WP explains what a REIT is, its pros and cons, and if it's the right investment vehicle for you
Real estate should be part of every balanced investment portfolio because it generally has a low correlation to stocks, so can provide your overall portfolio with stability. So, investing in a REIT (Real Estate Investment Trust) can be a great way to diversify your portfolio, adding income and growth to it without adding too much risk.
Financial advisors agree that 10% to 26% of your investments should be in real estate, so you can learn some of the pros and cons here to determine if a REIT is a good investment vehicle for you.
What is a REIT?
A REIT is an alternative way to directly buy real estate. You can think of it as a pool of real estate assets traded freely on the stock market exchange.
It also offers some of the most attractive features of stock investing.
How does a real estate investment trust work?
A REIT is a trust that passively holds interests in real property. Its trustees hold legal title to, and manage, the trust property on behalf of the REIT’s unit holders. It is generally subject to fiduciary duties, like those that apply to a corporation’s directors.
There is no legislation that governs a REIT’s organizational structure, so principles of contract law and trust law apply to it instead.
Trust income can flow through the trust into the unit holders’ hands, so it’s not taxed at the trust level.
What are the benefits of REITs?
A REIT is great for those who want exposure to real estate, but don’t have the capital for direct investment. Like real estate, it allows you to invest in different categories or geographical regions. Those can be industrial and office, retail, residential, lodging and resorts, and health care, and include storage units, mortgages, malls, or a mix of investments. Some REITS aso pay dividends, so can be included in income portfolios.
Here are some of the most important benefits that a REIT can provide.
- No corporate tax: To be classified as a REIT, a company must meet some strict requirements. For example, it must invest at least three-quarters of its assets in real estate and pay at least 90% of its taxable income to shareholders. If it meets these requirements, a REIT gets a big tax advantage because, regardless of how profitable it is, a REIT pays zero corporate tax. With most dividend stocks, profits are effectively taxed twice – once on the corporate level and again on the individual level when they’re paid as dividends.
- High dividend yields: Since a REIT must pay at least 90% of the taxable income to shareholders, it tends to have above-average dividend yields. It could, for instance, have a safe dividend yield of 5% or more while the average stock on the S&P 500 yields less than 2%. This can make a REIT an excellent choice if you need income or want to reinvest your dividends and compound your gains over time.
- Total return potential: A REIT has the potential for capital appreciation as the value of its underlying assets grow. Real estate values tend to increase over time and a REIT can use several strategies to create additional value. It could develop properties from the ground up or sell valuable properties and redeploy the capital. This, combined with high dividends, means a REIT can be an excellent total return investment.
- Access to commercial real estate: The main reason REITs were created was to allow everyday investors to put their money to work in assets that would otherwise be beyond their reach. Most people can’t go out and buy an office tower, but there are REITs that allow you to do that.
- Portfolio diversification: Most experts would agree that diversifying your investment portfolio is good. Although REITs are technically stocks, real estate is a different asset class than equities. A REIT tends to hold its value better than stocks during tough economies, and it's a great way to add steady, predictable income. These are just two factors that help offset the inherent risk of an all-stock portfolio.
- Liquidity: Buying and selling real estate properties can take awhile, but REITs are an extremely liquid investment. You can buy or sell a REIT whenever you want. When you need the money, it’s easy to get it because traded REITs can be bought and sold like stocks.
- Passive investment: Directly owning and managing a property is a business and requires time and effort. REIT shareholders do not own the property or mortgages in their portfolio, so they don’t have to deal with maintaining or developing the property, providing landlord services, or collecting rent payments as a property owner or manager would.
What are the risks of REITs?
No investment is perfect, so you should know a REIT’s potential drawbacks before adding them to your portfolio.
- Dividend taxation: REITs tend to have above-average dividends and aren’t taxed at the corporate level. The downside is that REIT dividends generally don’t meet the tax definitions of "qualified dividends”, which are taxed at lower rates than ordinary income.
- Interest rate sensitivity: REITs can be highly sensitive to interest rate fluctuations as rising interest rates are bad for REIT stock prices. As a rule, when the yields investors can get from risk-free investments like Treasury securities increase, yields from other income-based investments rise accordingly. The 10-year Treasury yield is a good REIT indicator.
- Declining value properties: While REITs can add diversification to your portfolio, most REITs are not very diversified. They tend to focus on a specific property type and each type has its own risks. Hotel REITs, for example, are very sensitive to recessions and other economic weakness. If you decide to invest in REITs, it's smart to choose a few with different levels of economic sensitivity.
- Fees and markups: While REITs offer the advantage of liquidity, trading in and out of a REIT has a high cost. Most of the fees that a REIT charges are paid upfront. They can be about 20% to 30% of the REIT’s value. This costs a large part of your potential return.