Real estate investment trusts (REITs) offer an affordable way to invest in real estate without lots of capital.
In addition, REIT dividends can feel like a shelter in a storm because they offer consistency as an inflation investment. However, anyone considering this option should do their due diligence before they invest in real estate.
This begs the question, are REITs a good investment? To answer this question, let’s take a look at the pros and cons of REITs, different investment options, and their outlook in the current economic climate.
What Are REITs?
REITs are an investment option that allows you to invest in real estate without the need to purchase a property on your own.
REITs own and operate income-producing commercial and residential properties.
Common REIT properties include apartment buildings, office buildings, warehouses, malls, hotels, and storage facilities. So while you’re not collecting monthly rent the way you would if you happened to be the sole owner, you are getting regular dividend yields with the perk of not having to take a hands-on approach to the day-to-day management or operations of the property.
You essentially own a stake in a property in the same way you own a stake in a business when you invest in S&P 500 companies in the stock market. However, since most REITs consist of a bundled set of properties, they’re more similar to index funds or other basket goods.
Investing in a REIT isn’t the same thing as just investing in commercial real estate as part of a group. REITs are required to meet certain standards that are determined by Congress and the IRS. A legitimate and legal REIT must meet the following qualifications:
- Must invest at least 75% of total assets.
- Must return a minimum of 90% of taxable income in the form of shareholder dividends annually. Consider this a big perk for your earning potential.
- Must receive at least 75% of gross income from real estate properties in the form of rents, mortgage interest, or sales.
- Must claim a minimum of 100 shareholders following a full year of existence.
- Must not have more than 50% of shares held by less than five investors during the second half of the tax year.
While some REITs are labeled as equity REITs that function as “landlords,” others are simply mortgage REITs that collect monthly payments from tenants after acquiring existing mortgages. Of course, finding a hybrid REIT that does both is possible.
The perk of qualifying for a REIT is that true REITs aren’t required to pay taxes at the actual corporate tax level. As a result, they are in a better position to finance real estate than other individuals or investment companies. What that means for you as an investor is that a REIT’s payout can grow to create larger and larger dividends over time.
Pros and Cons of REITs
REITs and small-time investors can be a match made in heaven during a downturn because investors enjoy a decent amount of insulation from volatile exchange traded funds. After all, people will always need a place to live. So let’s dive into the pros and cons to get the full picture.
- REITs allow you to diversify away from being dependent on bonds and stocks.
- REITs offer high dividend yields due to the rule that REITs must pay at least 90% of taxable income to shareholders.
- REITs allow you to diversify your investments geographically. That means you can invest in real estate in specific markets with stronger performance compared to the nation as a whole.
- REITs offer a hands-off way to benefit from real estate investments. In addition, the personal risk is much lower than trying to flip, lease, or manage properties on your own.
- REITs create a historically high-performing asset class. In fact, the three-year average for total returns on REITs between November 2017 and November 2020 was 11.25%. That beat the S&P 500’s 9.07% for the same period.
- REITs are pretty liquid. While unloading your own property might be a hassle, you can buy or sell REITs online quickly online using a brokerage account.
- REITs offer power in numbers. For many people, a REIT is the only way to get access to class A office buildings as investments.
- Rising interest rates can sometimes reduce the value of a REIT.
- Dividends are typically taxed at your normal income rate. Of course, you’ll want to chat with a CPA to maximize your tax options.
- REITs can ebb and flow with commerce trends. While you may be riding high when spaces for cupcake shops are in demand, value can fall once the fad fades.
- Some REITs charge high management fees. Do your homework!
- While REITs can be great in the long term for steady and robust dividends, this isn’t a good option if you’re looking for dramatic short-term returns.
Who Can Invest in REITs?
Anyone can invest in a REIT. However, the bottom line isn’t so crisp. This is where it becomes necessary to talk about how much is needed to invest, how much you need to be worth, and the different types of REITs available to you.
How Much Money Do You Need to Invest in a REIT?
REITs often require minimum investments ranging from $1,000 to $25,000. Most private and non-traded REITs are only open to elite accredited investors with a net worth of $1 million. For non-millionaires, the requirement is typically two to five years of annual income between $200,000 and $300,000.
Are REITs Safer Than Stocks?
It’s hard to get a consensus on this. A combination of expense and lack of safety margin on stocks can make them intimidating for smaller investors. On the other hand, many people think that REITs are safer than stocks during times of inflation and uncertainty because they:
- Are resilient.
- Have low debt.
- Can potentially provide protection against inflation because rents rise with inflation. In addition, debt that is used to finance properties can be “inflated away” while property values rise.
- Tend to have very reasonable valuations that bring stability.
- Have been known to outperform stocks in times of rising rates.
The bottom line is that REITs aren’t intended to replace your investments in stock exchanges. Instead, they are there to round out, enhance, and diversify your portfolio. While REITs can definitely have high returns, they carry some risks that aren’t seen with other investment options. For instance, you may have your REIT dividends taxed as ordinary income instead of enjoying the dividend or capital gains taxes that go with stocks.
Types of REITs
The main REIT categories are the equity, mortgage, and hybrid options covered above. However, REITs are also classified by how investors buy and hold shares.
The first option is a publicly-traded REIT with shares listed on a national security exchange. Publicly traded REITs are regulated by the U.S. Securities and Exchange Commission (SEC). Next, public non-traded REITs are registered with the SEC without being traded on national securities exchanges. Finally, private REITs are non-regulated REITs that sell shares to investors without being traded on national securities exchanges.
Which REIT Is Best for Me?
First, it’s important to know that financial advisors can help you determine which REITs to invest in the same way they can help you to choose which stocks vs. crypto to buy.
First-time investors are more likely to feel comfortable with publicly traded REITs because they offer the stability, transparency, regulation, and liquidity to help you find your way around this investment niche. However, it’s important to know that you can get caught up in fraudulent REITs when you choose private real estate companies.
Concluding Thoughts: Are REITs a Good Investment?
REITs are worth looking into if you want a little extra protection during a potential downturn. A REIT can be a great way to get cash flow from a property without putting in any elbow grease. However, REITs should be seen as vehicles to balance stocks instead of “investment hacks” for abandoning stocks.