Pros and Cons of Investing in REITs - Experian (2024)

In this article:

  • What Is a Real Estate Investment Trust?
  • Pros of REITs
  • Cons of REITs

Real estate investment trusts (REITs) have been around since 1960, but they've become increasingly popular in the past 25 years as a way for more investors to access the real estate market.

REITs can be a great way to diversify your investment portfolio beyond the stock market, but before you invest, it's important to understand both the benefits and drawbacks REITs present. Here's what you need to know.

What Is a Real Estate Investment Trust?

A real estate investment trust is a company that invests in a variety of income-producing properties, both residential and commercial. Interested investors can invest in medical offices, gas stations, movie theaters, storage facilities, farmland, casinos and many more types of properties.

REITs receive income from the properties they own and then distribute at least 90% of it to their shareholders. That said, many REITs pay out all of their earnings due to the tax benefits.

Because many REITs are listed on major stock exchanges, investors can also generate a return on the share price. Some REITs are public but not listed on an exchange, however, while others are private and inaccessible to the general public.

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Pros of REITs

Investing in REITs can come with a lot of benefits, especially as a companion to other types of investments.

Portfolio Diversification

Asset allocation involves investing in a good mix of asset classes, such as stocks, bonds, real estate and cash.

By investing in REITs, along with other types of investment securities, you can mitigate some of the risks associated with each type of asset. For example, the stock market tends to be more volatile in the short term than the real estate market, allowing you to have a mixture of more and less risky investments.

Additionally, REITs give real estate investors an opportunity to diversify their real estate holdings—something that's tough to do when you're buying individual investment properties, which requires a large amount of cash.

Accessibility

Investors who are interested in the real estate market don't have to save up tens of thousands of dollars for a sizable down payment on an investment property or make regular mortgage payments with REITs.

Depending on which broker you choose, you may even be able to buy fractional shares of a REIT if you can't afford a full share.

Passive Income

As a REIT shareholder, you'll receive regular dividends—monthly, quarterly or annually—based on your holding in the company. If you're in or nearing retirement, or you simply want to build a passive income stream, REITs can be a great way to receive regular income without doing anything.

Liquidity

Unlike traditional real estate investments, REITs allow you to buy and sell shares by simply logging in to your brokerage account and making a trade. If you want to sell an investment property, on the other hand, it can take several months and a large amount of cash to make it happen. This liquidity gives you more flexibility in your investments, allowing you to access cash if you need to.

Competitive Returns

In addition to regular income payments, REIT investors can also take advantage of price appreciation for their shares. Like stock prices, REIT prices can fluctuate over time.

That said, a significant number of REITs outperform the stock market in terms of annualized returns, especially when you hold your position for 10 or more years.

Cons of REITs

While there are some clear benefits to investing in REITs, there are also some disadvantages to consider, especially if you don't diversify your portfolio well.

Dividend Taxes

REIT dividends can be a great source of passive income, but the money you receive is subject to your ordinary income tax rate, which will depend on your tax bracket. And because dividends are paid out regularly, you'll have to pay taxes on the income each year, even if you reinvest your dividends.

In contrast, when you sell a stock after holding it for longer than a year, any gains you receive will be subject to the long-term capital gains tax rate, which is lower than your ordinary income tax rate. In other words, expect a higher and more consistent tax bill with a REIT.

Interest Rate Risk

The value of a REIT is based on the real estate market, so if interest rates increase and the demand for properties goes down as a result, it could lead to lower property values, negatively impacting the value of your investment.

Market Volatility

The fundamentals of the real estate market aren't all the same as the stock market, so you generally won't get as much short-term volatility with a REIT as you would with a stock.

That said, the real estate market is still subject to a variety of influences, some of which don't affect the stock market. As such, you'll still experience market volatility with a REIT, which could impact you in the short term.

You Have Little Control

Just as if you were to buy a mutual fund or exchange-traded fund, you don't have any say in how a REIT invests its money, and you have no control at all over the properties themselves.

As a result, some REITs are less diversified than others, focusing on a specific niche, such as office buildings or apartment complexes. If you don't pick a well-diversified REIT or invest in multiple REITs, you may not be as diversified as you think.

Some Charge High Fees

Publicly traded REITs typically don't have a lot of fees beyond trading commissions, which many online brokers don't charge anymore.

But if you decide to invest in a non-listed REIT or a private REIT, upfront costs can be as high as 11% or more of your investment. Private REITs may also charge a 2% management fee each year.

Navigating REIT Investing

Investing in REITs can add some diversification to your portfolio and give you access to passive income, liquidity and excellent long-term returns. However, taxes can be more expensive with REITs compared to other investment options, and there are still risks involved with the real estate market.

If you're looking to add REITs to your portfolio, spend time researching several options. Look at past performance, dividend yields and property holdings to get an idea of what you're getting. You may also consider consulting with a financial advisor to get some personalized expert advice and guidance for your situation and personal finance goals.

Pros and Cons of Investing in REITs - Experian (2024)

FAQs

Pros and Cons of Investing in REITs - Experian? ›

Real estate investment trusts reduce the barrier to entry for investors in the real estate market and provide liquidity, regular income and other perks. However, you'll be exposed to risks that aren't inherent in the stock market and dividends are subject to ordinary income tax.

Why high interest rates are bad for REITs? ›

While higher rates negatively impacted nearly every sector of the economy in 2022 and most of 2023, real estate was hit especially hard. Rising interest rates hurt not only the value of REITs' property holdings but also the cost of debt to finance those properties or even refinance already-owned assets.

Are REITs a good investment in 2024? ›

April 2, 2024, at 2:50 p.m. Real estate investment trusts, or REITs, are a great way to invest in the real estate sector while diversifying your options. Real estate investments can be an excellent way to earn returns, generate cash flow, hedge against inflation and diversify an investment portfolio.

Are REITs riskier than stocks? ›

Key Points. REITs have outperformed stocks on 20-to-50-year horizons. Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large.

Do REITs outperform the S&P 500? ›

Over the long term, our research found that REITs have outperformed stocks. Since 1994, three REIT subgroups stood out for their ability to beat the S&P 500. Here's a closer look at these market-beating REIT types.

Is there a downside to investing in REITs? ›

Risks of investing in REITs include higher dividend taxes, sensitivity to interest rates, and exposure to specific property trends.

What are the dangers of REITs? ›

Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.

What is the 90% rule for REITs? ›

How to Qualify as a REIT? To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

What is the lifespan of a REIT? ›

During the REIT operation period that can last up to 7 to 10 years, the sponsor manages its properties to produce an income stream. REIT management seeks to monetize the portfolio in an effort to realize a capital gain for investors, although there's always the risk of a loss instead.

What is the average return of a REIT? ›

The FTSE Nareit All REITs index, which tracks the performance of all publicly traded REITs in the U.S., had an average annual total return (dividends included) of 3.58% during the five-year period that ended in August 2023. For the 10-year period between 2013 and 2022, the index averaged 7.48% per year.

How do you get out of a REIT? ›

While a REIT is still open to public investors, investors may be able to sell their shares back to the REIT. However, this sale usually comes at a discount; leaving only about 70% to 95% of the original value. Once a REIT is closed to the public, REIT companies may not offer early redemptions.

Should I invest in REITs or S&P 500? ›

REITs can make great investments

REITs have outperformed the S&P 500 over the long term. A big driver has been the robust returns from self-storage, industrial, and residential REITs. The factors that have enabled those REIT subgroups to deliver strong returns remain in place.

What percentage of your portfolio should be REITs? ›

“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.

What happens to REITs when interest rates go down? ›

REITs. When interest rates are falling, dependable, regular income investments become harder to find. This benefits high-quality real estate investment trusts, or REITs. Strictly speaking, REITs are not fixed-income securities; their dividends are not predetermined but are based on income generated from real estate.

Does Warren Buffett recommend the S&P 500? ›

“In my view, for most people, the best thing to do is own the S&P 500 index fund,” Buffett said at Berkshire's 2020 annual meeting. Buffett's thinking here is straightforward. Most non-professional investors (and even many professional stock-pickers) have very little chance of outperforming the market.

Why is REITs dropping? ›

This is because when interest rates rise, it becomes more expensive for Reits to borrow money to refinance their loans, resulting in an erosion of their dividends. On top of that, returns from yield products like fixed deposits and government Treasury bills were also on the rise, competing for investors' capital.

Are high interest rates good for mortgage REITs? ›

As the higher interest rate residential mortgage loans are paid off and replaced with loans with lower interest rates, this can negatively impact mortgage REITs that invest in these securities.

How does inflation affect REITs? ›

Historically, REITs have provided inflation protection with their unique ability to increase revenue through rent repricing, as well as via inflation-linked growth of their portfolio values, since replacement cost value increases exhibit strong correlation with inflation.

Why are REITs underperforming? ›

Two of the primary factors contributing to the recent underperformance of REITs are the rising interest rates and the recent bank failures. However, the fundamentals of many of these REITs remain strong. Their performance is tied more to stock market fears than the actual performance of the real estate market.

Why are mortgage REITs getting killed? ›

When interest rates rise, the cost of borrowing for mREITs increases. This can compress their profit margins in two ways. First, if their existing mortgage holdings are locked into fixed-rate loans, the spread between their borrowing costs and investment income narrows.

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