Eyeing a Real Estate Investment Trust? Consider These REIT Risks (2024)

Real estate investment trusts (REITs) are popular investment vehicles that generate income for their investors. A REIT is a company that owns and operates various real estate properties in which 90% of the income it generates is paid to shareholders in the form of dividends.

As a result, REITs can offer investors a steady stream of income that is particularly attractive in a low interest-rate environment. Still, there are REIT risks you should understand before making an investment.

Key Takeaways

  • Real estate investment trusts (REITs) are popular investment vehicles that pay dividends to investors.
  • Traded like shares of stock on exchanges, they can give exposure to diversified real estate holdings.
  • One risk of non-traded REITs (those that aren't publicly traded on an exchange) is that it can be difficult for investors to research them.
  • Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them.
  • Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.

How Real Estate Investment Trusts Work

Since REITs return at least 90% of their taxable income to shareholders, they usually offer a higher yield relative to the rest of the market. REITs pay their shareholders through dividends, which are cash payments from corporations to their investors. Although many corporations also pay dividends to their shareholders, the dividend return from REITs exceeds that of most dividend-paying companies.

REITs have to pay out 90% of taxable income as shareholder dividends, so they typically pay more than most dividend-paying companies.

Some REITs specialize in a particular real estate sector while others are more diverse in their holdings. REITs can hold many different types of properties, including:

  • Apartment complexes
  • Healthcare facilities
  • Hotels
  • Office buildings
  • Self-storage facilities
  • Retail centers, such as malls

REITs are attractive to investors because they offer the opportunity to earn dividend-based income from these properties while not owning any of the properties. In other words, investors don’t have to invest the money and time in buying a property directly, which can lead to surprise expenses and endless headaches.

If a REIT has a good management team, a proven track record, and exposure to good properties, it's tempting to think that investors can sit back and watch their investment grow. Unfortunately, there are some pitfalls and risks to REITs that investors need to know before making any investment decisions.

Risks of Non-Traded REITs

Non-traded REITs or non-exchange traded REITs do not trade on a stock exchange, which opens up investors to special risks.

Share value

Non-traded REITs are not publicly traded, which means investors are unable to perform research on their investment. As a result, it's difficult to determine the REIT's value. Some non-traded REITs will reveal all assets and value after 18 months of their offering, but that’s still not comforting.

Lack of liquidity

Non-traded REITs are also illiquid, which means there may not be buyers or sellers in the market available when an investor wants to transact. In many cases, non-traded REITs can't be sold for a minimum of 10 years. However, some allow investors to retrieve a portion of the investment after one year, but there's typically a fee.

Distributions

Non-traded REITs need to pool money to buy and manage properties, which locks in investor money. But there can also be a darker side to this pooled money. That darker side pertains to sometimes paying out dividends from other investors’ money—as opposed to income that has been generated by a property. This process limits cash flow for the REIT and diminishes the value of shares.

Fees

Another con for non-traded REITs is upfront fees. Most charge an upfront fee between 9% and 10%—and sometimes as high as 15%. There are cases where non-traded REITs have good management and excellent properties, leading to stellar returns, but this is also the case with publicly traded REITs.

Non-traded REITs can also have external manager fees. If a non-traded REIT is paying an external manager, that expense reduces investor returns. If you choose to invest in a non-traded REIT, it’s imperative to ask management all necessary questions related to the above risks. The more transparency, the better.

Risks of Publicly Traded REITs

Publicly traded REITs offer investors a way to add real estate to an investment portfolio or retirement account and earn an attractive dividend. Publicly traded REITs are a safer play than their non-exchange counterparts, but there are still risks.

Interest rate risk

The biggest risk to REITs is when interest rates rise, which reduces demand for REITs. In a rising-rate environment, investors typically opt for safer income plays, such as U.S. Treasuries. Treasuries are government-guaranteed, and most pay a fixed rate of interest. As a result, when rates rise, REITs sell off and the bond market rallies as investment capital flows into bonds.

However, an argument can be made that rising interests rates indicate a strong economy, whichwill then mean higher rents and occupancy rates.But historically, REITs don’t perform well when interest ratesrise.

Choosing the wrong REIT

The other primary risk is choosing the wrong REIT, which might sound simplistic, but it’s about logic. For example, suburban malls have been in decline. As a result, investors might not want to invest in a REIT with exposure to a suburban mall. With Millennials preferring urbanliving for convenience and cost-saving purposes, urban shopping centers could be a better play.

Trends change, so it's important to research the properties or holdings within the REIT to be sure that they're still relevant and can generate rental income.

Tax treatment

Although not a risk per se, it can be a significant factor for some investors that REIT dividends are taxed as ordinary income. In other words, the ordinary income tax rate is the same as an investor's income tax rate, which is likely higher than dividend tax rates or capital gains taxes for stocks.

500,000+

In 2023, REITs collectively held in excess of 575,000 individual properties.

Are REITs Risky Investments?

In general, REITs are not considered especially risky, especially when they have diversified holdings and are held as part of a diversified portfolio. REITs are, however, sensitive to interest rates and may not be as tax-friendly as other investments. If a REIT is concentrated in a particular sector (e.g. hotels) and that sector is negatively impacted (e.g. by a pandemic), you can see amplified losses.

What Are Fraudulent REITs?

Some investors may be defrauded by bad actors trying to sell "REIT" investments that turn out to be scams. To avoid this, invest only in registered REITs, which can be identified using the SEC's EDGAR tool.

Do All REITs Pay Dividends?

In order to be classified as a REIT by the IRS and SEC, they must pay out at least 90% of taxable profits as dividends. This provision allows REIT companies to have exemptions from most corporate income tax. REITs dividends are taxed as ordinary income to shareholders regardless of the holding period.

The Bottom Line

Investing in REITs can be a passive,income-producing alternative to buying property directly.However, investors shouldn't be swayed by large dividend payments since REITs can underperform the market in a rising interest-rate environment.

Instead, it's important for investors to choose REITs that have solid management teams, quality properties based on current trends, and are publicly traded. It's also a good idea to work with a trusted tax accountant to determine ways to achieve the most favorable tax treatment. For example, it's possible to hold REITs in a tax-advantaged account, such as a Roth IRA.

Eyeing a Real Estate Investment Trust? Consider These REIT Risks (2024)

FAQs

What are the risks of REITs? ›

Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them. Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.

What are the three principal risks that all REITs face? ›

Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.

What are the pros and cons of REIT real estate? ›

Real estate investment trusts reduce the barrier to entry for investors in the real estate market and provide liquidity, regular income and other perks. However, you'll be exposed to risks that aren't inherent in the stock market and dividends are subject to ordinary income tax.

What is a real estate investment trust (REIT) Quizlet? ›

Real estate investment trusts (REITs) are companies that own, and usually operate income producing real estate. REITS generally own many types of commercial real estate, including multifamily, warehouses, and retail.

Are REITs safe during a recession? ›

By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions. Typically, the upfront costs of investing in a REIT are low, while their risk-adjusted returns tend to be high.

Are REITs safer than stocks? ›

REITs have outperformed stocks on 20-to-50-year horizons. Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large. Several individual REITs delivered significantly higher returns than the S&P 500.

Why are REITs doing so poorly? ›

Here's an explanation for how we make money . More than a year of interest rate hikes by the Federal Reserve pushed down returns on real estate investment trusts, or REITs. While higher rates negatively impacted nearly every sector of the economy in 2022 and most of 2023, real estate was hit especially hard.

What causes REIT to fall? ›

REIT share prices, like the broader stock market, often react to changes in the outlook for interest rates, including both the short-term rates set by the Federal Reserve and the long-term rates that are governed more by market forces.

Do REITs have inflation risk? ›

REIT investors have an expectation that a REIT's dividends will keep up with inflation. Historically, this has worked well. However, we can't forget, at least for publicly-traded REITs, that they are still traded like stocks. As interest rates rise, they can depress the price of these REITs.

What I wish I knew before buying REITs? ›

Must Know #1 - Lower Leverage = Higher Returns

The conservatively financed REITs have outperformed the aggressively financed REITs in most cases over the long run. That's despite typically offering much lower dividend yields and trading at higher valuation multiples.

Is it better to buy real estate or REIT? ›

Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making. Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

Is it better to buy property or REIT? ›

Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.

Why do people invest in REIT? ›

Benefits of REITs

REITs typically pay higher dividends than common equities. REITs are able to generate higher yields due in part to the favorable tax structure. These trusts own cash-generating real estate properties. REITs are typically listed on a national exchange and provide investors considerable liquidity.

Which of these is a disadvantage of a REIT investment? ›

Here are some of the main disadvantages of investing in a REIT. Market volatility: Value can fluctuate based on economic and market conditions. Interest rate risk: Changes in interest rates can affect the value of a REIT.

What is the difference between a trust and a REIT? ›

Legal structure

The trustee of a business trust is considered the trustee-manager and is the same entity that owns and manages the assets on behalf of the unitholders of the business trust. Meanwhile, a REIT requires a trustee to hold the assets and a separate manager to manage the properties for unitholders.

Are REITs considered high risk? ›

REITs closely follow the overall real estate market and are subject to much of the same risks, including fluctuations in property value, leasing occupancy, and geographic demand. Real estate is typically very sensitive to changes in interest rates, which can affect property values and occupancy demand.

What happens when a REIT fails? ›

If the REIT fails this ownership test for more than 30 days (31 days if the year has 366 days) in a taxable year of 12 months, it can lose REIT status and cannot elect to be treated as a REIT for five years (IRCазза856(a)-(b)). The test is pro-rated for taxable years shorter than 12 months.

What happens to REITs when interest rates go down? ›

REITs. When interest rates are falling, dependable, regular income investments become harder to find. This benefits high-quality real estate investment trusts, or REITs. Strictly speaking, REITs are not fixed-income securities; their dividends are not predetermined but are based on income generated from real estate.

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