TL;DR: A real estate investment trust, or REIT, is a company organized under a tax election: it holds real estate or real estate financing, and in exchange for distributing at least 90 percent of its taxable income to shareholders, it generally pays no corporate income tax on the distributed earnings. On $100 million of taxable income, at least $90 million must go out as dividends, since 0.90 times $100 million equals $90 million. That rule is why REITs yield more than typical stocks and why they rely on external capital for growth far more than other companies do. The 90 percent test applies to taxable income, not cash flow: depreciation shrinks taxable income below the cash the properties generate, so a REIT can retain some cash. Paying out most of its taxable income still leaves large growth to be financed from outside. The income is real, and so is the dependence on capital markets that comes with it.
Key Takeaways
- Two families: equity REITs own properties and collect rent; mortgage REITs hold real estate debt and earn interest spreads. Their risks are different species sharing a tax structure.
- REIT earnings are read as FFO, funds from operations, because depreciation, a huge non cash charge on buildings, distorts ordinary EPS. A REIT with $50 million of net income and $30 million of real estate depreciation reports FFO of $80 million, since $50 million plus $30 million equals $80 million.
- The 90 percent distribution rule means major growth is financed mostly externally: new shares, new debt, or asset sales, since what it can retain is limited to the cash left after distributing at least 90 percent of taxable income, less any tax owed on the portion it keeps. Dilution discipline and balance sheet quality are therefore core REIT research, not side topics.
- Dividends from REITs are generally taxed as ordinary income for United States individuals, the main exception in the qualified dividend world of how are dividends taxed.
- REIT prices are interest rate sensitive twice over: their borrowing costs reset, and their dividends compete with bond yields in income portfolios.
How does the structure actually work?
Congress created the election so small investors could own diversified real estate with the tax profile of direct ownership: income taxed once, at the investor level. Qualification tests govern asset composition, income sources, and ownership spread, and the distribution rule enforces the pass through character. Management is usually internal in modern listed REITs, which own and operate properties in a sector: apartments, warehouses, malls, offices, data centers, cell towers, self storage, farmland, and more. Sector economics dominate the analysis. A warehouse REIT is a logistics business with leases; a mall REIT is a consumer spending business with percentage rents; the shared tax wrapper should not fool anyone into analyzing them alike.
FFO exists because real estate accounting depreciation pretends buildings waste away on schedule while the market often disagrees. Adding back real estate depreciation and adjusting for gains on property sales gives a figure closer to recurring operating earnings, and its refined sibling, AFFO, further subtracts the capital spending needed to maintain the properties, the honest number for dividend coverage. When a REIT's payout is quoted as a percentage, check whether it divides by FFO or AFFO. Illustrative only: a dividend of $75 per share unit against FFO of $100 is a 75 percent payout, since $75 divided by $100 equals 0.75, while the same $75 against AFFO of about $79 is roughly a 95 percent payout, since $75 divided by $79 is about 0.95. The difference is the maintenance money the buildings actually consume. The payout ratio discipline translates directly, with REIT denominators.
What are the risks specific to the wrapper?
Rate exposure is the famous one. REITs carry substantial debt against properties, so rising rates raise refinancing costs at the same moment they make the dividend look less competitive against bonds, a pincer that can compress REIT valuations when rates rise, though the size of the effect depends on growth, lease terms, and how the debt is structured. The debt to equity reading habit applies, adjusted for the fact that property debt is normal in this sector and judged against asset values and lease durations rather than against industrial company norms.
The second risk is the growth treadmill. Paying out 90 percent means expansion capital is raised, and raising it by issuing shares below the value of the underlying properties dilutes existing holders even while headline FFO per share inches up. Net asset value, the appraised value of properties minus debt, is the anchor metric for judging issuance and buyback decisions in this sector, the real estate cousin of book value per share. A management that issues equity above NAV and buys assets accretively is compounding for you; the reverse is a transfer machine wearing a yield costume.
How should a REIT sit in a dividend portfolio?
As its own sleeve with its own rules. Its income is ordinary taxed, its cycle is the property and rate cycle rather than the consumer cycle, and its coverage is measured on AFFO. In a portfolio built along the lines of how to build a dividend portfolio, REITs add property exposure and current income at the price of rate sensitivity, a trade to make deliberately and in sized proportion, never as a yield chasing accident discovered in a screener's top yield column, where the sector's most leveraged members reliably congregate.
FAQ
Why do REITs pay such high dividends? Because the law requires distributing at least 90 percent of taxable income to keep the tax election. The yield is structural, not generous: the company is a conduit. Judging a REIT by yield alone ignores that the same rule limits how much it can retain for growth or cushion, leaving it more dependent on outside capital than an ordinary company.
What is the difference between FFO and AFFO? FFO is net income plus real estate depreciation and related adjustments. AFFO subtracts recurring capital expenditures, tenant improvements, and leasing costs needed to sustain the properties. AFFO is the stricter, more cash honest figure, and the better denominator for payout coverage.
Are REIT dividends qualified for lower tax rates? Generally no for United States individuals; they are mostly ordinary income, with occasional portions characterized differently in a given year, which the REIT reports after year end. This is a material planning fact for taxable accounts.
Can a REIT lose its status? Yes, by failing the qualification tests, which triggers corporate level taxation and usually a bar on re electing for several years. It is rare among established listed REITs because compliance is a core management function, but the consequence is severe enough that the tests shape every structural decision the company makes.
Large, established REITs are sometimes described with the informal quality label examined in what are blue chip stocks, though the label certifies nothing.
Sources
- Internal Revenue Service material on real estate investment trust qualification and distribution requirements, accessed October 2026.
- Nareit, the REIT industry association, material on FFO definitions and REIT structure, accessed October 2026.
- Investor.gov (U.S. Securities and Exchange Commission), investor education material on REITs, accessed October 2026.
- Every worked example in this post was computed directly from the stated inputs shown in the text.
Educational content, not financial advice. Any worked example uses hypothetical, illustrative figures chosen for round numbers. It is not a projection of any security's returns and not a recommendation to buy or sell any security.
