REIT, you'd have to purchase shares through a broker that's associated with a non-traded REIT.³

What Kind of REITs Are There?

There are a handful of different types of REITs out there, which can make things feel pretty complicated. So let's unpack the differences below.

Equity REITs

Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.

Some of these types may be:

Apartment complexes
Single-family homes
Malls
Big-box retail space (a shopping center featuring at least one big store like Best Buy or Home Depot)
Hotels and resorts
Health care buildings and hospitals
Long-term care facilities
Self-storage facilities
Office buildings
Industrial buildings
Data centers
Mixed-use developments

Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.

Now, equity REITs make money for their investors in several ways:

Rent: They make the most money by collecting rent from tenants on the property they own.

Appreciation: As the property values go up, the values of the shareholders' investments grow too.

Strategic purchasing: They make money by buying low and selling high.

Mortgage REITs

Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates. To maximize returns, mortgage REITs tend to use a lot of debt—like $5 of debt for every $1 in cash, and sometimes even more.

Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. The profit is in the difference between the two interest rates.

Okay, this gets complicated, so let's put it in numbers to try to simplify it. Let's say a mortgage REIT raises $1 million from investors. It then borrows $5 million at a 2% short-term interest rate. This gives it $100,000 in annual expenses that it has to pay back. But it takes the $6 million in cash it now has to buy a bunch of mortgages owing 4% interest, which produces $200,000 in interest income for the REIT. This difference ($100,000 in our example) is the profit.

Because you're smart, you may be asking yourself, What happens if the short-term interest rate goes up?

Any increase in the short-term interest rate eats into the profit—so if it doubled in our example above, there'd be no profit left. And if it goes up even higher, the REIT loses money. All of that makes mortgage REITs extremely volatile, and their dividends are also extremely unpredictable.

Non-Traded REITs

Now, some REITs aren't publicly traded on national stock exchanges. Non-traded REITs might still be registered with the Securities and Exchange Commission (SEC), but you won't find them available for trade on the stock market. A big risk here is that it can be very hard to know the value of a non-traded REIT until years after you're invested.⁴ So if it's a dud that's losing your money, you won't know for a long time—yikes!

Private REITs

A private REIT is neither registered with the SEC nor available for trade on stock exchanges.⁵ If you invest in one, be prepared to forget you had that money. They're usually illiquid—a fancy term that means an investment can't be easily turned back into cash. To get the best returns, you probably won't have access to the money for a long time. That makes it very difficult to get out of a private REIT once you're in one. It's not as easy as selling a mutual fund.

For a private REIT to work for you, you'd need to be in a group that isn't milking the REIT for their profit and driving up management fees—leaving nothing on the table for investors. Beware! This is risky stuff.

Is a REIT a Good Investment?

Let's get this out of the way up front: Mortgage REITs are a terrible idea. They use debt to buy debt and they're so risky you don't want to come within 50 miles of one. What happens when interest rates go up? You lose money. What happens when people stop making their house payments? A REIT can probably withstand one or two homeowners who bail on their mortgages. But if we get into a situation similar to 2008 when millions of people lost their homes? Forget it.

Mortgage REITs are a terrible idea. They use debt to buy debt and they're so risky you don't want to come within 50 miles of one.

Equity REITs are not as risky, and there are maybe one or two out there that perform as well as good growth stock mutual funds. But, in general, if you're going to invest in real estate, then you should just buy real estate. When you invest in a REIT, you don't have any control over which properties they buy, how the properties are managed, or any decisions made about those properties.

If you're going to invest in real estate, then you should just buy real estate. When you invest in a REIT, you don't have any control over which properties they buy, how the properties are managed, or any decisions made about those properties.

This isn't rocket science or brain surgery—a REIT simply isn't your best investment option.

Invest in Real Estate the Old-Fashioned Way

Real estate is a great investment, but you need to know what you're doing, and you should be passionate about it. Start by learning about real estate from a pro—like one of our real estate Endorsed Local Providers (ELPs).

A real estate ELP can educate you about the types of properties you can buy and what types of renters you can expect. They can help you get a deal. In real estate, money is made at the buy. Our ELPs can teach you to be patient so you can buy real estate like a pro—for pennies on the dollar.

To invest in real estate the smart way and keep your financial risk low, you need to answer yes to the following questions before you start investing:

Are you completely debt-free?
Do you have an emergency fund of at least 3–6 months of expenses?
Are you contributing 15% of your income to retirement?
Are you able to pay cash for your investment property?

And because HVACs break down and garbage disposals stop working, it's a good idea to have money set aside for upkeep and repairs. As a landlord, that's up to you.

How Traditional Real Estate Investing Makes Money

Just like with REITs, you'll make money several ways as the owner of an investment property. You'll make money over the long term as the value of your property increases—especially when you buy a house at a low price, then ride out any downturns in the market, and sell it when the value has gone up. And if you reinvest your profits into another similar property within a certain period of time, the 1031 exchange allows you to avoid paying capital gains tax.

You also make money with rental income. This is why most investors buy property. Once you get a quality renter, your property will generate monthly income without too much effort on your part. Heck, you can even hire a property management company to handle repairs and maintenance for you, although that will cut into your profits.

Just keep in mind that dealing with renters can sometimes be unpleasant and time-consuming. And they can cost you a lot of money if they damage the property. Evicting a renter can be a headache too. Depending on the laws in your area, it may require you to hire a lawyer. But if you're prepared, the long-term benefits can be pretty sweet.

Are You Ready to Buy Some Real Estate?

If you're passionate about owning investment property, now is a great time to talk to one of our real estate Endorsed Local Providers (ELPs). They're experts at buying property in your area, they put serving you above commission, and they'll educate you on all of the ins and outs of buying real estate.

Find a top real estate agent near you!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.