Real estate investment trusts (REITs) are popular among those looking to benefit from real estate markets without the high costs of owning physical property. But are REITs good investments? In this post, we’ll look at the pros and cons to help you get a better picture.
Note that this guide is purely educational. I’ll never tell you that you should or shouldn’t invest in something. Rather, I aim to give you a detailed look at the pros and cons of various investments so that you can have informed conversations with an advisor.
If you’re completely new to investing, I recommend reading this beginner’s guide before you proceed.
Are REITs good investments? The basics
Real estate investment trusts (REITs) are companies offering an alternative means of exposure to physical property and related markets. They behave much like ETFs in that shares of the portfolio trade on exchanges based on demand and underlying value. You can find REITs offering exposure to various types of real estate, including:
- Healthcare (medical facilities, etc)
- Hospitality (hotels, resorts, etc)
- Consumer storage
The above investments fall under a category known as equity REITs. There are also mortgage REITs, which generate returns via interest payments from investments such as mortgage-backed securities.
You can also purchase ETFs containing various types of REITs if you’d like to achieve even greater diversification than the investment provides in its “unpackaged” form. Not sure what ETFs are? Check out this article to learn more about them and how they compare to mutual funds, another common investment.
Why invest in REITs?
Since the 2008 housing crisis, banks in the United States have gotten much stricter about evaluating potential borrowers. It’s a similar story in Canada, where minimum down payments have gone up and stress testing is quite stringent. These restrictions make it difficult to accumulate a portfolio of physical properties large enough to be truly diversified.
Comparatively, REITs are a very affordable means of gaining exposure to the real estate market. There’s no income verification or down payment required. Rather, anyone with a brokerage account and enough money to cover the price of a single share plus commissions can immediately invest in hundreds of residential and commercial properties – something requiring very significant amounts of money to do physically.
Hands-free real estate investing
Owning physical real estate isn’t just costly in the financial sense. You typically have to spend significant amounts of time maintaining your property, following up with non-paying tenants, etc. When it comes to investing in Section 8 housing, keeping up with these commitments is key for maintaining your status as a participant.
With REITs, all of that work is taken care of for you. The large companies that run these investments have the resources to manage several properties on behalf of shareholders.
Another potential downside of owning physical real estate is its lack of liquidity. It can take weeks, months, or even years to sell a property and get your money out of it. Selling a REIT, meanwhile, takes mere minutes. Log into your brokerage account, click a few buttons, and you’ll have liquid cash again.
REITs are also slightly more liquid than investments such as mutual funds since they trade throughout the day like stocks or ETFs.
High dividend yields
The United States Securities and Exchange Commission (SEC) mandates that REITs pay at least 90% of their annual taxable income to investors in the form of dividends. This high percentage makes REITs quite popular among people looking to generate income from their investments.
It’s worth pointing out that the 90% rule has a lot of nuances involved. There are a few accounting rules (such as property depreciation) that can make for lower payouts than investors might expect. This article from Dividend.com is a pretty good explainer.
That said, REITs following the 90% rule receive attractive tax benefits and are not hard to find.
REITs have an average annual return of 10.5%, according to Investopedia. That’s higher than the stock market’s roughly 10% average annual growth. Now, as with all market-traded asset classes, you will have outliers in the form of exceptionally good or bad years. Average returns, by definition, benefit long-term investors rather than those who have limited time (or patience, in the case of weathering a downturn) to invest.
In-depth financial disclosures
All publicly-traded companies are required to disclose certain data related to their financial health. This reporting goes one step further with REITs since their high dividend payouts mean more frequent requests for capital, which must be explained to investors in accordance with the SEC, Generally Accepted Accounting Principles (GAAP), and exchanges.
Available in tax-advantaged accounts
Most types of investment accounts in America do not allow for the application of their tax benefits to physical real estate. In many cases, however, you can achieve exposure to the real estate market through REITs while also enjoying benefits like tax deferral.
Why not to invest in REITs
No investment is perfect. Here are some of the most common criticisms levelled against REITs.
Interest rates can have a huge impact on performance
History has shown that REITs tend to be quite sensitive to interest rate fluctuations. Share prices often rise with interest rates during strong economic times while moving in the opposite direction when rate hikes are accompanied by a financial slowdown. During the latter scenario, REITs can substantially underperform stocks as investors move towards more stable assets like treasury bonds.
Again, if you’re investing for the long haul, this tends to even out into an average annual growth rate of 10.5%. However, short-term investors should be aware of how heavily economic policy (specifically, the circumstances surrounding it) can affect returns.
REIT dividends are taxed like income
Depending on what type of investment account you hold REIT shares in, you’ll pay taxes on dividends as if they were regular income rather than capital gains, which means a larger percentage you don’t get to keep. A portion of your dividends will be return of capital and therefore not subject to tax but you’ll have to set aside some of what’s left to pay Uncle Sam.
Even if the amounts you owe seem financially insignificant, you’ll have to go through the trouble of documenting the payout and including it on your return come tax season.
You may already have massive exposure to the real estate market
If you own a home, you’ve invested hundreds of thousands of dollars (possibly through leverage aka a mortgage) into the real estate market. Depending on your goals and risk tolerance, increasing your exposure by investing in REITs may not make financial sense. Downturns in the real estate market may gut your net worth more than if you’d spread yourself out in different asset classes.
Not all REITs are good investments
While investors often argue that real estate is essential and therefore destined to grow, it’s important to remember that REITs can expose you to classes of properties affected by a wider range of economic factors than housing (which is what many physical real estate buyers start out with) might be.
Shopping mall REITs, for example, have been struggling for some time now as e-commerce takes off and leaves physical retail locations in its wake. Amid the COVID-19 pandemic, hotel REITs have (predictably) struggled as well.
REITs are a popular investment among people seeking affordable exposure to real estate markets. While many investors choose REITs because of their comparatively high dividend payouts, they also have several other things going for them. On average, REITs have produced slightly better returns than stocks, for example.
No investment is perfect, however, and you should always consult an advisor before making decisions. Potential downsides of REITs include dividend taxation and high sensitivity to interest rates. If you own property, you also need to consider your existing exposure to the real estate market and whether buying REITs might leave you too heavily-exposed to this one sector.
Frequently asked questions
Well, it depends on what you mean by safe. REITs have historically produced competitive average annual returns of 10.5% along with impressive dividend yields. As is typical of equities, however, you can lose money even with the best of REITs. It’s important that you analyze your risk tolerance when deciding whether to invest in REITs and which ones best suit your portfolio.
Now, you may occasionally run into shady websites offering non-traded REITs that are unregulated. Avoiding this is simple; just purchase REITs through a licensed and reputable brokerage. If you’re ever uncertain, however, you can verify a REIT’s legitimacy through the SEC’s EDGAR tool.
Data has shown that REITs, on average, have tended to perform quite well compared to other asset classes. There are a number of caveats to keep in mind, of course. Just like individual stocks may deviate from the entire market’s average performance, a single REIT may perform better or worse than the entire class. Also, past performance is not indicative of how REITs will behave in the future.
REITs, just like stocks, can lose money. Depending on what type of account you hold REITs in, you may be able to claim these losses in order to offset gains in other areas.
For starters, no investment is recession-proof. That said, some REITs may perform better than others during recessions. It can be difficult to choose these REITs ahead of time, however, since the factors surrounding a recession can vary wildly, impacting various types of properties in somewhat unpredictable ways.
For example, it would have been hard to predict prior to 2020 that the next market crash would cripple hospitality and retail REITs to the extent that it did.
This hasn’t always been the case, however. In scenarios where businesses remain open and capable of maintaining their long-term lease agreements, REITs can remain somewhat stable compared to other assets.
If you choose the right REITs, contribute to your portfolio regularly, and don’t panic sell during downturns, you could become rich. It’s not something that will happen overnight, however. You’ll need to build your portfolio consistently and make wise decisions.
The SEC requires that REITs distribute at least 90% of taxable income to shareholders each year. Other assets don’t have this requirement, which is why REITs have an advantage when it comes to dividend yield.