Risks of investing in REITs need to be recognized and managed effectively.
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The biggest risks associated with real estate investment trusts (REITs) are over-leveraged balance sheets, market risk, liquidity risk, taxes, declining property values and property-specific pitfalls. Non-traded and private REITs have special risks that must be taken into account. Gain further guidance about these risks of investing in REITs by reading below.
Risks of Investing in REITs: An Introduction
What is a REIT?
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A REIT owns, operates or finances income-producing real estate. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.
Generally, REITs follow a straightforward business model: the company buys or develops properties and then leases them to collect rent as its primary source of income. However, some REITs do not own property, choosing the alternative route of financing real estate transactions. The REITs generate income from the interest earned on the financing.
Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors can buy REIT shares on major public stock exchanges such as the NYSE or NASDAQ.
There are more than 225 REITs in the United States that trade on major stock exchanges, as well as are registered with the Securities and Exchange Commission (SEC). These REITs are primarily traded on the NYSE and have a combined equity market capitalization of more than $1 trillion.
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Like every investment, REITs come along with their own individual risk factors. However, non-traded REITs and private REITs have their own risks that will be discussed below.
Risks of Investing in REITs: Non-Traded REITs
Non-traded REITs carry a higher risk than public REITs because there is no public information that investors can use to research or determine their values. They are illiquid, and investors may not be able to access their funds for a predetermined period of time.
Another risk associated with investing in non-traded REITs is that there is no guarantee that investors will receive their dividend distributions. If they are received, it may be derived from sources other than the cash flow from business operations, which can decrease an investor’s interest. These sources may include borrowings, sale of offerings, sales of assets or even other investors’ money.
Non-traded REITs are also subject to significant expenses and commissions that eat into the value of an investor’s stake. For example, REITs charge an upfront fee of 8%-10% or sometimes as high as 15%. Another cost is the external REIT manager’s fees that are paid to a third-party professional manager for managing the REIT’s portfolio of assets. The expenses reduce the returns that are available for distribution to shareholders.
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Risks of Investing in REITs: Private REITs
Private REITs are not listed in the public exchange market and are exempted from registration with the Securities and Exchange Commission (SEC). Therefore, they are not subject to the same regulations as public REITs and public non-traded REITS.
The lack of government regulation makes it difficult for investors to evaluate them since little to no information is available publicly. They also are not required to prepare audited financial statements, creating additional risk for investors.
Risks of Investing in REITs: Over-Leveraged Balance Sheets
REITs are required to pay out 90% of taxable income to shareholders. Therefore, the company is generally only left with 10% of its income to reinvest into the core business each year. Because of this, REITs may rely heavily to have more money available to invest in new properties. Many REIT managers choose to take out debt to expand the number of properties owned in the portfolio.
However, leverage creates additional expenses and increases the fund’s losses in case of underperformance of underlying investments.
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If a REIT is constantly borrowing money to buy new properties, the company may find itself in a position where its liabilities are far greater than its assets. It is important to note that REITs can be expected to have some level of leverage on their balance sheets. However, there are scenarios where REITs become overleveraged to a financially unhealthy amount.
Many REITs have strong balance sheets, but their managers still seek to maintain a healthy amount of leverage to maximize the production of income from the properties. Investors should pay attention to the leverage on a REIT’s balance sheet when deciding where to put their money because not all of them have healthy leverage.
Risks of Investing in REITs: Market Risk
REITs are traded on public exchanges, and are therefore subject to market risk. Causes of market risk include changes in interest rates, inflation and recessions.
REITs are usually highly sensitive to fluctuations in interest rates. This means interest rates can make REITs volatile in the short term. High interest rates are bad for REITs in more ways than one. Given the REIT business model and the fact that REIT growth generally stems from raising debt or issuing stock, higher interest rates imply that REITs will face higher borrowing costs. Additionally, rising interest rates can affect property values.
Recessions also can be highly influential for REIT performance. Certain types of properties are more susceptible to the effects of recessions than others. For example, health care REITs generally perform well during recessions because people still prioritize their health and use health care services. On the other hand, hotel REITs underperform during recessions because people cut back on leisure travel to save money.
Risks of Investing in REITs: Liquidity Risk
Although public REITs allow investors to sell their shares on the public exchange market, the investments are less liquid compared to other investments such as stocks and bonds. There is no secondary market for finding buyers and sellers for the property.
Also, there is no guarantee that all the shareholders leaving their investments will be able to sell all or part of the shares they desire to sell in the quarterly repurchase offers. Due to this liquidity risk, investors may be unable to convert stocks into cash at the immediate time of need.
Risks of Investing in REITs: Tax Treatment
Although not a risk per se, it can be a significant factor for some investors that REIT dividends are taxed as ordinary income. In other words, the ordinary income tax rate is the same as an investor’s income tax rate, which is likely higher than dividend tax rates or capital gains taxes for stocks.
Risks of Investing in REITs: Declining Property Values
Real estate does not always go up in value. REIT investors face the risk that they may choose the wrong one and not gain any notable returns. When choosing where to invest, it is important to consider property types, geographical location and the growth prospects of different REIT sectors.
Risks of Investing in REITs: Property-Specific Risks
There are also property-specific risks associated with REITs. Since many REITs may only hold one type of property, they may face serious financial distress if an event occurs that decreases the demand for such property.
For example, office REITs have taken a considerable hit throughout the COVID-19 pandemic, as long-term work from home policies have diminished the need for office space and some tenants have stopped paying their rent, asked for rent relief or have gone out of business.
Some types of properties are very economically sensitive, while others are regarded as recession-resistant. Individual investors must decide what level of risk they are willing to take on and research which types of properties fit those risk preferences.
Risks of Investing in REITs: The Bottom Line
REITs face key risks that are important for investors to recognize. However, these risks should not scare potential investors away. REITs also come with their fair share of advantages that other investments do not provide. Non-traded and private REITs should be analyzed and researched with extreme caution. Overall REITs are a unique investment, so it is critical for potential investors to do their research, as well as assess their own risk tolerance.
Adam Johnson is an editorial intern who writes for www.stockinvestor.com and www.dividendinvestor.com.
