For those who want to invest in real estate but don’t want to go full-time into property management or deal with tenants, REITs might be the answer. While different from direct real estate investing, REITs provide real estate exposure without all of the property management hassles.
What are REITs
REIT stands for real estate investment trust. Basically, a REIT is a real estate stock. REITs are both public and private. Public REITs trade on a public exchange just like any other stock. A REIT invests in income-producing properties. When you buy a REIT, there are no property management responsibilities, making the investment passive.
REIT investors collect distributions and eventually sell their REITs. If the REIT is sold for profit, the investor realizes capital appreciation.
REITs pay out 90% of their income in distributions. Distributions are not the same as dividends. As we’ll see below, there are tax differences between the two.
REIT Pros
- Someone else is in control, which means they also take care of any management responsibilities. The investor doesn’t have any management responsibilities and doesn’t have to deal with tenants. This might appeal to investors who prefer passive investments.
- The REIT’s management decides what to invest in. This can be an advantage for investors who don’t have much real estate experience.
- A REIT investment is purely passive.
- REITs historically have had higher returns than real property.
- Just like stocks, REITs may have lower transaction costs compared to buying real property.
- Many REITs are very liquid. You can easily convert them to cash.
- Depending on the REIT, investors can gain access to broad diversification.
- REITs seek to provide regular distributions. They are required to pay out 90% of any income earned.
REIT Cons
- REITs have real-time price discovery and can move quickly. For example, if the stock market sells off, REITs may go down with it.
- While REITs have regular payouts (called distributions), unlike dividends, distributions are taxed at an investor’s regular income tax rate. However, investing within a tax-advantaged account such as a Roth IRA can avoid distribution taxes.
- Some REITs may face economic adversity and become unable to meet the 90% payout requirement. In this case, the payout can drop or even stop/cease, creating uneven cash flows.
- A 90% payout means REITs have little cash flow to invest in new projects. To get around this limitation, they often raise cash through debt financing and issuing new shares (or units in REIT terms). This can dilute existing investor shares. The result is that distributions aren’t likely to grow over time.
- Also, due to the high payout, REITs may not appreciate as quickly as some other assets. Income is mainly from distribution payouts rather than stock price appreciation.
REIT Performance
REITs are fairly new compared to real estate investing. To get an idea of REIT returns, we can look at their track record going back to the late 1970s. From that period to current, you can see that REITs have performed quiet well.
If you’re looking for a passive investment with exposure to real estate, REITs could be a good investment route.
