As economic markets, and more specifically real property values, continue to escalate, it may be prudent to add real estate ownership to your personal portfolio. However, the responsibility of being a landlord can lead to extensive time commitments, operational headaches and significant expenses. To obtain the income and diversification benefits of real estate without the challenges of direct ownership, many investors are turning to a more convenient alternative – real estate investment trusts (REITs).

How REITs Work

A REIT is a special kind of corporation that owns and typically operates income-producing real estate or related assets. These may include office buildings, shopping malls, and residential apartments to name a few. To qualify as a REIT, at least 75% of the company's income must come from real estate. (Be sure to discuss with your advisor the adverse consequences that may occur if your REIT is unable to qualify as a REIT.)

Unlike normal corporations, REITs are not required to pay taxes at the corporate level. In exchange for this benefit, they must distribute 90% or more of their rental income to shareholders in the form of dividends.

These property companies can be either private or publicly traded. Public REITs are similar to regular equities in that both trade on public stock exchanges. For example, shares of the country's largest REIT, mall operator Simon Property Group, can be bought and sold on the New York Stock Exchange.

Income, Diversification and Liquidity Benefits

Perhaps the biggest draw to REITs for investors is the potentially large income stream. The requirement to distribute, at a minimum, 90% of net rental income to shareholders in the form of dividends is enticing. Baby boomers in or approaching retirement may look to REITs' dividends as a steady source of regular income in a historically low interest rate environment.

Another advantage to REITs is the diversification they provide. Since real estate values do not always correlate to stock prices, the two commodities can move together or in completely opposite directions. A portfolio that contains both stock and real estate holdings may provide protection over market declines that affect only one or the other. A secondary form of diversification occurs directly within the real estate sector. Pooled money from several investors allows the trust the ability to purchase a variety of properties, both in terms of type and geography. In this manner, one underperforming building will not destroy your overall portfolio.

Liquidity is another benefit of REITs, as shares can be bought and sold on public markets. Instead of having to endure the arduous process of selling the property to cash out, you simply sell your shares. Thus, REITs afford you the flexibility to achieve your target real estate exposure because you can own the exact amount that fits your investment strategy.

Buyer Beware

While there are distinct advantages to these investment vehicles, REITs also contain certain drawbacks. There is no guarantee that a REIT will distribute a dividend. In addition, when a dividend is distributed, the proceeds are taxed as ordinary income, which is subject to a higher rate than qualified stock dividends. One way to limit REITs' tax impact, however, is to hold them in an IRA, 401(k) plan or other tax-advantaged investment account.

REITs might also have low growth potential. As 90% of net income returns to investors, only 10% of income can be reinvested back into the business. This might force the REIT management to take on increased debt to expand real estate holdings.

As with all investments, REITs can also be exposed to significant investment risk. Due diligence needs to be considered for all factors of the real estate market including but not limited to property values, interest rates, occupancy rates, geography, etc. Rising interest rates and increasing vacancies could diminish profitability.

Is a REIT Right for You?

Thanks to the current low-interest-rate environment, REITs are an especially attractive addition to investor portfolios. While no investment is a sure thing, REITs offer an opportunity at real estate exposure with potential cash flow. Your advisor can help you determine whether REITs belong in your portfolio, and if so, how best to invest in this asset class.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.