A Real Estate Investing Trust (or REIT) is a very popular investment vehicle where you can buy shares of a company and gain partial ownership over a diverse group of real estate assets.
If you’re not familiar with REITs and how they work, check our article explaining the ins and outs of a Real Estate Investment Trust.
Most REITs are traded on the stock market (though not all), so, with the simple purchase of stock, you are gaining ownership in the real estate sector. For those who want real estate in their portfolio but who don’t want any of the hassle associated with the ownership, REITs make a ton of sense.
There are a lot of great aspects to a REIT but there are also a number of drawbacks. So, let’s dive into the pros and cons to see if a REIT is a bad investment or not.
How a REIT Works
REITs tend to have a very simple and understandable business model. They purchase property with the intent to lease it out. The property gets rented, maintained, and upgraded as needed. Then, 90% or more of taxable profits are passed on to the shareholders. The corporation avoids those taxes and instead, shareholders pay tax on that income.
Mortgage REITs are slightly different as they finance real estate and earn income from interest on those investments. It’s fundamentally the same though.
How REITs Earn and Distribute Money
REITs invest in just about everything related to real estate and their investments are categorized into 13 property sectors.
It’s also pretty amazing that REITs collectively own more than $4.5 trillion in assets across the US.
REITs invest in all kinds of real estate. Everything from offices, apartment buildings, warehouses, retail centers, medical facilities, data centers, cell towers, infrastructure, hotels, and more. Most REITs invest in only one type of real estate but some do hold properties of various types in their portfolio.
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Your Investment Portfolio With vs Without Real Estate
Traditionally, adding real estate to an investment portfolio reduces the overall risk profile of the portfolio while increasing returns. So, how do REITs place into this?
Historical Returns of Real Estate Investment Trusts
REITs have actually outperformed the broader stock market during most periods of time. They provide reliable and increasing dividends over a long period of time which is combined with long-term capital appreciation through stock price increases.
Drawbacks to Investing in a REIT
The biggest pitfall with REITs is they don’t offer much capital appreciation. That’s because REITs must pay 90% of their taxable income back to investors which significantly reduces their ability to invest back into properties to raise their value or to purchase new holdings.
Another drawback is because of their structure, REITs tend to have very high management and transaction fees.
Additionally, REITs have become more and more correlated with the broader stock market over time. So, one of the prior benefits has lost its appeal as your portfolio will become more subject to market swings.
Risks of Non-Traded REITs
Non-traded REITs or non-exchange traded REITs do not trade on a stock exchange, which opens up investors to special risks.
Non-traded REITs are not publicly traded, which means there are far fewer disclosure requirements and the asset is illiquid. As a result, it’s difficult to determine the value of the underlying assets, but also what the market value is at any given point in time.
Lack of Liquidity
Non-traded REITs are also illiquid because they are not trading on a public market.
One of the big benefits of a REIT is the ability to sell your shares, so if the REIT is not publicly traded then you are giving up one of the biggest advantages of having a REIT in the first place.
In many cases, non-traded REITs can’t be sold after a minimum of three, five, or even seven years with no fee. Sometimes one can redeem early but with a penalty.
Non-traded REITs function by pooling money to buy real estate then manage those assets.
Sometimes dividends get paid out of the pooled money rather than from income generated by the assets. This process limits cash flow for the REIT and diminishes the value of shares.
A very big drawback to many non-traded REITs are the upfront fees.
Many charge 7-10% and some as much as 15% of all cash invested. Imagine buying an investment and starting of 10%+ in the hole before a single property has even been bought.
Additionally, management fees are the silent killer of REIT returns. Pay attention to how much the managers are being compensated and if they are taking a portion of gross rents, purchase/sale price, etc.
Risks of Publicly Traded REITs
Publicly traded REITs offer investors a way to add real estate to an investment portfolio and earn an attractive dividend. Publicly traded REITs are a safer play than their non-exchange counterparts, but there are still risks.
Interest Rate Risk
The biggest risk to REITs is when interest rates are increasing. This reduces demand for REITs because it makes real estate more expensive and makes investors more risk-averse.
Alternatively, rising interest rates indicate a strong economy which means lower vacancy, rent growth, and increasing property value. But historically, REITs don’t perform well when interest rates rise.
Which REIT Should I Choose?
A major risk with investing is choosing the wrong sector to invest in or investing too heavily in one type of stock, leading to an unbalanced portfolio.
This is true in real estate as well.
For example, suburban malls have been in decline for a very long time, so if you invested in a suburban mall REIT, you probably won’t be too happy with it.
On the other hand, mixed use urban living has been doing exceptionally well as millennials prefer the live/work/play living environment over suburban housing (though this may be changing).
Trends change, so it’s important to research the properties or holdings within the REIT to be sure that they’re still relevant and can generate good returns for your portfolio..
This isn’t specifically a risk, but rental income is considered ordinary income for tax purposes. Therefore, REIT dividends will have a significant portion that is taxed as ordinary income.
Stock Market Correlation
While rental income and property values are not correlated with the stock market, publicly traded REIT prices are highly correlated with the stock market.
In fact, since the crash of 2008, REITs have actually proven more volatile than the broader market. It turns out that REITs are highly susceptible to external shocks because 90% of all profits have to be paid out to investors. This leaves very little cash available for inevitable market corrections.
Without cash to ride out downturns, they may be forced to liquidate assets at bargain prices. Additionally, recessions can cause a reduction in rental income that exacerbates this issue.
How to Invest in a REIT
It’s really straight forward, depending on what kind of REIT you’re looking for. If you want a publicly traded REIT simply go to a finance website, search all the available REITs, pick one, and buy just like you buy any stock.
If you are looking for something a bit more exclusive with higher potential returns, we recommend Fundrise (check out our review of Fundrise).
Go here to set up a free account, browse their offerings, and choose your investing strategy, and invest. It’s pretty straightforward.
Here at RealEstateInvesting.org, we put together real estate deals by offering both debt and equity investments. If you are interested in learning about investing alongside us, get in our investor database and set up a call to learn more. It’s totally free, no pressure, and we don’t offer any investment opportunities in the first call anyhow.
Conclusion – Are REITs a Bad Investment, or a Good One?
There are arguments on both sides of the debate. REITs are a good investment for some investors while they may be a terrible investment for others.
If you do want to invest in a REIT, we do recommend Fundrise which has extremely low fees as compared to the rest of the industry.
Additionally, if you want the highest potential returns, contact us about investing alongside us in the deals we are doing.