A real estate investment trust (REIT) is a company that buys, sells, operates, and finances income-producing properties. REITs raise capital to acquire and manage these properties by selling units or shares to investors. Income generated by the owned properties through rent and property appreciation is distributed to investors as dividends or cash flow.
REITs can be a good choice if you’re interested in owning real estate but don’t want property or asset management headaches. However, REIT investments also have the following downsides.
Market Volatility
Publicly traded REITs are available as stock shares to buy and sell to the general public on exchanges such as NYSE. While this makes REIT shares available to anyone with a few dollars, it also makes those shares sensitive to market forces, including investor perception and economic trends.
Private REITs (not traded on public exchanges) tend not to be as impacted by market forces and investor sentiment. However, they can be affected by economic trends.
Interest Rate Sensitivity
Interest rate movement impacts public and private REITs. As interest rates increase, so does the cost of borrowing. Higher borrowing costs can put downward pressure on real estate acquisitions, development, and capital improvements.
Additionally, a higher interest rate environment means investors might shift their capital to fixed-income investments, like bonds. Less capital could impact REIT valuations negatively.
No Asset Control
REITs take away the trials of hands-on property ownership. REITs also have total control over decisions regarding that property. As the investor, you must rely on the REIT’s management to make good decisions when it comes to buying or selling properties, containing operational costs, determining lease terms and tenants, and more.
Tax Issues
As a condition of doing business, REITs are required to distribute at least 90% of their taxable income to their shareholders every year. This means high dividends–and high taxes. The majority of REIT dividends are taxed at ordinary income rates, though some portions may qualify for capital gains rates or be classified as return of capital (ROC), which defers taxation. If you’re a high-earner, you could experience a reduction in your investment return.
Sector Risks
REIT performance is influenced by the strength of its property sectors, which, in turn, undergo economic cycles, including lower occupancy rates, falling rent yields, and reduced property values.
For example, REIT-owned retail properties could struggle when consumers don’t spend due to poor sentiment or dropping wages which in turn could impact REIT’s tenants. For example, in recent years, the office sector has struggled due to a shift to remote work, especially during the pandemic era.
Liquidity Issues for Private REITs
Private REIT shares are unlisted and highly illiquid, meaning you may be unable to sell your investments quickly or at a fair value. Additionally, these REITs might have lock-up periods and redemption restrictions, which could tie up your capital for years.
Adding REITs to a Portfolio
REITs, especially publicly traded REITs, may be considered as part of a diversified portfolio for investors seeking passive income. However, before diving into REIT ownership, knowing the limitations, risks and costs is essential. Take the time to talk with a professional to assess your risk tolerance and financial objectives before embarking on a REIT investment strategy.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
