Advantages and Disadvantages of Investing in REITs
A real estate investment trust is an entity that owns and operates and/or arranges financing for income-producing real estate. Many investors join REITs and pool their capital for the benefit of receiving regular dividends from commercial real estate investments — without actually having to shoulder the burden of buying, managing, or financing an asset on their own. That said, REITs do have drawbacks as well. In this article, we’ll take a look at some of the more substantial advantages and disadvantages that real estate investment trusts provide investors.
Advantages of Investing in REITs
Many investors find REITs desirable for a plethora of reasons. For starters, they are a relatively easy starting point in commercial real estate investment. Because most REITs can be traded on public exchanges and are substantially liquid in nature, they are simple to buy and sell — easily removing one of the biggest drawbacks of traditional commercial real estate investing. This of course lends to their popularity as a means of diversifying an investment portfolio that may be weak in the real estate sector.
On that same note, investing through a REIT also reduces the need for an investor’s hands-on property and operations management. REITs handle these while providing investors a stable dividend paid out at regular intervals.
In terms of performance, REITs have actually managed to outperform the S&P 500 and the rate of inflation over the course of the last 20 years. Beyond the stability of the cash flow REITs can provide, many investors simply enjoy the attractive risk-adjusted returns. And, while it may not always be the case, the dividends that can be earned from them are often much higher than any dividends that can be achieved through most other investment vehicles.
Disadvantages of Investing in REITs
For all their benefits, REITs are not always guaranteed victories for investors. For example, while not exactly a dealbreaker to many, REITs aren’t necessarily the best investment vehicle in terms of capital appreciation. REITs are, after all, required to pay no less than 90% of their taxable income to investors as dividends — leaving only a meager 10% which can be reinvested by new acquisitions or capital improvements. In most cases, it is price appreciation that drives any perceived growth.
Related Questions
What are the benefits of investing in REITs?
Many investors find REITs desirable for a plethora of reasons. For starters, they are a relatively easy starting point in commercial real estate investment. Because most REITs can be traded on public exchanges and are substantially liquid in nature, they are simple to buy and sell — easily removing one of the biggest drawbacks of traditional commercial real estate investing. This of course lends to their popularity as a means of diversifying an investment portfolio that may be weak in the real estate sector.
On that same note, investing through a REIT also reduces the need for an investor’s hands-on property and operations management. REITs handle these while providing investors a stable dividend paid out at regular intervals.
In terms of performance, REITs have actually managed to outperform the S&P 500 and the rate of inflation over the course of the last 20 years. Beyond the stability of the cash flow REITs can provide, many investors simply enjoy the attractive risk-adjusted returns. And, while it may not always be the case, the dividends that can be earned from them are often much higher than any dividends that can be achieved through most other investment vehicles.
What are the risks associated with investing in REITs?
Investing in REITs can be a great way to diversify your portfolio and gain exposure to the real estate market. However, there are some risks associated with investing in REITs that you should be aware of.
The main risk associated with investing in REITs is that they are not always guaranteed victories for investors. REITs are required to pay no less than 90% of their taxable income to investors as dividends, leaving only a meager 10% which can be reinvested by new acquisitions or capital improvements. This means that any growth in the value of the REIT is likely to come from price appreciation rather than capital appreciation.
In addition, REITs are subject to both real estate market and stock market trends, so their performance can be affected by changes in either market. They also have higher maintenance fees than other investment vehicles, and fewer tax benefits. Finally, investors have no control over the fund’s operation and no passive income.
What are the tax implications of investing in REITs?
Investing in REITs can have both advantages and disadvantages when it comes to taxes. REITs are required to pay no less than 90% of their taxable income to investors as dividends, leaving only a meager 10% which can be reinvested by new acquisitions or capital improvements. This means that any perceived growth is usually driven by price appreciation. Additionally, when it comes to taxes, investors should work with a tax professional to reduce their levels of stress and use some of the best strategies when it comes to taxes and their property. Wages paid to employees or independent contractors, as well as professional fees, are all tax deductible on Schedule E of the tax return.
What types of REITs are available for investors?
There are three distinct types of REITs available for investors: equity REITs, mortgage REITs, and hybrid REITs. Equity REITs own and sometimes operate income-generating real estate, with rental income providing the basis for revenue generation. Mortgage REITs serve as lenders to owners and operators of commercial real estate assets, with interest, or more specifically the net interest margin, providing the basis of revenue generation. Hybrid REITs partake in both equity REIT and Mortgage REIT strategies, earning from both revenue streams and sharing the risks of both as well.
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How do REITs compare to other real estate investments?
REITs offer many benefits to investors, including regularly distributed dividends and a reasonably low-risk level. Most REIT portfolios focus on a specific sector containing any number of income-generating assets. REITs are often categorized into three different types: equity, mortgage, and hybrid REITs. Equity REITs are the most common and focus on holding and sometimes operating income-generating real estate, with rental income providing the basis for returns. Mortgage REITs focus primarily on lending money to commercial real estate investors, with interest driving returns. Hybrid REITs are mashups of equity and mortgage REITs, offering both sources of investor returns. REITs are also known for their liquidity, as most can be publicly traded on securities exchanges.
Real estate mutual funds, unlike REITs, carry an opportunity for capital appreciation over medium- to long-term holding. REITs, on the other hand, are required to distribute 90% of their revenues as dividends to their investors — leaving only 10% for further investment. Real estate mutual funds are known to carry higher maintenance fees than REITs, but they have the added benefit of in-depth market research and professional portfolio management. Even so, REITs are considered the more liquid of the two and carry fewer tax implications for investors.