Pros and Cons of Investing in REITs
If you’re looking for a way to diversify your portfolio and get involved in real estate investing, there are a multitude of options. And as is usually the case with investing, choosing the appropriate strategy is all about balancing the risk and the reward.
For some people, investing outright in a piece of real estate – like a rental property – isn’t financially feasible or desirable. Thankfully, there are other ways to expose your portfolio to real estate and enjoy some of the upside of this part of the economy. REITs are one option.
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What are REITs?
A real estate investment trust, or REIT, is basically a real estate investment company that owns, operates, and manages income-producing real estate like single-family rental properties, office buildings, warehouses, strip malls, or healthcare facilities.
Rather than only relying on their own money, REITs allow anyone to invest in their portfolio of real estate assets in the same way that people invest in companies by purchasing individual stocks. When you invest in a REIT, you share in the income that it produces without having to buy real estate or put your name on a title.
From an individual investor’s perspective, REITs are extremely simple and easy to understand. The company/fund owns a portfolio of income-producing real estate. The income that is generated is paid out to shareholders as dividends. By law, they are required to pay out a minimum of 90 percent of their taxable income (though most pay out 99 to 100 percent).
The power of REITs is found in numbers. REITs don’t just have one, three, or five properties in their portfolios – they have hundreds or thousands of individual units. This spreads out the idiosyncratic risk and makes them relatively safe investments (which can’t always be said when you’re investing in a single income-producing property where any number of things could go wrong).
5 Common Types of REITs
While most REITs are fairly similar in their structure, different real estate investment trusts invest in different types of assets. Here are some of the most common ones:
1. Retail REITs
Did you know that 24 percent of REIT investments are in freestanding retail and shopping malls? This makes it the single-largest investment type in the United States. In fact, the majority of all shopping centers are owned by REITs.
While retail REITs are (and have been) relatively healthy investments over the years, there is some long-term concern about this sector as more shopping moves online and physical storefronts become less important. That being said, retail REITs are generally a good addition to any portfolio.
2. Office REITs
With office REITs, the company invests in commercial office buildings and generates rental income from tenants who sign long-term leases. Much like retail REITs, nobody knows what the future will hold with remote work and virtual work, but finding solid funds in economic strongholds like Washington D.C., New York, San Francisco continues to be a good practice.
3. Residential REITs
With residential REITs, the company usually owns and operates multi-family rental apartment buildings. A single REIT might own thousands of “doors” in different cities and states across the country. However, the biggest and most successful residential REITs are usually focused on large urban centers. Long-term, the outlook is pretty strong for this type.
4. Healthcare REITs
Many REITs niche down to very specific types of properties. For example, there are healthcare REITs that focus on medical centers, hospitals, nursing facilities, and retirement homes. By specializing in these types of properties, the investment team is able to make very targeted and educated investments that (ideally) produce a higher than average return based on their knowledge and experience.
5. Mortgage REITs
Roughly 10 percent of all REIT investments are in mortgages (rather than the actual real estate). Common examples include Freddie Mac and Fannie Mae. With these companies, the REIT invests in the mortgages, not the actual asset or equity. As interest rates rise, mortgage REIT values decline (and vice versa).
The Pros of Investing in REITs
People invest in REITs for any number of reasons. Some of the most enticing benefits include:
- Low-risk exposure to real estate. If you’re looking to diversify your investment portfolio by including real estate, REITs are probably the lowest-risk option. Rather than investing your money into a single property that could go boom or bust, your money gets spread across hundreds or thousands of properties (and you don’t have to find the deals or put your name on the title).
- No corporate tax. REITs get pretty favorable tax treatment by not having to pay a corporate tax. This is much different than dividend stocks, which essentially have double taxation. As a result, there’s usually a higher payout for investors.
- High dividend yield. REITs are legally required to pay out at least 90 percent of their income in the form of dividends. This means you never have to worry about the company withholding profits.
- High liquidity. Unlike traditional real estate investments that can take months to pull out money, REITs are extremely liquid. You can sell shares any time you want and have cash in hand within just a day or two.
The Cons of Investing in REITs
REITs aren’t perfect. (No investment is.) Here are some of the potential negatives and drawbacks:
- Dividend taxes. While REITs don’t have to pay corporate tax, individual investors are typically forced to pay higher tax rates than other investments. Unlike dividend stocks which are usually taxed at long-term capital gains rates, dividends from REITs don’t qualify for this lower rate. They’re typically taxed at the same rate as an individual’s ordinary income.
- Longer-term investments. While you can technically pull out your funds whenever you want, advisors typically recommend keeping your money invested for at least five years in order to maximize your return. (Anything shorter can leave you exposed to micro-changes in interest rates.)
- Future uncertainty. There’s no telling what will happen with real estate over the next five to 10 years. In sectors like retail and office space, there could be a lot of change. Some of this change may be good, while some could have a negative effect on returns. REITs are typically on a cycle with the movements of the economy.
Where Do REITs Fit Into Your Portfolio?
There’s no such thing as a risk-free investment. Real estate investment trusts, like any other investment, come with their own set of risks and rewards. It’s up to you to calculate your own risk tolerance and weigh it against your financial goals.
Generally speaking, most savvy investors like to diversify with REITs (rather than relying on them for the bulk of a portfolio). When plugged in alongside stocks, mutual funds, ETFs, bonds, cryptocurrency, insurance products, and other real estate investments, REITs are a great option.
