Real Estate Investment Trusts (REITs) Let You Invest In Real Estate Without Owning Property, but Here Are The Downsides

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Dipping your toes into the real estate market sounds like a great idea on paper, but it requires a lot of upfront capital. Then there is the constant maintenance, the ever-changing housing market and the responsibility to find reliable tenants for your short or long term rental. After you add up all the costs, you might decide that investing in real estate isn’t as easy as you imagined.

One way to invest in real estate without owning properties is through REITs. Short for “Real Estate Investment Trusts,” REITs are a type of real estate investment trust. REIT companies pool money from hundreds or thousands of investors, then spend it on revenue-generating real estate companies and share the profits.

“There are a lot of ongoing costs when someone owns real estate, and they get some sort of income out of that real estate,” says Omar Morillo, a certified financial planner and wealth advisor at Octavia Wealth Advisors in Miami, Florida. “A REIT provides a way to tap into the real estate market without incurring all that expense.”

But REITs aren’t perfect. There are some drawbacks to consider. Read on to learn about the pros and cons of REITs and whether you should add them to your investment portfolio:

What is a real estate investment trust?

Imagine spending anywhere from $1,000 to $25,000 in REIT stock and, in turn, getting a new income stream.

That’s how it works with REITs. REITs are publicly traded or private companies that own, operate and/or finance real estate and assets that generate income. The assets included in a REIT may include commercial buildings such as office spaces, hotels, self-storage facilities, warehouses, hospitals, data centers, cell towers, or residential apartment buildings. It is common for REITs to be clustered by sector or type, such as industrial, healthcare, retail or residential. There are even REITS for marijuana.

To qualify as a REIT, a company must check off a long list of criteria. This means that they pay their shareholders at least 90% of their taxable income as dividends each year. In addition, they must invest at least 75% of all their assets in real estate assets and derive at least three quarters of their gross income from real estate associated resources. The lion’s share (95%) of their gross income has to come from real estate sources and dividends. Finally, no more than one-fourth of REITs’ assets may come from non-qualifying securities or stock in taxable REIT subsidiaries.

How do REITs make money?

REITs monetize their properties by selling or leasing them. Rather than other real estate companies developing real estate for the purpose of selling it, the primary goal of a REIT is to develop, operate, and include real estate in their own investment portfolio. As ownership of a REIT increases in value, the owners provide the shareholders with income in the form of dividends.

Types of REITs

There are three main types of REITs:

Equity REITs. These make up the majority of REITs. They usually own and operate real estate companies that generate rental income.Mortgage REITs. These REITs provide capital in the form of loans or mortgages to those who own real estate.Hybrid REITs. As the name implies, they are a mix of both equity REITs and mortgage REITs.

There is also a difference between a publicly traded or privately traded REIT: Privately traded REITs are also known as untraded REITs, which means that they are not traded on an exchange. Publicly traded REITs tend to have smaller dividends. However, according to Morillo, publicly traded REITs offer greater transparency and higher liquidity than privately traded REITs.

“A common problem with the private REITs markets is that, unfortunately, some actors will do what I call ‘milking their REITs,’” Morillo says. “In other words, they will charge excessive fees and expenses because the REIT is required to return at least 90% of their profits to shareholders. But as long as those internal costs are jacked up, shareholders won’t really get their rights.”

Pros and Cons of REITS

Let’s look at some of the pros and cons of REITs.

Pros

REITs can be a great way to diversify your portfolio

If you have mutual funds invested in stocks and bonds, instead of going out and buying a rental property, REITs give you a way to tap into that real estate sector, explains Niv Persaud, a CFP and director and founder of the Atlanta-based financial planning firm, Transition planning and guidance

REITs are tied to a tangible asset

If you want to get some income out of your portfolio, a REIT often seems like an attractive way to do that. REITs are often easier because you don’t have to buy a property yourself, Morillo says. “You don’t have to play landlord and deal with the operations on a daily basis, whether it’s an apartment building, a hotel, or a retail store,” he says.

cons

Market forces or economic conditions may affect earnings potential

Because REITs are clustered by industry or type of real estate, such as healthcare, retail, residential, or commercial real estate, they can be affected by economic conditions or state or local mandates because of their location. For example, in the midst of COVID-19, there were rental moratoriums where people didn’t pay for their rental properties. Meanwhile, healthcare tends to be less cyclical, so with some research and good diversification, you can try to offset unfavorable market conditions.

Untraded REITs Are Fairly Liquid

The time horizon for REITs can be tricky. Publicly traded REITs tend to be more liquid than private REITs, which don’t sell very quickly. However, it’s best to give yourself at least a few years before using the money: “You have to pretend this money won’t exist in a few years,” Morillo says. “You can’t turn around and try to liquidate it in six months because you had an emergency, or in a year and a half because your daughter is getting married and you’re going to pay for the wedding.”

REITs are sensitive to interest rates

Like any type of real estate you buy, REITs are tied to federal interest rates. “If the Federal Reserve says they’re going to raise interest rates, the prices of your REITs will often fall,” Persaud says. Interest rates affect each type of REIT differently in different industries and companies.

REITs are taxed as ordinary income

As Persaud explains, if you’re done in a high tax bracket, dividends from your REITs are taxed as ordinary income. “But because REITs are part of your investment portfolio, your financial advisor can manage some of the taxes,” Persaud says.

Should You Invest in REITs?

Not all REITs are created equal. Know whether you are most interested in residential, commercial healthcare, or retail REITs, and the risks associated with them. Stay up to date with industry news and inquire about both local and federal regulations that may affect your ROI.

“At retail REITs, if you look at what the market is like, more people are shopping online than going to a store. You really want to understand what you’re investing in,” says Persaud.

Like any financial move, Persaud recommends asking your financial advisor to recommend some REITs that best fit your portfolio.

And don’t get too caught up in the allure of passive income, Morillo says. Just because REITs generate income and pay annual dividends, they are not risk-free.

Pro tip

Investments that generate income are not necessarily less risky than other types of investments: always research fees, tax implications and expected returns.

“People tend to have this view that because something is paying income or dividends, it’s less risky,” he says.

Weigh the pros and cons and look closely at the fees and charges. If you decide to invest in REITs, keep in mind the timeless adage, don’t put your eggs in one basket.

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