Investing in REITs: Pros and Cons offers important information for investors.
It is crucial 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).
What is a REIT?
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. Read about the various types of REITs here.
Generally, REITs follow a simple 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. 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
REITs Provide Diversification Within an Investment Portfolio
Even though REITs are bought and sold like stocks, real estate is a different asset class than 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 are largely beneficial 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. Therefore, many REITs have above-average dividend yields. It is common for REITs to have safe dividends that are considerably higher than the average dividend yield associated with equities.
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.
Liquidity
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.
Investing in REITs: Cons
Dividend Taxation
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.
Volatility/Interest Rate Sensitivity
REITs are usually highly sensitive 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.
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. 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, hotel REITs have taken a considerable hit throughout the COVID-19 pandemic, as travel has decreased and the demand for hotels has diminished. 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. Click here to learn more about the various types of REIT properties and risks associated with each type.
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.
As with any investment, it is important for investors to conduct research and consider both positives and negatives associated with REITs before investing. Investors should weigh the pros and cons and decide what is best for their personal portfolios.
Want more? Read our related articles:
The Ultimate Guide to Investing in REITs
The 13 Types of REIT Stocks and How to Invest in Them
Why Do REITs Have High Dividend Payout Ratios?
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