Real Estate Investment Trusts: Hassle-Free, But Not Risk-Free

May 2, 2016
DMD Staff

Real Estate Investment Trusts can be a great opportunity for investors who want to keep some money in brick-and-mortar assets. However, they come with the same risks of real estate investment.

In an age when digital is king, you’re not alone if you sometimes wish for the halcyon days of compact discs, hardcover books, and waiting in line at the bank to make a deposit. Ok, no one misses that last one, but you get the idea.

Investments or savings accounts, too, can sometimes seem less than real. Unless you’re holding bearer bonds like the supervillain Hans Gruber in “Die Hard,” it may often feel like your investments are ephemeral. If you long for a brick and mortar investment, you might consider…a brick and mortar investment. Real estate investment trusts (REITS) offer investments in real estate, without much of the hassle. REITS are increasingly popular investments, but because they are an investment vehicle and not a dream, they also come with risks. Let’s take a look.

What is a REIT?

A REIT is a company that owns and manages income-producing real estate, such as rental properties. They were created by an act of Congress more than 50 years ago to allow modest-means investors to share in rental income from commercial property without needing the kind of starting capital one would need to actually purchase and rent out a commercial property.

REITs are subject to many different kinds of regulations. One that is particularly important to investors is that they must distribute at least 90% of their taxable income to shareholders each year as dividends. While REIT managers can invest in other assets, the majority (75%) must come from real estate, cash, and government securities, and the same percentage of income must come from rents, interest mortgages, or related real estate investments. REITS are available by property type—some might invest in office buildings, while others invest in leased space such as malls or industrial facilities.

Advantages of REITs

The key advantage most investors find attractive is that they can earn relatively high yields, and much of the income generated is generally from stable rents from long-term leases. Even though a REIT is technically a partnership of many investors, tax treatment for them is generally simple. The REIT itself sends investors a tax form that includes a breakdown of the dividend distributions from the fund, and the income from REITs is considered part of “ordinary income, capital gains, and return of capital.” Investors are taxed at the individual level on REIT dividends, rather than the REIT being subject to a corporate tax like with corporate bonds.

REIT trading is generally aggressive, so REIT shares tend to be much more liquid than, say, the direct sale of property. And the vehicles can offer diversification from stock-heavy portfolios. A REIT investment doesn’t offer diversification within the investment, but it does offer it as part of a larger portfolio. Though this isn’t a hard and fast rule, the value of REITs is rarely tied to stock indexes like the NASDAQ or S&P 500, in the same way that real estate overall rarely mirrors those indexes.

REIT Risks

Here’s where the wicket gets a little sticky. Most investors understand the general parameters of investing in corporate stocks and bonds; as the company’s value improves, so does the stock price (generally). Real estate is a horse of a different color. There are many interrelated factors that can affect the profitability of the REIT’s overall portfolio, including the management of the REITs, the mix of the income-generating streams, market forces, and interest rates, among many others. This makes it more difficult to determine whether the value is likely to go up or down.

And remember above when we said that REITs don’t offer diversification within the investment. What we mean by that is that because REITs may specialize in a certain geographic area or kind of interest property, a market slowdown may disproportionately impact the value of a REIT. A natural disaster, while rare, could wreak havoc on a REIT, as could a major legal issue or some other unforeseen issue. Mortgage REITs can be complicated by the complexity of how mortgage banking companies buy and sell mortgages based on their relative repayment risk.

REITs may be a solid investment for many different types of investors. But make sure you understand the risks, which are different from other investment vehicles.

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