Real estate investment trusts (REITs) have been around since 1960, but they've become increasingly popular in the past 25 years as a way for more investors to access the real estate market.
REITs can be a great way to diversify your investment portfolio beyond the stock market, but before you invest, it's important to understand both the benefits and drawbacks REITs present. Here's what you need to know.
What Is a Real Estate Investment Trust?
A real estate investment trust is a company that invests in a variety of income-producing properties, both residential and commercial. Interested investors can invest in medical offices, gas stations, movie theaters, storage facilities, farmland, casinos and many more types of properties.
REITs receive income from the properties they own and then distribute at least 90% of it to their shareholders. That said, many REITs pay out all of their earnings due to the tax benefits.
Because many REITs are listed on major stock exchanges, investors can also generate a return on the share price. Some REITs are public but not listed on an exchange, however, while others are private and inaccessible to the general public.
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Pros of REITs
Investing in REITs can come with a lot of benefits, especially as a companion to other types of investments.
By investing in REITs, along with other types of investment securities, you can mitigate some of the risks associated with each type of asset. For example, the stock market tends to be more volatile in the short term than the real estate market, allowing you to have a mixture of more and less risky investments.
Additionally, REITs give real estate investors an opportunity to diversify their real estate holdings—something that's tough to do when you're buying individual investment properties, which requires a large amount of cash.
Investors who are interested in the real estate market don't have to save up tens of thousands of dollars for a sizable down payment on an investment property or make regular mortgage payments with REITs.
Depending on which broker you choose, you may even be able to buy fractional shares of a REIT if you can't afford a full share.
As a REIT shareholder, you'll receive regular dividends—monthly, quarterly or annually—based on your holding in the company. If you're in or nearing retirement, or you simply want to build a passive income stream, REITs can be a great way to receive regular income without doing anything.
Unlike traditional real estate investments, REITs allow you to buy and sell shares by simply logging in to your brokerage account and making a trade. If you want to sell an investment property, on the other hand, it can take several months and a large amount of cash to make it happen. This liquidity gives you more flexibility in your investments, allowing you to access cash if you need to.
In addition to regular income payments, REIT investors can also take advantage of price appreciation for their shares. Like stock prices, REIT prices can fluctuate over time.
That said, a significant number of REITs outperform the stock market in terms of annualized returns, especially when you hold your position for 10 or more years.
Cons of REITs
While there are some clear benefits to investing in REITs, there are also some disadvantages to consider, especially if you don't diversify your portfolio well.
REIT dividends can be a great source of passive income, but the money you receive is subject to your ordinary income tax rate, which will depend on your tax bracket. And because dividends are paid out regularly, you'll have to pay taxes on the income each year, even if you reinvest your dividends.
In contrast, when you sell a stock after holding it for longer than a year, any gains you receive will be subject to the long-term capital gains tax rate, which is lower than your ordinary income tax rate. In other words, expect a higher and more consistent tax bill with a REIT.
Interest Rate Risk
The value of a REIT is based on the real estate market, so if interest rates increase and the demand for properties goes down as a result, it could lead to lower property values, negatively impacting the value of your investment.
The fundamentals of the real estate market aren't all the same as the stock market, so you generally won't get as much short-term volatility with a REIT as you would with a stock.
That said, the real estate market is still subject to a variety of influences, some of which don't affect the stock market. As such, you'll still experience market volatility with a REIT, which could impact you in the short term.
You Have Little Control
Just as if you were to buy a mutual fund or exchange-traded fund, you don't have any say in how a REIT invests its money, and you have no control at all over the properties themselves.
As a result, some REITs are less diversified than others, focusing on a specific niche, such as office buildings or apartment complexes. If you don't pick a well-diversified REIT or invest in multiple REITs, you may not be as diversified as you think.
Some Charge High Fees
Publicly traded REITs typically don't have a lot of fees beyond trading commissions, which many online brokers don't charge anymore.
But if you decide to invest in a non-listed REIT or a private REIT, upfront costs can be as high as 11% or more of your investment. Private REITs may also charge a 2% management fee each year.
Navigating REIT Investing
Investing in REITs can add some diversification to your portfolio and give you access to passive income, liquidity and excellent long-term returns. However, taxes can be more expensive with REITs compared to other investment options, and there are still risks involved with the real estate market.
If you're looking to add REITs to your portfolio, spend time researching several options. Look at past performance, dividend yields and property holdings to get an idea of what you're getting. You may also consider consulting with a financial advisor to get some personalized expert advice and guidance for your situation and personal finance goals.