Investing in real estate is a well-established and often very effective way to earn passive income, but not everyone has the time, inclination, or resources to be the owner of a rental property. Fortunately, there is an alternative for those who prefer a more hands-off real estate investing strategy: real estate investment trusts.
Commonly known as REITs, these investment vehicles have become very popular among investors who want to access the benefits of real estate investing without having to directly purchase and manage properties themselves. Read on to learn more about what REITs are, how they work, and the pros and cons to consider before investing.
What are REITs all about?
Created by Congress in 1960, REITs are companies that use investors’ money to purchase, and usually operate, income properties and commercial real estate such as office and retail spaces, warehouses, hotels, and apartments. Unlike non-REIT real estate companies, REITs are exempt from corporate tax provided they meet certain standards established by the IRS. For example, REITs must return at least 90 percent of their annual taxable income in the form of shareholder dividends. By not having to shoulder a corporate tax burden, REITs can finance real estate relatively inexpensively, which, in turn, often translates to bigger growth and even larger dividends.
While some REITs are either private or public non-traded entities, most investors typically choose to invest in publicly traded REITs. These are traded on an exchange just like stocks and ETFs, and they can be easily purchased through an ordinary brokerage account. From an investor’s perspective, investing in a REIT is essentially like owning a little piece of many different commercial properties and benefiting from the growth they experience.
What are the advantages of REITs?
Given the significant advantages they can offer, it’s not difficult to see why publicly traded REITs have become such a popular investment option. Some of the main benefits include:
Steady dividends—Because 90 percent of their annual income must be paid out as shareholder dividends, as mentioned earlier, REITs offer some of the most consistent, highest-dividend yields to be found anywhere in the stock market. Some of the best-known and most reliable REITs have a proven track record of paying large and growing dividends for decades, making them an ideal choice for investors whose main priority is a long-term, steady stream of income.
High returns—Again, because of the specific rules they are governed by, REITs typically offer returns that outperform equity indexes not only in terms of consistency and steadiness but yield as well. For example, on average, a stock on the S&P 500 typically yields less than 2 percent, whereas it’s not uncommon for a REIT to offer a dividend yield of 5 percent or more.
Portfolio diversification—According to just about every financial expert, diversifying your portfolio is one of the most important investment best practices. REITs help with diversification because real estate is a different asset class than equities, so even though you are technically still purchasing stocks, investing in REITs allows you to avoid the risks of an all-stock portfolio.
Lower volatility—Although no investment is completely immune to volatility, REITs are usually significantly less volatile than traditional stocks. If you are an investor with a more conservative approach to risk, REITs can offer more stability and a way to hedge against the rapid ups and downs of other asset classes.
Liquidity—Buying, managing, and selling physical real estate is a highly laborious process, and you can’t always get your capital out quickly and easily. REITs give you the best of both worlds: the financial advantages of investing in real estate with the ease and convenience of buying and selling publicly traded stocks.
What are the disadvantages of REITs?
While REITs can be an excellent addition to a diversified investment portfolio, there are some drawbacks to these investment vehicles that prospective investors should consider. These include:
Tax burden—The flip side of the high-dividend payments offered by REITs is a higher tax burden for individual investors. REITs themselves pay no taxes, but investors do pay tax on any dividends they receive, so it’s important to make sure that these additional taxes don’t outweigh the financial benefits of the original investment.
Heavy debt—Because of their legal status and the way they operate, REITs typically carry heavy debts; in fact, they are often among the market’s most indebted companies. The risk this presents is usually balanced out by the long-term, income-generating contracts that most REITs have, but it’s still something to be aware of, particularly if REITs are a part of a long-term investment strategy such as a retirement plan.
Low growth and capital appreciation—Because REITs pay out such a large percentage of their profits as dividends, the only way they can grow is by issuing new stock shares and bonds. This means that if new investors aren’t willing to buy, REITs can’t always buy real estate exactly when they want to, resulting in slower growth.