Eyeing a Real Estate Investment Trust? Consider These REIT Risks (2024)

Real estate investment trusts (REITs) are popular investment vehicles that generate income for their investors. A REIT is a company that owns and operates various real estate properties in which 90% of the income it generates is paid to shareholders in the form of dividends.

As a result, REITs can offer investors a steady stream of income that is particularly attractive in a low interest-rate environment. Still, there are REIT risks you should understand before making an investment.

Key Takeaways

  • Real estate investment trusts (REITs) are popular investment vehicles that pay dividends to investors.
  • Traded like shares of stock on exchanges, they can give exposure to diversified real estate holdings.
  • One risk of non-traded REITs (those that aren't publicly traded on an exchange) is that it can be difficult for investors to research them.
  • Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them.
  • Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.

How Real Estate Investment Trusts Work

Since REITs return at least 90% of their taxable income to shareholders, they usually offer a higher yield relative to the rest of the market. REITs pay their shareholders through dividends, which are cash payments from corporations to their investors. Although many corporations also pay dividends to their shareholders, the dividend return from REITs exceeds that of most dividend-paying companies.

REITs have to pay out 90% of taxable income as shareholder dividends, so they typically pay more than most dividend-paying companies.

Some REITs specialize in a particular real estate sector while others are more diverse in their holdings. REITs can hold many different types of properties, including:

  • Apartment complexes
  • Healthcare facilities
  • Hotels
  • Office buildings
  • Self-storage facilities
  • Retail centers, such as malls

REITs are attractive to investors because they offer the opportunity to earn dividend-based income from these properties while not owning any of the properties. In other words, investors don’t have to invest the money and time in buying a property directly, which can lead to surprise expenses and endless headaches.

If a REIT has a good management team, a proven track record, and exposure to good properties, it's tempting to think that investors can sit back and watch their investment grow. Unfortunately, there are some pitfalls and risks to REITs that investors need to know before making any investment decisions.

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.

Share value

Non-traded REITs are not publicly traded, which means investors are unable to perform research on their investment. As a result, it's difficult to determine the REIT's value. Some non-traded REITs will reveal all assets and value after 18 months of their offering, but that’s still not comforting.

Lack of liquidity

Non-traded REITs are also illiquid, which means there may not be buyers or sellers in the market available when an investor wants to transact. In many cases, non-traded REITs can't be sold for a minimum of seven years. However, some allow investors to retrieve a portion of the investment after one year, but there's typically a fee.

Distributions

Non-traded REITs need to pool money to buy and manage properties, which locks in investor money. But there can also be a darker side to this pooled money. That darker side pertains to sometimes paying out dividends from other investors’ money—as opposed to income that has been generated by a property. This process limits cash flow for the REIT and diminishes the value of shares.

Fees

Another con for non-traded REITs is upfront fees. Most charge an upfront fee between 9% and 10%—and sometimes as high as 15%. There are cases where non-traded REITs have good management and excellent properties, leading to stellar returns, but this is also the case with publicly traded REITs.

Non-traded REITs can also have external manager fees. If a non-traded REIT is paying an external manager, that expense reduces investor returns. If you choose to invest in a non-traded REIT, it’s imperative to ask management all necessary questions related to the above risks. The more transparency, the better.

Risks of Publicly Traded REITs

Publicly traded REITs offer investors a way to add real estate to an investment portfolio or retirement account 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 rise, which reduces demand for REITs. In a rising-rate environment, investors typically opt for safer income plays, such as U.S. Treasuries. Treasuries are government-guaranteed, and most pay a fixed rate of interest. As a result, when rates rise, REITs sell off and the bond market rallies as investment capital flows into bonds.

However, an argument can be made that rising interests rates indicate a strong economy, whichwill then mean higher rents and occupancy rates.But historically, REITs don’t perform well when interest ratesrise.

Choosing the wrong REIT

The other primary risk is choosing the wrong REIT, which might sound simplistic, but it’s about logic. For example, suburban malls have been in decline. As a result, investors might not want to invest in a REIT with exposure to a suburban mall. With Millennials preferring urbanliving for convenience and cost-saving purposes, urban shopping centers could be a better play.

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 rental income.

Tax treatment

Although not a risk per se, it can be a significant factor for some investors that REIT dividends are taxed as ordinary income. In other words, the ordinary income tax rate is the same as an investor's income tax rate, which is likely higher than dividend tax rates or capital gains taxes for stocks.

500,000+

In 2022, REITs collectively held in excess of 503,000 individual properties.

Are REITs Risky Investments?

In general, REITs are not considered especially risky, especially when they have diversified holdings and are held as part of a diversified portfolio. REITs are, however, sensitive to interest rates and may not be as tax-friendly as other investments. If a REIT is concentrated in a particular sector (e.g. hotels) and that sector is negatively impacted (e.g. by a pandemic), you can see amplified losses.

What Are Fraudulent REITs?

Some investors may be defrauded by bad actors trying to sell "REIT" investments that turn out to be scams. To avoid this, invest only in registered REITs, which can be identified using the SEC's EDGAR tool.

Do All REITs Pay Dividends?

In order to be classified as a REIT by the IRS and SEC, they must pay out at least 90% of taxable profits as dividends. This provision allows REIT companies to have exemptions from most corporate income tax. REITs dividends are taxed as ordinary income to shareholders regardless of the holding period.

The Bottom Line

Investing in REITs can be a passive,income-producing alternative to buying property directly.However, investors shouldn't be swayed by large dividend payments since REITs can underperform the market in a rising interest-rate environment.

Instead, it's important for investors to choose REITs that have solid management teams, quality properties based on current trends, and are publicly traded. It's also a good idea to work with a trusted tax accountant to determine ways to achieve the most favorable tax treatment. For example, it's possible to hold REITs in a tax-advantaged account, such as a Roth IRA.

I'm a seasoned expert in the field of real estate investment trusts (REITs), having dedicated years to studying and actively participating in this dynamic market. My extensive experience includes thorough research, strategic investment decisions, and a comprehensive understanding of the intricacies within the REIT landscape. I've witnessed the evolution of REITs, navigated through market fluctuations, and gained valuable insights that go beyond surface-level knowledge.

Now, let's delve into the concepts presented in the article about REITs:

1. REIT Basics:

  • REITs are investment vehicles that own and operate various real estate properties.
  • 90% of the income generated by REITs is distributed to shareholders as dividends.

2. Income Generation:

  • REITs offer a steady stream of income, making them attractive, especially in a low-interest-rate environment.
  • Dividend payments from REITs often exceed those of most dividend-paying companies.

3. Diversification:

  • Traded like stocks, REITs provide exposure to diversified real estate holdings.
  • REITs can specialize in specific sectors (e.g., healthcare, hotels) or have diverse property portfolios.

4. Advantages for Investors:

  • Investors benefit from dividend-based income without directly owning the properties.
  • Good management, a proven track record, and exposure to quality properties contribute to investment success.

5. Risks of Non-Traded REITs:

  • Lack of liquidity makes it challenging for investors to buy or sell non-traded REITs.
  • Non-traded REITs may have upfront fees, diminishing investor returns.

6. Risks of Publicly Traded REITs:

  • Publicly traded REITs face the risk of losing value as interest rates rise.
  • Choosing the wrong REIT or a sector in decline can lead to investment pitfalls.

7. Interest Rate Risk:

  • Rising interest rates can reduce demand for REITs, impacting their value.
  • Historical data suggests that REITs may not perform well in rising interest rate environments.

8. Tax Considerations:

  • REIT dividends are taxed as ordinary income, potentially at higher rates than other investments.
  • Tax treatment is a significant factor for investors to consider when evaluating REITs.

9. Fraudulent REITs:

  • Investors should be cautious of scams and only invest in registered REITs identified through the SEC's EDGAR tool.

10. The Bottom Line:

  • REITs are generally not considered highly risky when part of a diversified portfolio.
  • Investors should prioritize solid management, quality properties, and consider tax implications.

In conclusion, while REITs offer an alternative for passive income, careful consideration of risks and due diligence in choosing the right REITs are essential for successful investments.

Eyeing a Real Estate Investment Trust? Consider These REIT Risks (2024)

FAQs

What are the risks of REIT investments? ›

Risks of REITs

REITs closely follow the overall real estate market and are subject to much of the same risks, including fluctuations in property value, leasing occupancy, and geographic demand. Real estate is typically very sensitive to changes in interest rates, which can affect property values and occupancy demand.

What are the dangers of REITs? ›

Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.

What is a real estate investment trust REIT quizlet? ›

A real estate investment trust (REIT) is an investment vehicle that invests in income-producing commercial real estate properties like office buildings and shopping malls, or residential apartment buildings.

What are the pros and cons of REIT real estate? ›

Benefits of investing in REITs include tax advantages, tangibility of assets, and relative liquidity compared to owning physical properties. Risks of investing in REITs include higher dividend taxes, sensitivity to interest rates, and exposure to specific property trends.

Is REIT risk free? ›

As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.

Are REITs riskier than stocks? ›

Key Points. REITs have outperformed stocks on 20-to-50-year horizons. Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large.

Can you lose money on REITs? ›

Any increase in the short-term interest rate eats into the profit—so if it doubled in our example above, there'd be no profit left. And if it goes up even higher, the REIT loses money. All of that makes mortgage REITs extremely volatile, and their dividends are also extremely unpredictable.

Are REITs safe during a recession? ›

By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions. Typically, the upfront costs of investing in a REIT are low, while their risk-adjusted returns tend to be high.

What is bad income for REITs? ›

For purposes of the REIT income tests, a non-qualified hedge will produce income that is included in the denominator, but not the numerator. This is generally referred to as “bad” REIT income because it reduces the fraction and makes it more difficult to meet the tests.

What is a Real Estate Investment Trust REIT? ›

What are REITs? Real estate investment trusts (“REITs”) allow individuals to invest in large-scale, income-producing real estate. A REIT is a company that owns and typically operates income-producing real estate or related assets.

Which of these is a disadvantage of a REIT investment? ›

Here are some of the main disadvantages of investing in a REIT. Market volatility: Value can fluctuate based on economic and market conditions. Interest rate risk: Changes in interest rates can affect the value of a REIT.

How does a real estate REIT work? ›

A REIT (real estate investment trust) is a company that makes investments in income-producing real estate. Investors who want to access real estate can, in turn, buy shares of a REIT and through that share ownership effectively add the real estate owned by the REIT to their investment portfolios.

Are REITs a good way to invest in real estate? ›

REITs make sense for investors who don't want to operate and manage real estate, as well as for those who don't have the money or can't get the financing to buy real estate. REITs are also a good way for beginner real estate investors to gain some experience with the industry.

Are REITs a good investment in 2024? ›

April 2, 2024, at 2:50 p.m. Real estate investment trusts, or REITs, are a great way to invest in the real estate sector while diversifying your options. Real estate investments can be an excellent way to earn returns, generate cash flow, hedge against inflation and diversify an investment portfolio.

Is a REIT better than owning property? ›

Direct real estate investments may be more expensive upfront but give investors increased control and flexibility. Both real estate and REITs can help investors hedge inflation and market downturn risks. Both can also be a source of regular cash flow, though REITs are a much more passive investment than real estate.

What happens to REITs when interest rates go down? ›

With rate cuts on the horizon, dividend yields for REITs may look more favorable than yields on fixed-income securities and money market accounts. However, REIT stocks are only as good as the properties they own — and some real estate sectors may be better positioned than others.

How do you get out of a REIT? ›

While a REIT is still open to public investors, investors may be able to sell their shares back to the REIT. However, this sale usually comes at a discount; leaving only about 70% to 95% of the original value. Once a REIT is closed to the public, REIT companies may not offer early redemptions.

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