Investing in REITs offer pros and cons, as well as rewards and risks, respectively.
It is critical to be aware of the advantages, as well as potential risks, associated with an investment. The following analysis provides the pros and cons of investing in real estate investment trusts (REITs).
Investing in REITs: What Are They?
First, it is important to understand what distinguishes a REIT from other investments.
A REIT owns, operates, or finances real estate that produces income. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.
Generally, REITs follow a straightforward business model: the company buys or develops properties and then leases them out to collect rent as its primary source of income. However, some REITs do not own any property, choosing the alternate route of financing real estate transactions. These REITs generate income from the interest on the financing.
Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors can buy REIT shares on major public stock exchanges such as the NYSE or NASDAQ.
There are more than 225 REITs in the United States that trade on major stock exchanges, as well as are registered with the Securities and Exchange Commission (SEC). These REITs, which are primarily traded on the NYSE, have a combined equity market capitalization of more than $1 trillion.
REITs are a unique investment, which makes it important for potential investors to research the advantages and disadvantages associated with REITs.
Investing in REITs: Pros
Investing in REITs can have several benefits, such as:
REITs Provide Diversification Within an Investment Portfolio
A diverse portfolio can reduce an investor’s risk because money is spread across different assets and industries. Investing in a REIT can help diversify a person’s investment portfolio.
Even though REITs are bought and sold like stocks, real estate is a different asset class from equities.
Real estate provides great diversification because it is a distinct asset class which does not have a strong correlation with other industries within the stock market. Historically, REIT performance tends to go up when other assets go down and vice versa. Therefore, REITs can be used in leveling out the overall volatility of a well-diversified portfolio.
High Dividend Yields
REITs are required to pay 90% of taxable income to shareholders in the form of dividends. The REIT’s management can decide to pay out more than 90%, but they can’t drop below that percentage. Therefore, many REITs have above-average safe dividend yields compared to average dividend yields associated with equities.
Zero Corporate Tax
REITs get a significant tax advantage since they do not have to pay a corporate tax. Usually, many dividend stocks pay taxes twice; once corporately, and again for the individual. Not having to pay a corporate tax can mean a higher payout for investors.
Exposure to Commercial Real Estate
Commercial real estate can be lucrative depending on the economic conditions and the level of demand. However, it can be difficult to gain access to the commercial real estate market. REITs provide a relatively easy way for investors to gain exposure to the commercial real estate market.
The alternate way for investors to reap the benefits of commercial real estate is for them to make a direct investment into real estate. In other words, the investor would own and operate the property themselves, and earn income from collecting rent. REITs are a much more viable option, allowing investors to bypass the responsibility of owning the property and instead giving them the opportunity to become a shareholder in a REIT company.
One reason that investors avoid real estate is that it is notoriously illiquid. Investing in REITs eliminates illiquidity risks, since REIT shares are bought and sold on major stock exchanges everyday. REITs are extremely liquid, as investors can sell them for cash with the click of a button. It is reassuring for an investor to know that he or she can easily free up cash.
Compared to other real estate opportunities, REITs are relatively simple to invest in and don’t require some of the legwork an investment property would take.
Investing in REITs: Cons
No investment is risk-free, REITs included. Here is what investors should keep in mind before diving into REITs:
It is crucial for potential investors to understand the way REITs are taxed before making investment decisions. REIT taxes are unique, and the concept can be difficult to understand.
As previously mentioned, REITs are legally required to pay out at least 90% of taxable income as dividends. Given that the dividends are the taxable portion of the REIT’s income, the REIT is able to pass its tax burden to the shareholders as opposed to paying the taxes itself. Therefore, the REIT itself pays no federal income taxes, and the tax obligation falls on the shareholders. It is most common for REIT dividends to be taxed at the investor’s income tax rate, and therefore REIT taxes are often taxed at a higher rate than qualified dividends.
REIT dividends are considered ordinary, or nonqualified dividends. Ordinary dividends are taxed at standard federal income tax rates. On the other hand, qualified dividends are taxed at the capital gains rate. Dividends are distinguished as qualified if they meet certain requirements from the IRS. Generally speaking, most dividends from U.S. corporations are qualified. REITs are one of only a few scenarios where dividends are considered ordinary.
Although the dividends can be heavily taxed, an investor can use the tax advantages of retirement investment vehicles such as Roth IRAs to bypass these taxes.
Volatility/Interest Rate Sensitivity
REITS are usually hypersensitive to fluctuations in interest rates. High interest rates are bad for REITs in more ways than one. Given the REIT business model, and the fact that REIT growth generally stems from raising debt or issuing stock, higher interest rates imply that REITs will face increased borrowing costs. Additionally, rising interest rates can affect property values.
Generally, the value of REITs is inversely tied to the Treasury yield. Therefore, when the Treasury yield rises, the value of REITs is likely to fall.
Changes in interest rates can make REITs volatile in the short term, which may be off-putting to more cautious investors.
Property Specific Risks
There are also property-specific risks associated with REITs. Unlike other investments, REITs can fall prey to risks associated specifically with the property. While investing in REITs provides diversification for the investor’s portfolio, most REITs do not hold diversified property portfolios. In other words, REITs that only hold one type of property may face serious financial distress if an event occurs that decreases the demand for such property.
For example, if a person invests in a REIT that’s specifically a portfolio of bagel shops in strip malls, they could see their investment take a hit if bagels or strip malls fall out of trend. While investments do fall prey to trends, REITs can be influenced by smaller trends, specific to the location or property type, that could be harder for an investor to notice.
Some types of properties are very economically sensitive, while others are regarded as recession-resistant. Individual investors must decide what level of risk they are willing to take and research which types of properties fit those risk preferences.
Plan for a Long-Term Investment
Generally, REITs are better suited for long-term investments, which can typically be thought of as those over five years. REITs are influenced by micro-changes in interest rates and other trends that can make them riskier for a short-term financial goal.
Investing in REITs: The Bottom Line
Even though REITs may be volatile in the short term, the long-term performance of REITs is impressive. There are too many factors that affect REIT share prices over short periods of time. Therefore, it is best to hold onto REITs as a long-term investment.
Additionally, some REITs are riskier than others, and some are better suited to withstand economic declines than others. For example, a REIT in the health care or hospital space can be more recession-proof than a REIT with properties in retail or luxury hotels.
Risks aside, investing in REITs pays dividends, which can be appealing to income seekers. While REITs are not without risk, they can be a strong part of an investor’s portfolio, while adding diversification.
As with any investment, it is important for investors to conduct research and consider both positives and negatives associated with REITs before investing. Investing in REITs includes both pros and cons, leaving each individual to decide what is best for his or her personal portfolios.