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Real estate investment trusts, or REITs, can be excellent ways to add income and growth to your portfolio without adding too much risk. But there’s no such thing as a perfect investment. Like other types of investments, REITs have pros and cons, so let’s go over the main points of REIT investing.
This discussion is about the pros and cons of investing in equity REITs, which are companies that own commercial properties. If you’re curious about another option, you can read a primer about investing in mortgage REITs here.
Benefits of REIT investing
Here are some of the most important REIT benefits for investors to know:
No corporate tax
To be classified as a REIT, a company needs to meet some strict requirements. For example, they have to invest at least three-fourths of their assets in real estate and pay at least 90% of their taxable income to shareholders. If it meets these requirements, a REIT gets a big tax advantage.
No matter how profitable a REIT is, it pays zero corporate tax. With most dividend stocks, profits are effectively taxed twice -- once on the corporate level, and again on the individual level when they’re paid as dividends.
High dividend yields
Since REITs are required to pay at least 90% of taxable income to shareholders, they tend to have above-average dividend yields. It’s not uncommon for a REIT to have a perfectly safe dividend yield of 5% or more, while the average stock on the S&P 500 yields less than 2%.
This can make REITs an excellent choice for investors who need income or want to reinvest their dividends and let their gains compound over time.
Total return potential
REITs have the potential for capital appreciation as the value of their underlying assets grow. Real estate values tend to increase over time and REITs can use several strategies to create additional value. They might develop properties from the ground up or sell valuable properties and redeploy the capital.
This, combined with high dividends, means REITs can be excellent total return investments. Several REITs have generated total returns that have handily beat the market for decades.
Access to commercial real estate
The main reason REITs were created was to allow everyday investors to put their money to work in assets that would otherwise be out of reach. Most people can’t go out and buy a class-A office tower all by themselves. But there are REITs that allow you to do just that.
Thanks to REITs, I own a piece of hundreds of shopping malls, apartment complexes, data centers, and the Empire State Building.
Most experts would agree that diversifying your investment portfolio is a good thing. And although REITs are technically stocks, real estate is a different asset class than equities.
Real estate tends to hold its value better than stocks during tough economies. And it's a great way to add steady and predictable income. These are just two of many factors that help offset the inherent risk of an all-stock portfolio.
Buying and selling real estate properties can take a while. On the other hand, REITs are an extremely liquid investment. You can buy or sell a REIT whenever you want with a click of a button. If you eventually need the money from your REITs, it’s easy to free up your cash.
Potential drawbacks of REIT investing
No investment is perfect. Here are the potential drawbacks you should know before adding any REITs to your portfolio:
REITs tend to have above-average dividends and aren’t taxed at the corporate level. The downside is that REIT dividends generally don’t meet the IRS definition of "qualified dividends," which are taxed at lower rates than ordinary income.
As pass-through investment vehicles, REITs qualify for the new 20% pass-through deduction that was created as part of the Tax Cuts and Jobs Act. Even so, REIT dividends are typically taxed higher than qualified dividends. This is something to keep in mind if you own your REITs in a standard (taxable) brokerage account.
Interest rate sensitivity
REITs can be highly sensitive to interest rate fluctuations. The key point is that rising interest rates are bad for REIT stock prices. As a general rule of thumb, when the yields investors can get from risk-free investments like Treasury securities increase, yields from other income-based investments rise accordingly. The 10-year Treasury yield tends to be a good REIT indicator.
Since price and yield have an inverse relationship, higher yields mean lower prices. As you can see in the chart below, REIT prices and Treasury yields typically move in opposite directions:
REITs work best as long-term investments. In addition to interest rate fluctuations, there are too many factors that affect REIT prices over short periods of time. I generally don’t suggest putting any money into REITs that you’re going to need within the next five years. Longer time horizons are even better.
While REITs can add diversification to your portfolio, it’s worth pointing out that most individual REITs are not very diversified. They tend to focus on a specific property type. And each type of commercial property has its own set of risks and drawbacks.
For example, hotel REITs are very sensitive to recessions and other economic weakness. If you choose to invest in REITs, it's smart to choose a few with different levels of economic sensitivity. You could also invest in a REIT ETF or mutual fund that spreads your exposure among different property types.
The bottom line on REIT investing
For most investors, the benefits of incorporating REITs into a well-diversified investment portfolio outweigh the risks. But it’s important to know what you’re getting into before adding any type of investment to your portfolio.
The above pros and cons can help guide your decisions about how much of your assets you want to invest in REITs. Use them to set realistic expectations about your investments and make the right decision for your portfolio.