The Risks Of REITS

REITs (real estate investment trusts) have become a popular way to generate income for investors. REITs are companies that own and operate real estate properties. 90% of their income is paid out to shareholders as dividends.

In low-interest rates environments, REITs offer investors an attractive stream of income. However, you need to be aware of the risks associated with REITs before investing.

How Real Estate Investment Trusts Work

REITs typically offer higher returns than the rest of the market because they return at least 90% of their taxable income. REITs pay shareholders dividends. These are cash payments from corporations for their investors. While many dividend-paying corporations pay dividends, REITs offer a higher dividend return than most other dividend-paying businesses.

While some REITs are focused on a specific real estate sector, others have broader holdings. REITs can own many types of properties, including:

• Apartment communities

• Healthcare facilities

• Hotels

• Office buildings

• Self-storage facilities

• Shopping centers such as malls

REITs offer investors the chance to make a dividend-based income while not actually owning the properties. As a result, investors don't need to spend the time and money purchasing a property, leading to unexpected expenses and endless headaches.

Investors can relax and watch their investments grow if a REIT has a solid management team and a track record. However, investors need to be aware of the risks and pitfalls that REITs can present before making investment decisions.

The Risks Of Non-Traded REITs

Non-traded REITs, or non-exchange traded REITs, are not listed on any stock exchange. This exposes investors to special risks.

Share Value

Investors cannot research non-traded REITs because they are not publicly traded. As a result, it isn't easy to assess the value of a REIT. While some REITs that are not traded will reveal all assets and values after 18 months, it is still not comforting.

Insufficient Liquidity

Non-traded REITs can also be illiquid. This means that there may not always be buyers and sellers available for investors who want to transact. Non-traded REITs cannot be sold for less than seven years in many cases. Some REITs allow investors to recover a part of their investment after one year. However, there is usually a fee.

Distributions

Non-traded REITs must pool money to purchase and manage properties. This locks in investor capital. There can be a darker side of pooled funds. This darker side includes the possibility of paying dividends out from other investors' money instead of income generated by a property. This reduces cash flow for REITs and decreases the share's value.

Fees

Upfront fees are another problem for non-traded REITs. Many charge upfront fees, ranging from 9% to 10%, and sometimes up to 15% for some. Again, this is the same as with publicly-traded REITs.

External manager fees can also be charged to non-traded REITs. Investor returns can be reduced if a non-traded REIT has to pay an external manager. It is essential to ask all management questions if you decide to invest in a REIT that is not traded. The greater transparency, the better.

The Risks Of Publicly-Traded REITs

Investors have the opportunity to add real property to their investment portfolio and to earn attractive dividends by investing in publicly-traded REITs. However, although they are safer than non-exchange REITs, there are still risks.

Interest Rate Risk

Reit funds are most at risk when the interest rate rises, which decreases the demand for REITs. Investors tend to choose safer income investments such as U.S. Treasury bills in a rising rate environment. Treasuries. Treasuries are government-guaranteed, and most pay a fixed rate of interest. In response, REITs can sell off when interest rates rise and the bond market booms because more capital is invested in bonds.

One argument that rising interest rates can indicate a strong economy is to argue that higher rents and occupancy rates will result. However, historically, REITs have not performed well when interest rates rise.

The Wrong REIT

Another risk is selecting the wrong REIT. This may sound simple, but it is about logic. Suburban malls, for example, are in decline. Investors might be reluctant to invest in REITs that have exposure to suburban malls. Urban shopping centers might be a better option for Millennials who prefer urban living for convenience and cost savings.

Trends change, so the REIT properties and holdings are checked to ensure that they are still relevant and can generate rental income.

Tax Treatment

While not a significant risk, REIT dividends are subject to ordinary income tax. This means that investors' ordinary income tax rate is the same as the dividend tax rates and capital gains taxes for stocks.

The Summary

REITs are a passive income-producing option for purchasing a property. Investors should not be seduced by huge dividend payments as REITs may underperform in an environment of rising interest rates.

Investors should instead choose REITs with solid management teams and quality properties that are based on current trends. To get the best tax treatment, it's a good idea for investors to consult a trusted tax accountant. It is possible to own REITs in a tax-advantaged account such as a Roth IRA.