Real Estate Investment Trusts: Pros, Cons and Dangers
A Real Estate Investment Trust, or REIT, may be a good choice for those wishing to invest in income-generating properties but who may lack the resources to purchases such investments directly. A REIT is an entity, like a corporation, that owns and manages apartment complexes, office buildings, warehouses and other types of rental properties. Investors purchase shares, similar to stocks. They receive dividends from the REIT every year (a more detailed explanation is available here).
For the sophisticated investor, there are distinct advantages to owning stock in a REIT. For example, yields can be high compared to other types of investments, Legally, a REIT must pay out a minimum 90% of its taxable income to investors. The Trust has the option to pay out more, but under financial regulations, it cannot pay less than that amount. REITs also enables one to invest in real property without the difficulties involved in making real estate purchases. Shareholders need not be concerned with property taxes, insurance, maintenance and upkeep, etc., as these are the responsibility of the REIT. This makes it easier to cash out when the time comes. The investor does not have to attempt to sell a property, only his/her shares in the REIT. The funds are also spread among several properties, so the investors do not have all their money riding on one building.
Holding shares in a REIT is an excellent way to diversify a portfolio. Real estate values are not tied to the stock or bond market, so economic conditions affecting one usually doesn't affect the others. That said, REIT shares can fall in value if the supply is greater than the demand (in other words, rental unit and building occupancy rates drop). This can affect the value of the properties, causing the value of shares to fall as well. In some cases, a REIT may be forced to incur greater debt to increase its holdings if dividend payouts are high. And, if the Federal Reserve decides to hike interest rates, this can cut into profits.
One thing to keep in mind is that, while dividends on REIT shares are considered investment income, not all of them are taxed as such. Some are “equity” REITS, which tend to focus on apartment complexes, lodging facilities and retail spaces. Income is generated from rents as well as the purchase of undervalued properties that are sold at a profit. These make up the majority of REITs. Other REITs invest in mortgages, with dividends coming from the interest on property loans. Mortgage REITs may also be invested in mortgage-backed securities. These are generally a “bundle” of mortgages pooled together into a single financial instrument.
It is important to consult a tax attorney or accountant before investing in REITs in order to determine the effect on your tax liability. Dividends on some REITs are taxed as regular income, whereas others – such as non-traded REITs (not traded on a securities exchange) may be taxed at the 15% rate on regular investment income. For this reason, non-traded REITs may seem attractive. However, they lack liquidity and may involve up-front fees of as much as 15%.
A broker or financial adviser is obligated under the law to provide full disclosure and recommend such investments only if they are suitable to the client's goals and risk tolerance. Some unscrupulous advisers have misrepresented the risks of these investments, and either understate or fail to disclose fully the fees involved.
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