REITs: Pros and Cons to Real Estate Investment Trusts

Real estate investing is one way to accelerate your journey to financial freedom.

Oftentimes, people associate real estate investing with flipping houses or owning rental properties. But, if that type of investing isn’t for you, don’t dismiss real estate entirely.

Instead, real estate investment trusts (REITs) might be the solution to diversifying your investment portfolio.

What is a Real Estate Investment Trust?

Think of a REIT like a mutual fund of sorts.

Whereas mutual funds use pooled money from investors to buy stocks, bonds, or short-term debt, a REIT allows individual investors to own a slice of income-producing real estate.

These real estate portfolios may contain a mix of property types depending on the REIT an investor selects.

The REIT buys the properties and then leases the real estate space to other companies or individuals. The income stream the rent generates is then distributed as dividends to shareholders.

The REIT you invest in is usually specific to one particular area of the real estate market.

For instance, a healthcare REIT might own skilled nursing facilities, senior living centers, medical offices, and hospitals.

Whereas an office REIT might own office parks, properties in business districts, or even skyscrapers.

Other types of REITs include residential, retail, and mortgage REITs.

While most REITs are registered with the Securities and Exchange Commission (SEC), they aren’t all publicly traded on the stock exchange.

It’s important to know what kind of REIT you're investing in because non-exchange traded (or non-traded) REITs have different pros and cons to consider.

What are the Benefits of Publicly Traded REITs?

As with any investment decision, weighing the pros and cons before you act is essential. These are some of the benefits of adding REITs to your investment portfolio:

Diversification

One of the first recommendations anyone who is building a portfolio is likely to receive is to keep your portfolio diversified. The old cliche of not putting all of your eggs in one basket is an ideal lens to use when thinking about investing.

Rather than keeping all of your money in one stock or even one mutual fund, investing in various areas is a way to guard against dips or capitalize on growth in different sectors.

REITs, though similar to mutual funds, are a relatively simple way to diversify your portfolio by adding real estate.

Time

When you talk about an investment portfolio, real estate is often recommended as an option for diversifying your portfolio.

REITs provide that diversification while allowing investors to be relatively hands-off in comparison to the active management of flipping properties or even owning rental units.

Liquidity

Contrary to what HGTV might have you believe, selling houses can be challenging. As a result, your money when buying and selling houses is relatively illiquid.

However, since REITs function on the stock exchange, it is much simpler to move through the buying and selling process.

Simple Taxation

Though all taxes can be complicated, the way in which REIT shareholders are taxed is generally straightforward. REIT shareholders will receive a 1099-DIV, and dividend distributions are taxed at the ordinary tax rate.

At times, REIT shareholder returns may also be allocated to capital gains and return of capital.

Additionally, most experts also agree the 2017 tax cuts were very favorable to REIT shareholders.

Drawbacks of Publicly Traded REITs

You can make a compelling case for adding REITs to your portfolio pretty easily. However, before any investment decision, it's essential you consider the downsides as well.

Here are some of the drawbacks of REITs:

Property Taxes

While REITs don’t impact your property taxes as a shareholder, you do still want to be cognizant of property taxes in the area your REIT owns the property.

Why? As property taxes increase, there may be less profit to pass along to shareholders.

This is further complicated by the fact that property taxes can be raised at the state and the municipal level. So it may require multiple considerations before you invest, and again while you monitor your investments.

Interest Rates

Typically, when interest rates go up, REIT share prices dip.

While some people may perceive this as a time to sell (remember REITs are much more liquid than other forms of real estate), it's important to consider your investment plan and any long-term goals you have.

Decisions to sell or to hold should be based on these plans and goals. However, if you're prone to impulsivity or have a hard time tuning out market noise, investing in REITs during a period of continued interest rate increases may not be the best decision for you.

Tax Rates

REITs make tax time relatively simple. They may also make it painful.

REITs are taxed as dividends, but a large portion of that dividend is considered ordinary income (as opposed to capital gains).

As a result, shareholders will be taxed at a higher rate for the portion that is considered ordinary income.

How Non-Traded REITs Differ

Non-traded REITs are sold by individual brokers and are considered illiquid investments because they can’t be sold readily on the open market.

This is a significant disadvantage for any investor with a short time horizon or who may need to sell assets to get cash.

The value of shares is challenging to determine because there is no available market price.

High upfront fees and large transaction costs are also typical for non-traded REITs. Non-traded REITs also don’t have their own employees, so shareholders have to rely on external managers who may have conflicts of interest.

Some people have an interest in non-traded REITs because they may offer higher dividend yields and less volatility. But ensure you fully understand what you're investing in before you decide on a non-traded REIT.

For more information, check out the SEC’s Investor Bulletin for a chart comparing the two types of REITs.

How do I Add REITs to My Investment Portfolio?

You’ve weighed the pros and cons of REITs, and now you have decided this investment strategy meets your needs.

How do you go about adding real estate investment trusts to your portfolio?

Your options are simpler than you might think!

1. Research. As with any investment option, doing your homework so you can make an informed decision is key. Explore different companies and their experiences. How long have they been around? What has been the past performance?
2. Stay single or go with a group. You have the option of investing in single shares of an individual REIT just like any other individual stock listed on a stock exchange. However, you can also invest in a mutual fund or ETF that invests in REITs. This second approach is a more hands-off option for those investors who might want professionals to make buying decisions. You can learn more about REIT offerings, by checking out companies including Vanguard, Fidelity, and Schwab.
3. Get modern. Typically, when you think of choosing a broker, you might think of the big-name options. Those are definite possibilities to consider. However, there are different startup options popping up like StREITwise you may also want to explore.

Final Thoughts on REITs

If you are looking to kick up your investment portfolio a notch and turbocharge your financial goals, there’s a good chance you have given real estate some thought.

If you're looking for an investment strategy that's a bit more hands-off than house hacking, house flipping, or rental properties, a real estate investment trust (REIT) may be an option for you.

After you weigh the pros and cons, you should have a clearer sense if now is the right time to invest in a REIT.

Article written by Penny