8 Pros And Cons Of REITs – Should You Invest?
What’s a REIT?
A REIT, or real estate investment trust, is a company that owns, operates or finances income-producing real estate. They can either be private or public but for today’s discussion, we’re going to focus on the publicly traded REITs.
An example of a REIT is one that buys and manages property such as office buildings, hotels, health care facilities, self-storage, retail centers, commercial property or apartments.
According to Investopedia, Congress established real estate investment trusts (REITs) in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. The provision allows individual investors to buy shares in commercial real estate portfolios that receive income from a variety of properties.
Investors can purchase these shares through the purchase of individual company stock, mutual fund or exchange traded fund (ETF).
This makes for a relatively simple way for investors to add real estate assets to their portfolio.
According to the Vanguard site: This fund invests in real estate investment trusts—companies that purchase office buildings, hotels, and other real estate property. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a portfolio already made up of stocks and bonds. The fund may distribute dividend income higher than other funds, but it is not without risk.
Here’s a breakdown of the Portfolio Composition:
As you can see below, it invests in a wide variety of different types of REITs which as of this writing includes assets over $64 Billion dollars.
8 Pros and Cons Of REITs
As with most investments, REITs have their advantages and disadvantages. Simply put, this may or may NOT be the right investment for everyone. As with anything else, make sure you do your part to educate yourself before making any investment decisions.
Here are the 8 pros and cons of REITs:
1) Buying and selling is easy
Because most REITs trade on public exchanges, they’re very easy to buy and sell. They are about as easy as buying and selling stocks.
2) Highly liquid
One of the reasons investors shy away from real estate is that it’s known as being notoriously illiquid. Occasionally, property can take a long time to sell or purchase.
Investing in REITs is way to eliminate the illiquidity risk as shares are bought and sold on major U.S. stock exchanges every day.
3) Lower cash flow risk
REITs offer attractive risk-adjusted returns and stable cash flow as they are highly diversified with 1000’s of properties to choose from.
4) Higher diversification
Several years ago, our investment portfolio was 98% in the stock market. I wanted to make a change and diversify some portion of it and did so with the Vanguard Real Estate Index fund discussed earlier.
For the most part, a real estate presence can be good for diversifying a portfolio by offering a different asset class that can act as a counterweight to equities or bonds.
Unfortunately for those that invest in the best REITs for income; they’ll have larger tax consequences to deal with. Why? The federal government taxes dividends at a lower rate than ordinary income but that dividend tax benefit doesn’t apply to REIT holdings.
Because of this, most advisors recommend holding REITs within tax-deferred accounts (401(k), IRAs, etc.) due to the fact that REIT dividends are considered ordinary income on tax returns.
2) May rely on debt
Occasionally, a higher dividend payout by many REITs may force their management to go for higher leverage to expand the real estate holdings. This would result in higher interest going out and also would reduce their earnings.
3) Property taxes
State and municipal authorities have the right to increase property taxes to increase their budget revenue. This would reduce the REITs’ earnings within those states.
4) Tax inefficient
When comparing REITs to rental properties, actively managed real estate is more tax efficient. Starting on the first year, they can take depreciation which can lower their “income” with a non-cash expense.
Also, other property-related expenses can be deducted including interest earned from the income.
There are several real estate crowdfunding platforms that invest in REITs. If you want to know more about them, check out the article showcasing Fundrise and DiversifyFund.