Creating a well-rounded investment strategy isn’t too different from making a nutritionally balanced meal. Like a healthy plate chock full of grains, greens, fruits, and protein, an investment strategy including a little bit of everything means an investor won’t miss out on a single food group.
While having a diversified portfolio can’t eliminate risk, it can help mitigate it. To use another food metaphor, diversification is the investment equivalent of not putting all eggs in a single basket.
Consider REITs as just one part of an investor’s balanced investment diet. Like any investment (or food group, come to think of it), too much of one thing could mean too much risk, and not enough diversification. On the other hand, ignoring an investment category entirely could mean missing out on future earnings.
So, what are REITs, and what makes them a good (and bad) investment?
What are REITs?
Once an investor has a well-planned budget, emergency savings, and retirement investments, often, they’re ready for more portfolio diversification. For some, that might mean trying their hand at an investment property.
But, an investment property requires lots of time and upfront cash. It means buying and potentially fixing a property before renting it out for additional income. But, the costs and responsibility of becoming a landlord might not be appealing to everyone, even after factoring in the revenue from monthly rent checks
There’s less responsibility and pressure on the shareholder, when compared to purchasing an investment property.
For those looking for a less hands-on approach to investing in the real estate world, look no further than REITs. A REIT is a Real Estate Investment Trusts. While developing and operating a real estate venture is out of reality for some, REITs make it possible for people to become investors in large-scale construction or other real estate projects. With a REIT, an investor buys into a piece of a real estate venture, not the whole thing. There’s less responsibility and pressure on the shareholder when compared to purchasing an investment property.
When a person invests in a REIT, they’re investing in a real estate company that owns and operates anything from malls, office complexes, warehouses, apartment buildings, mortgages, and more. It’s a way for someone to add real estate investments to their portfolio without developing real estate.
Many, but not all, REITs are registered with the SEC (Securities and Exchange Commission) and can be found on the stock market, where they’re publicly traded. Investors can also buy REITs registered with the SEC but not publicly traded.
Non-traded REITs (aka, not publicly traded ones) can’t be found on NASDAQ or the stock exchange. They’re traded on the secondary market between brokers, who can make trading them a bit more challenging. Simply put, this class of REITs has a whole different list of risks specific to its type of investing.
Non-traded REITs make for some pretty advanced investing, so the rest of this article will discuss publicly-traded REITs.
Types of REITs
Real Estate Investment Trusts broadly fall into two categories:
• Mortgage REITs. These REITs can specialize in commercial, residential, or both. When an investor purchases Mortgage REITs, they’re investing in mortgage and mortgage-backed securities that invest in commercial and residential projects. Think of it as taking a step back from directly investing in real estate.
• Equity REITs. These REITs often mean someone’s investing in a specific type of property. There are diversified equity REITs, but there are specialized ones, including:
◦ Apartment and lodging
◦ Healthcare
◦ Hotels
◦ Offices
◦ Self-storage
◦ Retail
Pros of Investing in REITs
Investing in REITs can have several benefits, such as:
• Diversity. A diverse portfolio can reduce an investor’s risk because money is spread across different assets and industries. Investing in a REIT can help diversify a person’s investment portfolio. REITs aren’t stocks, bonds, or money markets but a class unto their own.
• Dividends. Legally, REITs are legally required to pay at least 90% of their income in dividends. The REIT’s management can decide to pay out more than 90%, but they can’t drop that percentage below. Earning consistent dividends can be a compelling reason for investors to get involved with REITs.
• Zero corporate tax. Hand in hand with the 90% payout rule, REITs get a significant tax advantage—they don’t have to pay a corporate tax. To put it in perspective, many dividend stocks pay taxes twice, once corporately and again for the individual. Not paying a corporate tax can mean a higher payout for investors.
• Tangibility. Unlike other investments, REITs are investments in physical pieces of property. Those tangible assets can increase in value over time. Being able to “see” an investment can also put some people at ease—it’s not simply a piece of paper or a slice of a company.
• Liquidity. Compared to buying an investment property, investing in REITs is relatively liquid . It takes much less time to buy and sell a REIT than it does a rental property. Selling REITs takes the lick of a button; no FOR SALE sign is required.
Compared to other real estate investment opportunities, REITs are relatively simple to invest in and don’t require some of the legwork an investment property would take.
Cons of Investing in REITs
No investment is risk-free, REITS included. Here’s what investors should keep in mind before diving into REITs:
• Taxes on dividends. REITs don’t have to pay a corporate tax, but the downside is that REIT dividends are typically taxed at a higher rate than other investments. Often, dividends are taxed at the same rate as long-term capital gains, which for many people, is generally lower than the rate at which their regular income is taxed. However, dividends paid from REITs don’t usually qualify for the capital gains rate. It’s more common that REIT dividends are taxed at the same rate as a person’s ordinary income.
• Sensitive to interest rates. Various factors influence investments, but REITs can be hypersensitive to changes in interest rates. Rising interest rates can spell trouble for the price of REIT stocks. Generally, the value of REITs is inversely tied to the Treasury yield—so when the Treasury yield rises, the value of REITs are likely to fall.
• Trends can influence value. Unlike other investments, REITs can fall prey to risks explicitly associated with the property. For example, if a person invests in a REIT that’s specifically a portfolio of frozen yogurt shops in strip malls, they could see their investment take a hit if frozen yogurt or strip malls fall out of trend. While investments do fall prey to trends, REITs can be influenced by smaller trends, specific to the location or property type, that could be harder for an investor to notice.
• Plan for a long-term investment. Generally, REITs are better suited for long-term investments, which can typically be thought of as those over five years. Micro-changes influence REITs in interest rates and other trends that can make them riskier for a short-term financial goal.
Are REITs a Risky Investment?
No investment is free of risk, and REITs come with risks and rewards specific to them. As mentioned above, they’re generally more sensitive to fluctuations in interest rates, which inversely influence their value.
Some REITs are riskier than others, and some are better suited to withstand economic declines.
Additionally, some REITs are riskier than others, and some are better suited to withstand economic declines than others. For example, a REIT in the healthcare or hospital space could be more recession-proof than a REIT with properties in retail or luxury hotels. Despite an economic recession, people will continue using real estate associated with healthcare spaces. In contrast, luxury real estate may not experience continued demands during times of economic hardship.
Risks aside, REITs pay dividends, which can appeal to investors. While REITS are not without risk, they can be a strong part of an investor’s portfolio.
Investing in REITs
Investing in publicly traded REITS is as simple as purchasing stock in the market—simply purchasing shares through a broker. Investors can also purchase REITs in a mutual fund.
Investing in a non-traded REIT is a little different. Investors must work with a broker that is part of the non-traded REITs offering. Not any old broker can help an investor get involved in non-traded REITs. A potential drawback of purchasing non-traded REITs is the high up-front fees. Investors can expect to pay fees, which include commission and fees, between 9 and 10% of the entire investment.
