Investors have a deep emotional attachment to their investments; abdicating control is not something that comes easily. Real Estate Investment Trusts (REITs) are alluring to investors due to the high dividends, which can boost the value of their portfolio. However, there are a few factors that should be considered prior to loading up on REITs. Read them below.
Lack of Controls
Handing over the reins goes with the territory; investors will not be able to participate in making any of the decisions regarding the REIT’s operations. This will include having no input on which properties the REIT owns or what trading tactics are employed.
Taxation on REIT Dividends
At tax time, REITs can be tricky; as yields rise, so do the dividends. This not only pleases the investor, but the IRS, as well. Those in high-income tax brackets who are wishing and hoping for relief may be dismayed to learn that these dividends are taxed as regular income. Note that some dividends may be distributed as “qualified dividends”, which will be subject to capital gains tax treatment.
Slow to Minimal Growth
The IRS stipulates that REITs must return at least 90% of income to its investors annually. That leaves them with only 10% to reinvest back into the business. Thus, any acceleration in growth will rely on increased leverage, extending the borrowing cycle.
No Tax Benefits from a 1031
The 1031 exchange is not permitted. In other words, investors may not leverage the 1031 as a mechanism to defer paying taxes on capital gains when exiting a REIT.
Further, whereas pure real estate investing allows stakeholders to write off taxable income, it doesn’t hold true in REITs. Translation:
- No write-offs to taxable income:
- mortgage interest and
- depreciation deductions
While REITs may have a history of strong performance over a longer time frame, they can have violent swings in shorter intervals – especially those that are publicly traded. When markets are rattled, they can be just as susceptive to downturns as stocks.
Not all REITs have the same framework – nor do they all trade on a stock exchange. Those that are not traded have elevated risks, due in part to not having full transparency. They are exempt from disclosing information in public filings. Also, investors can expect to pay some hefty sales commissions on non-traded REITs. Some of their upfront fees and commission may be as high as 15%. Because of their illiquidity, these types of REITs are often hard to value. And when you are ready to unload, they are not always quick and easy to sell. Sophisticated investors would be wise to perform due diligence and compare their average rate of return to publicly traded returns prior to investing.
Potential Lockout Periods
Due to the steep commissions, jumping in and out of a non-traded REIT would be counterproductive; in other words, these are not designed for short-sellers or day traders. It’s common practice for non-traded REITs to place restrictions on a lockout period. To avoid having your capital held hostage, zoom in on what is hiding in the fine print. Also, determine your comfort level with the imposed time horizon.
Build a REIT Nest Egg?
It’s not all doom and gloom with REITs. They have been appearing on the radar of many serious investors and do offer many benefits, including asset diversification and potential income growth. Below is a non-exhaustive list of the advantages of REITs:
- Passive Alternative to Buying Direct Property
Many investors are laser focused on creating a robust passive income stream – not managing real estate properties. REITs allow individuals to gain exposure to the real estate market without the usual landlord headaches.
- Lower Investment Thresholds (usually applicable to Public REITs)
Minimum investments are typically $1,000 to $3,000. This is infinitesimal compared to the capital required to purchase a property.
- High Liquidity
Public REITs offer liquidity and can be bought/sold in a brokerage account, at the same cost brokerages charge cost for buying/selling any publicly-traded stock.
The appetite for risk varies among investors; however, a growing group of individuals prefer to have some degree of market diversification. REITs are practically custom made, allowing investors to diversify their portfolios in a variety of real estate holdings.
As with any type of investing, conducting research will increase your understanding into the benefits and potential hazards of REITs.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
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