Everything You Need to Know About REITs

Founder and CEO Bernie Schaeffer explains Real Estate Investment Trusts

Oct 12, 2021 at 10:50 AM
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The real estate investment trust (REIT)is a vital part of the U.S. economy. In recent years, these securities have been coveted by small and large investors looking for a reliable way to produce attractive returns. Investors of all stripes have jumped at the opportunity to buy REITs in a wide range of investment vehicles—from individual stocks to mutual funds and exchange-traded funds (ETFs).

REITs provide an excellent alternative to mutual funds, which own a portfolio of different companies, and ETFs, which hold a basket of stocks. With a REIT, you own a piece of the properties they've invested in. If you invest in individual REITs, your money is riding on those specific properties and mortgages. If you buy into an index fund or ETF that tracks the broader market, you're investing in various sectors such as industrial and retail.

REITs offer a unique way to invest in properties, yet they come with certain risks to be aware of before investing. Therefore, it's wise to do your homework before investing in any company, even if it's not a REIT.

What is a Real Estate Investment Trust (REIT)?

Real estate is one of the oldest investments around. REITs are relatively new on the scene, having only been around since 1960. Their structure allows individuals to pool their money together, leading to more capital for real estate development. Their business model means that they don't have to hold onto properties forever, such as a general partnership would, and can quickly (and painlessly) sell their assets if prices rise. This structure makes them attractive, and they're pretty popular amongst investors today.

REITs offer investors diversification. REITs pool investor capital to purchase commercial properties, hotels, self-storage facilities, and student housing. The pooling of capital helps REITs lower real estate acquisition costs, allowing them to act more like asset managers than property owners. In addition, by managing the properties directly, REITs can pass income back to investors through dividends or distributions paid by the company.

Investing in a REIT can provide many of the benefits of real estate investing without drawbacks. REITs typically offer investors a more liquid investment vehicle than a direct investment in a real estate business or a rental property. Here are some highlights that you must understand about REITs:

  • REITs are private companies that own properties. Investors often use them to invest in real estate.
  • Most REITs are publicly traded, which are listed on an exchange like the New York Stock Exchange (NYSE).
  • Publicly traded REITs have higher liquidity than non-traded REITs because they can be purchased and sold on the market.
  • The risk of losing money is lower for publicly-traded REITs because they can be sold at any time.
  • REITs are also tax-efficient because their income is taxed as ordinary income, not qualified or capital gain.

How Do I Get Started in Buying REITs?

REITs are a relatively inexpensive way to achieve diversification. They also have historically been one of the best performing asset classes over the long term. In 2016, for example, they returned almost 16%. But REITs are not without their risks. Before investing, you should carefully consider the real estate market, the REIT's business model, payout ratio, leverage, and the stock's sensitivity to interest rate changes.

REITs can be used as exchange-traded funds (ETF), direct investment, or mutual funds. Despite the variety of methods you can use to invest, there are risks involved with each choice. You should be aware of these risks to choose an option that suits your investing needs and goals.

What are the Pros and Cons of Investing in REITs?

Property ownership has always been viewed as a reliable way to create a stream of passive income. As a result, REITs have a lot in common with traditional property investing. They're a low-risk investment vehicle that offers investors stable returns over the long haul. However, the biggest advantage REITs have to provide is their high-yield dividends. Even after considering the risk of losing principal, REIT dividends pay more than most other investments.

REITs must pay 90% of taxable income to shareholders; thus, REIT dividends are much higher than the average stock on the S&P 500. However, there are other risks associated with REITs as well. Here is a shortlist of pros and cons that will help you better understand REITs.

REITs offer diversification, tax efficiency, and higher yields than most other income investments. However, they present risks unique to the REIT investment strategy. If you understand these conditions, you can mitigate that risk and enjoy the advantages of owning or investing in REITs.

Pros:

  • Dividends are typically higher yield
  • Diversification of your portfolio
  • Very Liquid Investment

Cons:

  • Taxed as ordinary income on dividend payouts
  • Interest Rates Create Sensitivity
  • Specific types of properties may create added risk

What are the Risks Behind Buying REITs?

Publicly traded REITs are typically sold by funds that buy them in bulk. Once they've purchased a large volume of shares, they may sell some of the holdings to raise investment capital for new projects.

The risks behind investing in a REIT include:

  • Lack of liquidity.
  • Lack of transparency.
  • Dependence on a specific sector or a single tenant for generating substantial revenue numbers.

A significant source of demand for publicly traded REITs is from investors who want to benefit from the steady and guaranteed income and dividends that these REITs provide. The value of publicly-traded REITs tends to rise with interest rates, which typically pushes investors into bonds.

Because many publicly-traded REITs are bond funds, this can put pressure on their value when interest rates rise. When this happens, it can be challenging for investors to exit their position — if they want to cash out — because there's no secondary market for these types of investments.

It's important to remember that even though many non-traded REITs aren't publicly traded on an exchange, they still have a widely accepted valuation and aren't worthless and volatile like penny stocks and alternative investments that aren't backed by any assets or liabilities.

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