Whatever your view on the direction on the housing market, whether we’re in a bubble and there’s going to be a fall in prices or even a crash, this post is by Financial Freedom Countdown on REITs is a really good adition to your reading list.
Although the Federal Reserve is not worried about inflation, housing prices throughout the country are through the roof.
There is no denying that the appetite for real estate is at an all-time high due to demographics, Central Bank policy, and major Wall Street firms stepping into the real estate markets.
There are various options to invest in real estate with little or no money as an individual investor.
Before adding any asset class to your portfolio, it is better to examine your risk tolerance and weigh the pros and cons to determine if REITs are a good investment for your situation.
What Is A Real Estate Investment Trust (REIT)?
Real estate investment trusts or REITs own, operate, or finance income-producing real estate across many property sectors. The real estate investment trust is a way to invest in real estate passively.
REITs allow anyone to invest in real estate assets by purchasing individual company stock or through a mutual fund or exchange-traded fund (ETF).
The stockholder of a REIT earns a share of the income produced without having to go out and buy, manage or sell the property.
Publicly-traded REITs are not the best substitute for real estate, as we saw in our stocks vs. real estate duel.
Types of REITs
Equity REITs are the most prevalent type of REITs. Equity REITs own or operate income-producing real estates like shopping malls, commercial real estate, health care facilities, apartment buildings, warehouses, office buildings, cellphone towers, and hotels.
The publicly-traded REITs are either index funds from prominent fund families like Vanguard, Schwab, and Fidelity, or niche REITs investing in only a real estate sector such as office space and self-storage, data centers, or malls.
Mortgage REITs (mREITs) only provide financing for income-producing real estate by borrowing money at low short-term interest rates and purchasing mortgages that pay more excellent long-term interest rates.
The difference between the two rates is the Mortgage REIT’s profit. Mortgage REITs don’t own or operate real estate property.
Unlike traditional equity REITs, mREITs fluctuate wildly based on interest rates. Also, mortgage REITs are highly leveraged.
The risk with mREITs is sudden changes in the Mortgage-backed securities (MBS) market, leading to massive losses or bankruptcy.
A hybrid REIT is a real estate investment trust company that effectively combines equity and mortgage REITs (mREITs).
They own and manage properties, collect rent and invest in mortgage securities. Hybrid REITs try to profit from rising and falling interest-rate environments by investing in actual properties and mortgages.
Public Non-listed REITs
Public non-listed REITs are registered with the SEC and are therefore regulated, but they are not traded on public exchanges.
They operate like listed REITs nearly every other way. Still, since they do not sell publicly, investors need to purchase shares directly from the REIT’s management company through its real estate crowdfunding platform or a third-party broker-dealer.
Also, public non-listed REITs are still required to make regular, periodic regulatory filings. Public non-listed REITs, however, are open to non-accredited investors.
The Fundrise eREIT is the most common example of a public non-traded REIT.
Private REITs are exempt from SEC registration and whose shares do not trade on national stock exchanges.
Private REITs have little liquidity; hence, it can be challenging if you need to sell immediately. They are typically only available to accredited investors.
Advantages Of Investing In REITs
If you wonder why REITs are a good investment, REITs have some essential characteristics that make them unique. The pros of REIT investing are
No Corporate Tax
Based on IRS laws, a REIT needs to invest at least 75% of its assets in real estate and pay 90% of its taxable income as dividends.
A company qualifying as a REIT then gets a tax break of ZERO corporate tax.
The absence of corporate tax is a considerable advantage compared to regular stocks.
Let us take Apple as an example which has had a great home run as part of my moonshot portfolio.
Based on its annual profit, it pays corporate tax. Then it pays a dividend to its shareholders.
When I receive the dividend, I pay taxes on it.
REITs avoid double taxation, which means more money in my pocket.
Since REITs are supposed to distribute 90% of their income as dividends, most REITs provide a higher dividend than other companies.
The real estate passive income in the form of dividends can fund essential lifestyle expenses.
Part of a prudent asset allocation strategy is to be diversified into several asset classes.
REITs provide an additional asset for diversification as compared to a vanilla stock-bond allocation.
Crowdfunded real estate requires at least $1,000 investment in a single property.
To be sufficiently diversified, it is better to at least invest in 5 different properties. It might not be possible to commit large amounts depending on your net worth.
With REITs, you benefit from diversification across several properties for relatively smaller amounts.
The large fund families like Vanguard, Schwab, and Fidelity all have Real estate index ETFs trading under the following ticker symbols – VNQ, SCHH, FREL, respectively.
Hassle-Free Real Estate Exposure
Another factor in favor of REITs is the real estate exposure combined with simplicity. REITs are a hassle-free way to have exposure to real estate, and you don’t have to deal with tenants or toilets.
Of course, you lose some of the benefits of real estate, but REITs fit the bill for individuals looking for simplicity in exposure to this unique asset class.
Access To Different Real Estate Niches
With a REIT, you can get specific and niche down to invest in only commercial office buildings, hospital REITs, hotel REITs, warehouse REITs, cell tower REITs, hospitality REITs, or medical REITs.
Or even REITs related to specific geographic areas, such as Empire State Realty Trust, which owns the iconic Empire State building and other commercial real estate properties.
Since publicly-traded REITs are traded like stocks, you have similar liquidity when investing in REITs.
Crowdfunded real estate investments typically have a 3-5 year duration and are not considered liquid if you need to withdraw your funds at short notice.
Comparable Total returns
Besides dividends, REITs have the potential for capital appreciation as the value of their underlying assets grows.
Several REITs have generated total returns (dividends and price appreciation combined) that have kept pace with the stock market returns.
Drawbacks Of Investing In REITs
Now that we looked at the benefits of investing in REITs let us look at the cons of investing in REITs
Limited Tax Benefit
It is harder to structure these benefits in public Equity REITs. While they claim depreciation on their own to reduce tax liability, it doesn’t help in lowering your tax bill. Private REITs and public non-traded REITs can claim and pass the tax benefits to you.
As per the IRS rules, REIT dividends are taxed at the same rate as ordinary income.
While REIT dividends benefit investors who prefer to use them to fund their lifestyle, you pay higher tax rates on dividends than capital gains tax rates.
As long as you are in a lower tax bracket, the taxation of dividends should not be an issue.
One method to avoid the taxation of dividends is to buy REITs in a tax-protected account such as a Roth or IRA when you are in a higher tax bracket.
Once your tax bracket is lower in retirement, you can buy the REITs in a taxable account.
Interest Rate Sensitivity
Publicly traded REITs risk losing value as interest rates rise, typically sending investment capital into bonds.
When interest rates are low, investors tolerate the risks that come with REITs to obtain better returns. When interest rates rise, investors gravitate towards risk-free investments like Treasury securities.
Given that we have been in a long-term declining interest rate trend for 40 years, I am not too worried about rising interest rates in the U.S.
Rising inflation could force the Fed to increase the interest rate. In such a scenario, you must assess the impact on your REITs. For example, if inflation increases, my residential real estate REITs should technically increase rents and pass the additional money.
Dollar-cost averaging when investing in all asset classes, including REITs, is a great way to reduce the interest rate fluctuations.
Can You Lose Money In A REIT?
If you are wondering, “can I lose money in a REIT” the answer is YES! Only the U.S. Treasury is considered a safe asset.
Our ranking of the best passive income-producing assets indicates that the REITs have a middle-of-the-pack risk profile but correspondingly higher return.
Besides rising rate environments, REITs are not safe during a recession, depending on what kind of recession we encounter.
REITs can lose money depending on what real estate is part of their portfolio and how the particular real estate sector performs.
For example, if you invest in REIT, which only holds mall and hotel properties, you should be ready for a scenario where malls and travel are closed for an extended period.
Similarly, if you invest in an office building REIT and everyone is forced to work from home, consider how that would impact your REIT performance.
On the other hand, with malls closed and everyone working from home, REITs focussed on warehouses did exceptionally well as the online economy boomed.
As always, it is best to be diversified when selecting REITs, so you have some real estate sectors always performing.
One of the primary reasons I like Fundrise is that I can look at the investments within the REIT and decide accordingly.
For example, Fundrise has income or growth eREIT. Similarly, they also have specific geographies, such as an east Coast eRIET or Heartland eREIT, where you know what you are investing in.
Publicly traded REITs risk losing value as interest rates rise, typically sending investment capital into bonds.
The 10-year yield is a good indication of the interest rate sensitivity of REITs.
Is Owning A Home A Substitute For Investing In REITs?
The short answer is No.
Homeownership is not a substitute for investing in REITs or real estate, for that matter.
The home you live in is a consumption item and does not generate any income; unless you Airbnb a portion of it or rent rooms for house-hacking.
REITs represent commercial real estate investment, generating continuing income flow from rents.
A REIT is a liquid investment diversified across various real estate properties in different geographic locations. A house is a comparatively illiquid asset whose investment risk is not diversified but relatively highly concentrated.
Real estate investment in REITs or rental property should be separate from your primary home.
What Is the Best REIT To Invest In Right Now?
The best REIT stock to buy now is one that aligns with your investing goals, risk tolerance, and overall portfolio allocation.
It is hard to provide blanket guidance, so please consult with a licensed professional since your situation will differ.
At a high level, I can share my framework.
Before adding any REITs, I would look at my overall portfolio and determine my asset allocation among the various asset classes.
If I already have direct investments in real estate via rentals, I would focus on my existing rentals and consider expanding or diversifying.
Of course, one might not want to deal with the hassles of tenants or toilets, and professional management might be a better option.
Since I live in the San Francisco Bay area and believe owning a rental property is no longer a good investment, I would add some professionally managed real estate to the mix.
The advantage of investing in crowdfunded real estate deals instead of public REITs is the tax advantages such as depreciation, 1031 exchanges, cost segregation, opportunity zones credit, etc. which will not be available in publicly-traded equity REITs.
Also, rates for long-term capital gains are lower than short-term capital gains, and the real estate syndicator can hold the property for over a year to qualify for a lower long-term capital gains rate.
2) If I qualify as an accredited investor and want to invest smaller amounts evaluating each property using a crowdfunding real estate checklist, I would consider PeerStreet, which has low minimum of $1,000. PeerStreet has both Debt and Equity deals. The Debt deals are similar to hard money lending, and I have invested in over 48 properties so far.
4) If I do not want to evaluate any of the above options or want to invest much more smaller amounts, then I would go with a diversified index ETF from Vanguard (VNQ), Schwab (SCHH), Fidelity (FREL).
Publicly traded REITs have the advantage of simplicity and liquidity. All the other options require some level of due diligence in evaluating the deal, but there is a possibility of higher returns and additional tax benefits.
As with everything in life, there are trade-offs in each investment option.
Again, please consult with a licensed professional and do not consider anything I said as investment advice.
Final Thoughts, Are REITs A Good Investment?
Based on your investing goals, risk tolerance, and overall portfolio allocation, REITs could provide a great hassle-free way to gain exposure to real estate.
Weigh the pros and cons listed above to decide how much you want to invest in REITs.
Readers, do you have real estate exposure in your portfolio? Besides publicly traded real estate investment trusts, have you invested in any other options?
Disclosure: The author is not a licensed or registered investment adviser or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
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Tim Thomas has investments in real estate.
Featured image credit: Unsplash.