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The pros and cons of investing in REITs

No investment is perfect, and the same is true of REITs. For example, while REITs tend to pay
above-average dividends, they aren’t taxed at the corporate level. In other words, REIT dividends
usually don’t meet the IRS’ definition of “qualified dividends,” which have a lower tax rate than the rate charged on ordinary income. REIT dividends are still taxed more than qualified dividends.

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Real estate investment trusts can make great investments at certain times, but like other
investments, they might not do as well as others. Here are the advantages and disadvantages of
investing in REITs.


What are REITs?


REITs are entities that hold or finance income-generating real estate, such as apartments or
condos, retail properties, office buildings, cell towers, and data centers, hotels, warehouses, and
medical facilities. In the U.S., REITs own about $3.5 trillion worth of real estate assets covering
over 500,000 different properties.


An entity must meet certain requirements to qualify as a REIT. For example, it must invest at
least 75% of its assets in real estate and derive at least 75% of its gross income from rental units,
interest on mortgages or sales of real estate. Additionally, REITs must pay at least 90% of their
taxable income out in dividends to shareholders every year, and they must be taxable as a
corporation.


They must also be managed by a board of trustees or directors and have at least 100
shareholders. Further, REITs must have no more than half of their shares held by five or fewer
individuals.


What are the benefits of investing in REITs?


Most REITs are traded on stock exchanges, which makes them just as easy to buy as stocks. One
of the great benefits of owning a REIT is that it generates income for you in the form
of dividends, and those dividends are often higher than what other dividend stocks pay. Many
REITs pay a dividend of 5%, while the average S&P 500 dividend stock pays less than 2%.
Since they have to pay at least 90% of their taxable income out, that can amount to quite a bit,
depending on how many shareholders they have.


Most REITs make money by collecting rents on properties and then pays out that money to
shareholders. Some REITs are mortgage REITs, and they don’t own real estate directly. Instead,
they earn income by financing real estate and then earning income from the interest on those
investments.


Historically, REITs have generated solid returns in the form of dividend income and long-term
capital appreciation through stock price increases. As the value of the assets they hold rises, so
their stock price appreciates. As a result, REITs have posted attractive total return performance
during most periods over the last 45 years.

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REITs also add diversification to your portfolio by introducing real estate to it. REITs make it
easy to invest in real estate because it’s the same as trading stocks if you invest in publicly-traded
REITs. You don’t have to own properties or collect rents on them because everything is done for
you. Additionally, owning REITs offers more liquidity than buying and selling actual property.

What are the possible disadvantages of investing in REITs?


No investment is perfect, and the same is true of REITs. For example, while REITs tend to pay
above-average dividends, they aren’t taxed at the corporate level. In other words, REIT dividends
usually don’t meet the IRS’ definition of “qualified dividends,” which have a lower tax rate than
the rate charged on ordinary income. REITs are pass-through investment vehicles, which means
they qualify for the 20% pass-through deduction that went into effect with the Tax Cuts and Jobs
Act. However, REIT dividends are still taxed more than qualified dividends.


Another potential problem for REITs is the fact that they can be susceptible to changes in interest
rates. At this time, it isn’t a big deal because low interest rates are good for REITs. However, as
rates rise, the stock prices of REITs fall because investors can see higher yields from other
investments like Treasuries, bonds and other income-based securities. One solid indicator of
REIT stock prices is the 10-year Treasury yield.


It’s also important to point out that REITs make good long-term investments, but they aren’t good
calls for those looking to make a quick buck. Many factors can affect REIT stock prices, so it’s
best to invest in them for at least five years at a time, although even longer timelines are better.


Risks associated with various property types


Economic growth also affects REIT stock prices, although it depends largely on what kinds of
properties each REIT holds. Some REITs are very cyclical because as the economy grows, so
their properties prosper. Others are less cyclical because there is always a need for office space
or healthcare.


While including REITs in your portfolio helps to diversify it, you should realize that the REITs
themselves usually aren’t very diversified. For this reason, it may be beneficial to have more than
one kind of REIT in your portfolio. These entities tend to invest only in one type of property,
which means they will be greatly affected by what’s happening to the type of property they hold.
For example, the pandemic brought leisure travel to a standstill, which meant that hotels have
struggled over the past year. As a result, REITs that hold hotels saw negative impacts from the
pandemic. Interestingly, office buildings also saw negative impacts due to the work-from-home
trend. E-commerce trends also drove declines in mall REITs as the shift to online shopping was
accelerated during the pandemic.

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Final thoughts on investing in REITs


If you decide to include REITs in your portfolio, it’s a good idea to hold more than one, so you
have exposure to a wide array of different property types. Another option is to invest in an
exchange-traded fund or mutual fund that invests in REITs because they will diversify their
holdings to entities holding a variety of different property types.

Most investors will find that the benefits of including REITs in their portfolios outweigh the
risks, but you should make sure that your REIT holdings aren’t skewed toward one type of
property. You don’t have to be wealthy to invest in real estate if you do it through REITs, so they
offer many of the benefits of investing in real estate without needing large amounts of capital
upfront.

(Featured image by nattanan23 via Pixabay)

DISCLAIMER: This article was written by a third party contributor and does not reflect the opinion of Born2Invest, its management, staff or its associates. Please review our disclaimer for more information.


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Jacob Wolinsky is the founder and CEO of ValueWalk. What started as a hobby ten years ago has turned into an acclaimed financial media empire with over five million views a month. Before doing ValueWalk full time, Jacob worked as a private equity analyst, small-cap stock analyst, and in hedge fund business development. Jacob lives with his wife and four kids in Passaic, New Jersey.