So, you’re curious about hopping into the real estate investing game, and you’ve heard that a real estate investment trust (REIT) is a great way to enter that space. Well, that definitely can be true!
REITs are a passive landlord’s dream since they don’t require you to perform constant maintenance on a property or find new tenants every couple of years—unlike traditional real estate investing. But even though REITs are sometimes a great investment, they can just as easily flat-out suck.
To help you avoid falling into a trap, we’ll break down exactly how REITs work and what they are in the first place. That way, you can confidently decide whether investing in a REIT is a good option for you. Let’s hop in!
What Is a REIT?
A real estate investment trust, or REIT (pronounced “reet”), is basically a mutual fund that buys real estate instead of stocks. REITs have a special tax status that requires them to pay at least 90% of their profits back to the shareholders.1 This payment is called a dividend. If they follow this rule, then they aren’t taxed at the corporate level like every other type of business.
All REITs have to meet certain requirements to qualify:
- Must be a trust, association or corporation
- Must be managed by at least one official trustee or director
- Must have at least 100 shareholders
- Five or fewer shareholders may not own more than 50% of the shares2
There are also rules around how much of a REIT must be invested in actual real estate properties and how much of the gross income from a REIT must be generated by real estate.
What Types of REITs Are There?
There are a handful of different types of REITs out there, which can make things feel even more complicated. So let’s unpack the differences.
Equity REITs
Equity REITs are the most common. They own and manage properties, and most of them are specialized, meaning they only invest in specific types of real estate.
Some of these types include:
- Apartment complexes
- Single-family homes
- Big-box retail space
- Hotels and resorts
- Health care buildings and hospitals
- Long-term care facilities
- Self-storage facilities
- Office buildings
- Industrial buildings
- Data centers
- Mixed-use developments
Equity REITs make money for their investors in three main ways:
- Collecting rent from tenants on the property they own
- Allowing the values of the shareholders’ investments to grow as property values appreciate
- Buying low and selling high
Mortgage REITs
Mortgage REITs borrow cash at short-term interest rates to purchase mortgages that pay higher long-term interest. The profit is in the difference between the two interest rates.
Confused? Don’t sweat it—mortgage REITs are complicated. Hopefully, looking at an example will make things a little clearer. Here’s what a typical mortgage REIT looks like in practice:
- The REIT raises $1 million from investors.
- It borrows $5 million on a short-term loan, giving them $6 million in cash.
- The loan has a 2% interest rate and a $100,000 annual payment.
- With the $6 million, the REIT buys up existing mortgages that pay 4% interest.
- Those 4% mortgages combine to earn the REIT $200,000 a year.
- So the REIT’s annual profit is $100,000.
To make as much money as possible, mortgage REITs tend to use a lot of debt—like $5 of debt for every $1 in cash, and sometimes even more. Plus, the interest rate on those short-term loans could increase, leading to smaller profits than expected—or even a loss.
All of that makes mortgage REITs extremely volatile. And investing in debt is always a bad idea because it introduces way too much risk into the equation.
If you do invest in REITs, stay far away from this variety.
Non-Traded REITs
Now, some REITs aren’t publicly traded on national stock exchanges. Non-traded REITs might still be registered with the Securities and Exchange Commission (SEC), but you won’t find them available for trade on the stock market.
A big risk here is that it can be very hard to know the value of a non-traded REIT until years after you’ve invested. So if it’s a dud that’s losing your money, you won’t know for a long time. Another knock on these REITs is that they usually come with higher up-front fees—sometimes totaling around 10% of your investment—that can significantly lower the value of your investment.3 Yikes!
Private REITs
A private REIT is neither registered with the SEC nor available for trade on stock exchanges. If you invest in one, be prepared to forget you had that money. They’re usually illiquid—a fancy term that means an investment can’t be easily turned back into cash. To get the best returns, you probably won’t have access to the money for a long time, which makes it very difficult to get out of a private REIT once you’re in one. It’s not as easy as selling a mutual fund.
For a private REIT to work for you, you’d need to be in a group that isn’t milking the REIT for their profit and driving up management fees—leaving nothing on the table for investors. To sum it all up, this is risky stuff. Beware.
Hybrid REITs
A hybrid REIT is basically a combination between an equity REIT and a mortgage REIT—meaning the fund has company-owned properties and mortgage loans as well.
This may sound like a smart and balanced way to invest in REITs. But in many cases, hybrid REITs lean more heavily toward one type of investment over the other. This means you need to be very careful when looking at hybrid REITs—especially if they look more like those mortgage REITs we talked about earlier that borrow a lot of money to try to generate profits for investors. That’s a dangerous game—one you should try to avoid.
Pros and Cons of Investing in REITs
Just like with most investments, investing in REITs has both risks and benefits. Let’s walk through the biggest ones:
Pros
- They can help you diversify your investments. REITs give you the chance to add real estate to your investment portfolio without the headaches that come with owning rental properties.
- Some offer higher dividends than other investments. Dividends are payments made to investors to reward their investment and share the profits with them. Since REITs are required to pay out most of their taxable incomes to shareholders, that means you could receive more in dividend income from REITs than other types of investments.
- They pay no corporate tax. Since REITs don’t pay corporate income taxes, investors don’t have to worry about “double taxation.” But you’ll still pay ordinary income taxes on the dividends you get and on capital gains when you sell your REITs at a profit. (It’s a good idea to talk to a tax pro before you invest in REITs.)
- They are professionally managed. Like actively managed mutual funds, REITs are usually managed by a team of professionals who know the real estate industry inside and out and can make sure that the properties inside of the fund are being maintained and managed for high returns.
Cons
- Interest rates can be volatile. Since real estate values tend to go up and down depending on what the interest rates are, the same rule applies to REITs. Rising interest rates can jack up the cost to take out a mortgage loan and put a damper on demand for real estate—and that could negatively affect the value of a REIT in the process.
- Some REITs use debt to invest in real estate. If you remember nothing else, remember this: Debt equals risk. And mortgage REITs almost exclusively use debt to build their funds, which means they’re very risky. That’s a no-no.
- Some REITs are hard to sell quickly. Since non-traded REITs can’t be sold on the open market, they’re considered “illiquid investments”—which is just a fancy way of saying they can be hard to get rid of if you want to sell.
- They don’t give you any control. When you invest in a REIT, you’re giving control over to the REIT’s management team. They’ll be the ones deciding which properties to invest in and how to manage those properties—you’re just along for the ride.
How to Invest in a REIT
There’s no secret formula here—anyone can invest in a REIT by simply purchasing shares through a broker, a REIT exchange-traded fund (ETF), or a REIT mutual fund. Basically, it’s the same process you would go through if you were buying mutual funds or single stocks.
But that’s only if the REIT is publicly traded. For a non-traded or private REIT, you’d have to purchase shares through a broker that’s associated with a non-traded REIT.
Bottom Line: Is a REIT a Good Investment?
It depends. REITs have come a long way over the past decade, and now they’re a legitimate way to invest in real estate if you have no interest in being a landlord. But they’re not for everyone, and there might be better ways for you to invest in real estate.
First off, you should only consider investing in REITs once you’ve paid off your own home and you’ve maxed out your tax-advantaged retirement accounts—like your 401(k) and Roth IRA. Until then, stick with the four types of growth stock mutual funds we recommend for retirement investing, which offer the most balanced growth over time.
Second, REITs range from awesome to really bad, so you have to do your homework before you invest in one.
If you are going to invest in a REIT, an equity REIT is probably the way to go. Since they own and manage the properties inside the fund, they aren’t as risky as mortgage REITs. They’re also registered with the SEC (unlike private REITs), and they offer more transparency than non-traded REITs. Plus, you might find a handful that perform as well as good growth stock mutual funds.
Ultimately, you want to choose a fund with a long track record of strong returns that’s run by a competent group of investors. And no matter what, your REIT investments should be no greater than 10% of your net worth.
Source: ramseysolutions.com ~ By Ramsey Solutions ~ Image: Canva Pro
