REITs Explained: What They Are, How They Work, and How to Value Them

May 9, 2026 · guides · 13 min read

REITs Explained: What They Are, How They Work, and How to Value Them

Real estate investment trusts (REITs) are one of the most misunderstood asset classes in retail investing. They look like stocks, they trade like stocks, but they behave nothing like the technology or consumer companies most investors are familiar with. The valuation metrics are different, the income math is different, and the interest rate sensitivity is different.

This guide gives you a complete REITs explained framework: what a real estate investment trust is, how the 90% distribution rule works, the difference between equity and mortgage REITs, how to value a REIT using FFO and AFFO instead of EPS, why REIT dividends run above market averages, and the key risks to understand before committing capital. If you have ever wondered why REITs pay such high dividends or why your standard P/E analysis does not work on them, this guide answers it.

What Is a REIT?

A real estate investment trust is a company that owns, operates, or finances income-generating real estate. Congress created the REIT structure in 1960 with the explicit goal of giving individual investors access to large-scale, diversified real estate portfolios the same way they access stocks and bonds: by purchasing shares through an exchange.

Before REITs, large commercial real estate (office towers, shopping centers, industrial warehouses, apartment complexes) was accessible only to institutional investors and wealthy individuals. The REIT structure democratized that access.

To qualify as a REIT under Internal Revenue Code rules, a company must meet several tests:

Meeting these requirements earns the REIT a special tax status: the company itself pays no corporate income tax on the income it distributes. The tax obligation passes through to shareholders, who pay tax on dividends received at their individual rates. This pass-through structure is the core reason REIT dividends are large. The company is not retaining earnings and paying a 21% corporate tax before paying you, as a typical C-corporation does.

How REITs Work: The 90% Distribution Rule

The 90% distribution requirement is the defining mechanical feature of REITs explained in simple terms: to maintain their tax advantage, REITs must pay out nearly all of their taxable income every year.

This has two important consequences.

First, REIT dividend yields are structurally higher than those of typical S&P 500 companies. When a company must pay out 90% of earnings by law, the yield relative to price will naturally exceed what a company paying out 30-40% of earnings produces.

Second, REITs cannot retain much capital internally. When they need to grow (acquiring new properties, developing new buildings), they cannot fund it from retained earnings the way a technology company funds R&D. They must return to capital markets: issuing new equity (diluting existing shareholders) or issuing debt (adding leverage). This makes the cost of capital, and therefore interest rates, deeply important to REIT economics.

The 90% rule applies to taxable income, not accounting net income. Because real estate carries large depreciation charges (a non-cash expense that reduces accounting income), a REIT's taxable income and its accounting earnings can diverge significantly. This is why EPS, the standard earnings-per-share metric used to value most companies, is nearly useless for REITs. Depreciation makes EPS appear low even when the property portfolio is generating strong cash.

Types of REITs: Equity, Mortgage, and Hybrid

Not all real estate investment trusts operate the same way. The three main types differ fundamentally in what they own and how they generate income.

Equity REITs

Equity REITs own and operate physical real estate properties. They collect rent from tenants, manage the properties, and distribute that rental income to shareholders. The vast majority of publicly traded REITs are equity REITs. Their income comes from leases. Property appreciation also contributes to total return over time.

Equity REITs are valued primarily on the income they generate from their property portfolios. The key metrics are FFO (funds from operations) and AFFO (adjusted funds from operations), both explained in detail below.

Mortgage REITs

Mortgage REITs (mREITs) do not own physical properties. They own mortgages or mortgage-backed securities. They earn income from the interest on those loans. Their business model is essentially a spread trade: borrow at short-term rates, lend at longer-term mortgage rates, and pocket the difference (net interest margin).

mREITs are highly sensitive to interest rate movements, in a different way than equity REITs. When the yield curve flattens or inverts (short-term rates rise toward or above long-term rates), the spread compresses and mREIT earnings fall sharply. mREITs also carry significant credit risk if the mortgages in their portfolio default.

Dividend yields on mREITs are often exceptionally high, sometimes 10-15%. This reflects the elevated risk of the model, not free income. Most retail investors researching REITs explained from a dividend perspective underestimate mREIT complexity.

Hybrid REITs

Hybrid REITs own both physical properties and mortgage assets. They are less common than pure equity or pure mortgage structures. The combination makes valuation more complex because you are blending property cash flows with interest-rate-spread economics.

REIT Sectors: Office, Retail, Industrial, Residential, Healthcare, Data Centers

Within equity REITs, the type of property owned drives performance dramatically. Each sector has its own demand drivers, lease structure, and competitive dynamics.

Office REITs

Office REITs own commercial office buildings. The sector faced severe structural pressure post-COVID. Remote and hybrid work reduced demand for leased square footage. Vacancy rates in major urban markets climbed to multi-decade highs in 2022 through 2025. Many office REITs cut dividends and traded at steep discounts to net asset value. The sector remains challenged by secular demand questions that were not present before 2020.

Retail REITs

Retail REITs own shopping malls and strip centers. Mall REITs in particular faced two compounding headwinds: e-commerce displacement of physical retail, and then pandemic-related store closures. Class-A malls with high-demand anchors performed better; Class-B and Class-C malls deteriorated badly. Strip centers with grocery-anchored tenants proved more resilient, as grocery demand is less vulnerable to online substitution.

Industrial and Logistics REITs

Industrial REITs own warehouses, distribution centers, and logistics facilities. This sector was the standout performer of the post-COVID era. E-commerce growth drove extraordinary demand for last-mile delivery infrastructure. Vacancy rates for industrial properties hit record lows. Rents surged. REITs in this sector compounded shareholder value at rates that made them look nothing like the slow-moving income vehicles people associate with REITs explained in traditional terms.

Residential REITs

Residential REITs own apartment complexes (multifamily), manufactured housing communities, and single-family rental homes. They benefit from persistent housing demand, limited new supply in high-barrier coastal markets, and favorable demographic tailwinds from millennial household formation. Rent growth in multifamily tracks closely with overall housing market conditions.

Healthcare REITs

Healthcare REITs own medical office buildings, senior housing, skilled nursing facilities, and hospitals. Their demand is driven by demographics: an aging population increases demand for healthcare real estate structurally. The sector is complex because many properties are operator-dependent. A senior housing REIT is not just exposed to real estate risk but to the operating risk of the companies running its facilities under triple-net or RIDEA structures.

Data Center REITs

Data center REITs own the physical facilities that house servers, networking equipment, and cloud infrastructure. Demand from cloud computing, artificial intelligence workloads, and enterprise IT migration drove strong growth throughout the early 2020s. Lease structures are typically long-term, providing revenue visibility. Power availability became a key constraint as AI compute demand accelerated from 2023 onward.

How to Value a REIT: FFO and AFFO

This section is where REITs explained gets most useful for investors who come from a traditional stock-valuation background. The valuation metrics that work for industrial companies or consumer brands do not work well for REITs.

Why EPS Fails for REITs

Real estate depreciates on the accounting books. The IRS and GAAP accounting rules require companies to depreciate buildings over their useful lives (27.5 years for residential, 39 years for commercial). In practice, well-maintained real estate often appreciates in value rather than declining. The depreciation expense on the income statement reduces GAAP net income and therefore EPS, but it does not represent a real economic cost the way depreciation on manufacturing equipment does.

This means GAAP EPS for a REIT frequently understates its true cash-generating power. A REIT with EPS of $0.50 might be generating cash of $2.00 per share because $1.50 is being absorbed by non-cash depreciation charges.

Funds From Operations (FFO)

Funds from operations is the REIT industry's primary earnings metric. It is defined by NAREIT (the National Association of Real Estate Investment Trusts) as:

FFO = Net Income + Depreciation and Amortization - Gains on Property Sales

By adding back depreciation (the distorting item) and removing gains from property sales (non-recurring), FFO gives a cleaner picture of the recurring cash a REIT generates from its property operations.

Most REIT management teams report FFO per share alongside EPS. When analysts describe a REIT's earnings, they almost always mean FFO, not EPS.

P/FFO: The REIT Equivalent of P/E

Just as P/E (price divided by earnings per share) is the primary valuation multiple for most equities, P/FFO (price divided by FFO per share) is the primary valuation multiple for REITs.

P/FFO = Share Price / FFO Per Share

A REIT trading at 15x FFO is evaluated similarly to a stock trading at a 15x P/E. Whether that multiple is attractive or elevated depends on the sector, growth rate, quality of the portfolio, and prevailing interest rates. Industrial REITs with high growth have historically commanded higher P/FFO multiples than mature, slower-growing office or retail REITs.

Comparing P/FFO across REIT sectors without accounting for growth and quality differences is a common mistake. A 12x P/FFO industrial REIT with 8% annual FFO growth is not equivalent to a 12x P/FFO office REIT with flat growth.

Adjusted Funds From Operations (AFFO)

AFFO refines FFO further by subtracting capital expenditures required to maintain the existing property portfolio (maintenance capex) and adjusting for straight-line rent (a GAAP adjustment where rent income is recognized evenly over a lease term even when actual cash payments ramp up over time).

AFFO = FFO - Recurring Maintenance Capex - Straight-Line Rent Adjustments + Other Adjustments

AFFO is the closest approximation to true free cash flow for a REIT. It represents the cash available to pay dividends and fund growth after maintaining the existing portfolio in its current condition.

When evaluating REIT dividend sustainability, AFFO payout ratio (dividends paid divided by AFFO per share) is the most relevant safety metric. A REIT paying out less than 80% of AFFO has meaningful coverage. A REIT paying out more than 100% of AFFO is paying dividends from debt or asset sales, which is structurally unsustainable.

Net Asset Value (NAV)

A third valuation approach for REITs is NAV, or net asset value per share. This is the estimated market value of the underlying real estate portfolio minus all debt and liabilities, divided by shares outstanding.

NAV is essentially what the REIT's properties would be worth if they were sold in the private market today. Comparing the REIT's share price to its estimated NAV per share tells you whether you are paying a premium or a discount to the private market value of the real estate.

REITs trading at large discounts to NAV (30-40%+) have historically attracted interest from value-oriented investors. However, distressed discounts often reflect real concerns about property quality, lease rollover risk, or balance sheet leverage rather than pure mispricings.

REIT Dividends: Why They Are Higher Than Average

REIT dividends run above S&P 500 dividend yields structurally for the reasons established earlier: the 90% distribution mandate forces high payout ratios, and the pass-through tax structure means no corporate tax layer is consumed before the distribution reaches shareholders.

The S&P 500's aggregate dividend yield typically runs in the 1.2-1.8% range. The FTSE NAREIT All Equity REIT index has historically yielded 3.5-5.5%. That gap is not accidental. It is structural.

Additional factors driving REIT dividend levels:

Dividend Growth in REITs

The best REIT operators do not just maintain dividends: they grow them. A REIT that grows its property portfolio by acquiring higher-yielding assets, developing new properties, or raising rents on existing leases generates increasing FFO per share over time. That FFO growth supports dividend increases.

Industrial and data center REITs delivered dividend growth rates of 8-12% annually through portions of the 2018-2024 period. Healthcare REITs with demographically-driven demand also grew dividends consistently. Office and retail REITs with structural headwinds cut dividends.

Dividend growth history is a useful signal of portfolio quality and management discipline. A REIT that has raised its dividend every year through a full interest rate cycle demonstrates pricing power and balance sheet resilience.

Tax Treatment of REIT Dividends

The tax treatment of REIT dividends is less favorable than that of qualified dividends from standard C-corporations, which is an important consideration for taxable account holders.

Most REIT dividends are classified as ordinary income (also called non-qualified dividends) rather than qualified dividends. Ordinary income is taxed at your marginal income tax rate rather than at the lower long-term capital gains rates (0%, 15%, or 20%).

For investors in the 32% or 37% tax brackets, this difference is significant. A 4% REIT yield on a taxable account generating ordinary income may net less after-tax than a 3% yield from a qualified-dividend-paying company.

The 20% Pass-Through Deduction

The Tax Cuts and Jobs Act of 2017 introduced a 20% deduction on qualified business income from pass-through entities under Section 199A. REIT ordinary dividends qualify for this deduction in most cases.

The practical effect: if you receive $1,000 in REIT ordinary dividends, you may deduct $200, taxing only $800 at your marginal rate. This partially (but not fully) offsets the ordinary income treatment disadvantage versus qualified dividends.

Account Location Strategy

Given the ordinary income treatment, most tax-efficient portfolio construction places REIT exposure inside tax-advantaged accounts (IRA, Roth IRA, 401k) where dividend tax character is irrelevant. In a Roth IRA, REIT dividends compound completely tax-free and are never taxed upon qualified withdrawal. This makes REITs particularly attractive Roth holdings relative to their taxable-account treatment.

Interest Rate Sensitivity of REITs

REITs are sensitive to interest rates for two distinct reasons, and understanding both helps explain their behavior during monetary policy cycles.

The Cost of Capital Effect

REITs finance their property portfolios with both equity and debt. When interest rates rise, the cost of new debt increases. This raises the hurdle rate for acquisitions and new developments. A property generating a 5% cap rate (net operating income divided by property value) was attractively financed at 3% debt. At 6% debt, the same property generates negative leverage. The entire return math changes.

Rising rates therefore slow REIT growth by raising the cost of capital. They also compress valuations: if 10-year Treasury bonds yield 5%, investors demand higher yields from REITs to compensate for real estate risk, which means REIT prices fall to push yields up.

The Income Comparison Effect

REITs compete with bonds for income-seeking investors. When risk-free Treasury yields rise from 1.5% to 5%, a REIT yielding 3.5% looks far less attractive than it did when the alternative was 1.5%. Capital rotates toward the higher-yielding and lower-risk Treasury, pressuring REIT prices.

This explains why REITs were among the worst-performing equity sectors during the 2022-2023 Federal Reserve rate-hiking cycle. It also explains why REIT valuations expanded significantly during the 2010-2021 low-rate environment.

REITs Are Not All Equal in Rate Sensitivity

Short-term leases give REITs the ability to reprice rents quickly when inflation rises, partially offsetting rate headwinds. Industrial and apartment REITs often have lease terms of one to three years. Office and retail REITs with 10-15 year leases cannot reprice as quickly. Long-duration lease REITs behave more like bonds in rate-sensitive environments.

Net lease REITs (which lease properties to single tenants on long-term triple-net leases) are particularly bond-like in behavior and are priced accordingly.

REITs vs Direct Real Estate Investment

Investors comparing REITs to owning physical real estate directly face a genuine tradeoff between liquidity, control, leverage, and cost.

Advantages of REITs vs Direct Ownership

Advantages of Direct Ownership vs REITs

For most retail investors, REIT exposure through a diversified portfolio makes more practical sense than direct ownership. Direct real estate rewards concentrated capital, hands-on management, and tax sophistication. REITs reward simplicity and diversification.

How to Screen REITs

Screening REITs requires different filters than screening standard equities. Here is a practical starting framework.

Primary metrics to evaluate:

Secondary signals:

Equity Rank's screener applies financial health, valuation, and coverage metrics across the full stock universe. Running REIT-specific filters for AFFO payout ratio, debt coverage, and occupancy-driven growth indicators surfaces research ideas without manually parsing dozens of quarterly supplements.

Risks of REIT Investing

A complete REITs explained discussion includes the full risk picture, not just the dividend appeal.

Interest Rate Risk

Covered above: rising rates increase the cost of capital, compress valuation multiples, and create competition from fixed income alternatives. This risk is structural and cannot be eliminated, only sized appropriately.

Leverage Risk

REITs carry more debt than most S&P 500 companies. The asset-heavy model requires financing. In normal credit conditions, this leverage amplifies returns. In credit crunches or rising-rate environments, it compresses returns and can threaten solvency if debt maturities arrive during a period of constrained capital markets. During the 2008-2009 financial crisis, several REITs faced equity dilution or outright failure due to overleveraged balance sheets meeting a shut capital market.

Sector-Specific Demand Risk

As illustrated by office REITs post-COVID, structural demand shifts can permanently impair a REIT sector. The properties do not disappear, but if tenants no longer need them at the prior rate, occupancy falls, rents decline, and property values follow. Sector concentration creates this risk; diversification across REIT types reduces it.

Concentration Risk

Many REITs own properties heavily concentrated in a single geography, sector, or tenant. A REIT with 60% of revenues from one tenant faces meaningful single-tenant risk. Tenant bankruptcies in net lease REITs have caused dividend cuts even when the broader portfolio performed well.

Management Quality and Capital Allocation

Because REITs must return to capital markets for growth, management's ability to allocate capital intelligently through the cycle is critical. Acquiring properties at peak valuations with expensive debt, then facing repricing in a downturn, destroys shareholder value. Track records of NAV per share growth over full cycles are the most meaningful management quality signal.

Liquidity Risk

REIT shares trade on exchanges, but the underlying real estate does not. During severe market dislocations, REIT shares can trade at steep discounts to NAV because sellers need liquidity now and buyers demand a discount for the inherent illiquidity of the asset class. This creates volatility that is disproportionate to underlying property value changes.

Key Takeaways

REITs explained in a single summary: they are a tax-advantaged pass-through structure that makes commercial real estate accessible through exchange-traded shares, with a legal requirement to distribute 90% of taxable income as dividends.

Core points to retain:

For investors building a diversified portfolio that includes real estate exposure without the complexity of direct property ownership, publicly traded equity REITs offer a practical structure. Understanding the valuation framework (FFO, AFFO, P/FFO, NAV) is the prerequisite to evaluating them intelligently rather than selecting on dividend yield alone.

If you want to screen REITs alongside the broader equity universe, compare FFO multiples, debt coverage ratios, and dividend sustainability metrics across hundreds of names at once, Equity Rank's tools surface those research ideas in seconds. Start your 7-day free trial at equity-rank.com. Cancel anytime.

Equity Rank is not a registered investment adviser. This content is for informational and educational purposes only and does not constitute personalized investment advice. All analysis and screening outputs are model-generated estimates. Past performance and simulation results do not guarantee future outcomes.