Dipping your toes into the real estate market sounds like a great idea on paper, but it takes lots of upfront capital. Then there’s the constant maintenance, the ever-changing housing market, and the responsibility of finding reliable tenants for your short- or long-term rentals. After adding up all the costs, you might decide that real estate investing isn’t as easy as you’d imagined.
One way to invest in real estate without owning properties is by way of REITs. Short for “Real Estate Investment Trusts,” REITs are sort of like mutual funds for real estate. REIT companies pool together money from hundreds or thousands of investors, then spend it on income-producing real estate ventures and share the profits.
“There are a lot of ongoing costs when one owns real estate, and they’re getting some kind of income from that real estate,” says Omar Morillo, a certified financial planner and wealth advisor at Octavia Wealth Advisors in Miami, Florida. “A REIT offers a way to tap into the real estate market without undergoing all of those expenses.”
But REITs aren’t perfect. There are some downsides to consider. Read on to learn more 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 on REIT shares and in turn getting a new stream of income.
That’s how things work with REITs. REITs are publicly traded or private companies that own, operate, and/or provide financing for real estate and assets that bring in income. The assets included in a REIT might include commercial buildings such as office spaces, hotels, self-storage facilities, warehouses, hospitals, data centers, cell towers, or residential apartment buildings. It’s common for REITs to be clustered according to sector or type—think industrial, healthcare, retail, or residential. There are even marijuana REITS.
To qualify as a REIT, a company must check off a long list of criteria. This includes paying their shareholders at least 90% of their taxable income each year as dividends. Plus, they must invest at least 75% of all their assets in real estate assets and make at least three-fourths of their gross income from sources that are tied to real estate. The lion’s share (95%) of their gross income has to come from real estate sources and dividends. Last, no more than one-fourth of REITs’ assets can come from non-qualifying securities or stock in taxable REIT subsidiaries.
How Do REITs Make Money?
REITs make money through their properties by either selling or leasing them. Instead of other real estate companies, which develop properties with the goal to sell them, the primary objective of a REIT is to develop properties, run them, and fold them into their own investment portfolio. Should property owned by a REIT appreciate in value, the owners provide 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 ventures that bring in 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, are a mix of both equity REITs and mortgage REITs.
There’s also a difference between a publicly-traded or privately-traded REIT: Privately traded REITs are also known as non-traded REITs, meaning they’re not traded on the stock exchange. Publicly traded REITs usually have smaller dividends. However, according to Morillo, publicly traded REITS provide greater transparency and higher liquidity than privately traded REITs.
“A common issue with the private REITs markets is that, unfortunately, some actors will do what I call ‘milking their REITs,’ ” says Morillo. “In other words, they’ll charge excessive fees and expenses because the REIT is obligated to distribute at least 90% of their profits back to the shareholders. But as long as those internal expenses are jacked up, then the shareholders don’t really get their fair due.”
Pros and Cons of REITS
Let’s look at some of the advantages and downsides of REITs.
REITs can be a good way to diversify your portfolio
If you have mutual funds that are invested in stocks and bonds, instead of going out and buying a rental property, REITs will give you a way to tap into that real estate industry, explains Niv Persaud, a CFP and managing director and founder of the Atlanta-based financial planning firm, Transition Planning and Guidance.
REITs are tied to a tangible asset
If you’re looking to earn some income from your portfolio, a REIT often seems like an attractive way of doing so. REITS are often easier, since you don’t have to go and acquire a property on your own, says Morillo. “You don’t have to play landlord and deal with the operations day to day, whether it’s an apartment building or hotel or retail,” he says.
Market forces or economic conditions can impact income-earning potential
Because REITs are clustered by sector or type of property such as healthcare properties, retail, residential, or commercial, they can be impacted by an economic condition or state or local mandates because of their location. For example, in the middle of COVID-19, there were rental moratoriums where people weren’t paying their rental property. Meanwhile, healthcare tends to be less cyclical—so with some research and good diversification you can try to balance out unfavorable market conditions.
Non-traded REITs are fairly liquid
The time horizon for REITs can be tricky. Publicly traded REITs are usually more liquid than private REITs, which can’t be sold very quickly. However, a best practice is to give yourself at least a few years before tapping into the money: “You need to act like this money doesn’t exist for a couple of years,” says Morillo. “There’s no turning around and trying to liquidate it in six months, because you had an emergency, or a year and a half from now because your daughter is getting married and you’re going to pay for the wedding.”
REITs are sensitive to interest rates
Just like any type of real estate you buy, REITs are tied to federal interest rates. “When the Federal Reserve says that they’re going to raise interest rates, a lot of times your REITs prices will fall,” says Persaud. Interest rates impact each type of REIT differently across industries and companies.
REITs are taxed as ordinary income
As Persaud explains, if you’re ready in a high tax bracket, then dividends from your REITs will be taxed as ordinary income. “But because REITs are part of your investment portfolio, your financial adviser will be able to manage some of the taxes,” says Persaud.
Should You Invest In REITs?
Not all REITs are the same. Know whether you’re most interested in residential, commercial healthcare, or retail REITs—and what risks are involved. Brush up on industry news and inquire about both local and federal regulations that might impact your ROI.
“For example, with retail REITs, if you look at how the market is, more people shop online than going into a retail store. You really want to understand what you’re investing in,” Persaud says.
Like any financial move, Persaud recommends asking your financial advisor to recommend some REITs that would best fit in your portfolio.
And don’t get too swept up in the allure of passive income, says Morillo. Just because REITs generate income and pay annual dividends doesn’t make them risk-free.
Investments that provide income aren’t necessarily less risky than other types of investments—always research fees, tax implications, and expected returns.
“People tend to have this point of view that because something pays income or dividends is less risky,” he says.
Weigh the pros and cons, and take a good look at the fees and costs involved. If you do decide to invest in REITs, keep the timeless adage, don’t put your eggs in one basket, in mind.