How risky are REITs? An investor rightly may ask that question and this article is intended to prove important insights to prospective investors in real estate investment trusts (REITs).
REITs are unique investments that offer a convenient way for investors to gain exposure to real estate markets and thereby diversify their portfolios while earning income. Keep reading to learn about the returns of REITs and the risk of such investments.
How Risky are REITs? REIT Defined
A REIT is a company that owns, operates or finances income-producing real estate. 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 alternative 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 further can buy publicly traded REIT shares on major stock exchanges such as the NYSE or NASDAQ.
Like every investment, REIT’s come along with their own individual risk factors that will be discussed below.
How Risky are REITs? Key RIsks Associated with REITs
Like any other investment, REITs are faced with a unique set of potential risks. These risks can be highly impactful on the returns that investors will obtain.
REITs are subject to market risk, which is arguably the most prevalent challenge for REIT performance. Fluctuations in interest rates and recessions are common causes for market risk. Rising interest rates create unfavorable economic conditions for REITs, which can become volatile when there are changes in interest rates.
In addition to market risk, REITs face the risk of having an overleveraged balance sheet. REITs commonly borrow money to buy more properties to expand their portfolios. REITs also may rely heavily on debt to have more money available to invest in new properties. REITs that constantly take on more debt may end up in a position where liabilities are far greater than assets, and the company may experience financial distress.
REITs also face property-specific risks. REITs that only hold one type of property may face serious financial distress if an event occurs that decreases the demand for such property. Some types of properties are very economically sensitive, while others are regarded as recession-resistant.
A common misconception about real estate is that all property values will appreciate in value. However, this is not always the case. Investors face the risk that they may choose the wrong one and not gain any notable returns. Therefore, it is important to consider property types, geographical location and the growth prospects of different REIT sectors.
Furthermore, liquidity risk must be considered as well. There is no guarantee that all the shareholders leaving their investments will be able to sell all or part of the shares that they desire to in quarterly repurchase offers. Due to this liquidity risk, investors may be unable to convert shares into cash at an immediate time of need.
For more information on the key risks associated with REITS, refer to Risks of Investing in REITs.
How Risky are REITs? REIT Returns: Best in the Long Term
REITs may appear volatile and risky from a short-term perspective, but the long-term returns of REITs are impressive. When looking at five- to ten-year time frames, it is common to see that stocks outperform REITs, even if it is by a relatively small margin. However, when taking 20 or more years into account, REITs routinely provide better returns than stocks as the table clearly illustrates below. The longer REIT investments are held, the more likely it is that they will provide better returns relative to stocks.
The following table outlines the comparison between stocks and REITs in terms of returns.
|TIME PERIOD||S&P 500 (Total Annual Return)||FTSE NAREIT ALL EQUITY REITS (Total Annual Return)|
|The Last 25 Years||11.35%||12.02%|
|The Last 20 Years||11.09%||13.10%|
|The Last 10 Years||17.15%||13.15%|
|The Last 5 Years||19.21%||13.89%|
*1972 was the first year that NAREIT began keeping track of REIT return data
Data Source: NAREIT and Slickcharts
Evidently, REITs provide the best returns when they are held onto as a long-term investment. This is important for potential investors to keep in mind.
However, it is important to note that the above comparison takes into account a broad range of stocks and a broad range of REITs. Individual investors may obtain different results depending on which specific stocks and REITs they hold.
Based on historical data, it can be said that it is likely that REITs will outperform stocks over long periods of time, especially lengths of time that exceed 20 years. Before the 20-year mark, stocks may perform better, although both investments could provide relatively similar returns. Additionally, it is possible where REITs greatly outperform the S&P 500 as shown in the outlier year of 2021 caused by a wide range of factors.
How Risky are REITs? How Do REITs Impact Investment Portfolios?
REITs have unique characteristics that may make them attractive to both income and growth investors. REITs trade like stocks and can fluctuate in price, but they also pay out a large part of their income in the form of dividends.
REITs typically do not have a strong correlation to other sectors of the market, and their performance is generally expected to deviate from the major stock indices. Between January 2011 and December 31, 2021, the correlation between REITs and the S&P 500 was 0.68.
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. This makes REITs a powerful tool for hedging.
How Risky are REITs? Conservative Investing Helps Reduce Risk
REITs may be used to help provide income in conservative portfolios or long-term growth in more aggressive portfolios, since they can reduce the overall volatility of an investors’ portfolio. Plus, REITs may also do better than other investments during periods of inflation because real estate prices typically rise with inflation.
More specifically, adding a 10% allocation to REITs in a stock, bond and cash portfolio increased return from 10.0% to 10.3%. Adding a 10% allocation to REITs in a fixed-income portfolio decreased risk from 11.2% to 10.2%.
Because stocks, bonds, cash and REITs generally do not react identically to the same economic or market stimuli, combining these assets may produce a more appealing risk-and-return trade-off.
How Risky are REITs? Best Ways to Invest in REITs
Investors can easily buy shares in a REIT the same way any other public stock is purchased. REIT shares are bought and sold on major public stock exchanges. Investors also can invest in a REIT mutual fund or a REIT ETF, though the investor would be buying a collection of shares in an entire index of REITs.
These different investment approaches are referred to as passive versus active REIT investing. The passive approach invests in a REIT mutual fund or REIT ETF. The active approach involves doing research, picking specific REITs to invest in and building an individual portfolio of REITs.
The passive and active investment approaches have different levels of risk associated with them. For example, an investor who is hesitant about investing in REITs and wants to minimize risk may opt to invest in a REIT mutual fund or ETF because the diversification of those options can be safer. The active investing approach comes with more risk, but has the potential to give greater returns.
How Risky are REITs? The Bottom Line
REITs provide multiple unique benefits and they have the potential to greatly enhance investment portfolios. As shown above, historical data supports the premise that REITS have outperformed the S&P 500 over a 20-year or more period. However, diversification of an investor’s portfolio will decrease the degree of risk and can allow for outperformance against the market, especially in times of market distress.
However, different REIT investments come along with varying degrees of risk. Individual investors should decide their risk tolerance, do research and invest accordingly.
Adam Johnson is an editorial intern who writes for www.stockinvestor.com and www.dividendinvestor.com.