Real estate can make an great addition to almost any portfolio. However, few of us have the large amount of capital needed to buy a property, and it can be difficult to get approval for a mortgage. Fortunately, there are alternative investments that allow you to become a real estate investor without having to overcome these two hurdles. One option is to invest in real estate related stocks, and another is to invest in REITs.
What are REITs?
A REIT, or Real Estate Investment Trust, is a corporation that invests in real estate. To qualify as a REIT, a company must satisfy three criteria:
- It must invest most of its assets in real estate.
- Its income must come mostly from real estate.
- It must pay out 90% of its taxable income to shareholders.
Three Main Types of REITs
REITs can hold a variety of investments. They can actually own different types of income-producing property, residential and/or commercial, or even finance real estate transactions.
- Equity REITs — These REITs buy, sell, and manage real estate properties, such as apartment buildings, shopping centers, office buildings and industrial parks. By investing in these REITs, you are making money from rental income and property value appreciation.
- Mortgage REITs — These REITs invest in mortgages and make money from interest payments, not on appreciation.
- Hybrid REITs — These REITs are combination of equity and mortgage REITs.
REITs Pros and Cons
Advantages of REITs
There are several benefits to investing in REITs:
- The biggest advantage of REITs is that you have the opportunity to add real estate to your investment portfolio without needing a large amount of capital.
- The dividend payout can provide you with a source of income. REITs have to distribute at least 90% of its taxable income to investors. This means that the dividends paid out can be quite generous.
- REITs are relatively easy to buy and sell on a stock exchange. They are more liquid than actually owning a property.
- REITs are diversified real estate investments that hold many underlying investments. Additionally, it’s possible to diversify your REIT holdings geographically. There are international REITs, as well as domestic REITs.
- You can look for REITs that specialize in one type of real estate, or choose one that has a variety of different types of real estate.
Disadvantages of REITs
As you might imagine, though, there are risks involved with investing in REITs.
- Because they are tied to real estate, many of them lost a great deal of share value after the financial crisis of 2008. While most have recovered, the reality is that there is always the risk of loss. If the real estate market suffers, so does the REIT. If you invest in a REIT that specializes in residential mortgages, and there are a high number of defaults, then your investment loses value.
- If you rely heavily on the dividends for income, you might be in trouble if the value drops and the REIT stops making as much money.
- REITs are not tax-efficient due to its distribution requirement.
REITs vs Rental Properties
I think investing in REITs is an excellent way to diversify your investment portfolio and generate income. For those that are considering real estate investing, here are some reasons why you might consider REITs over rental properties:
- You get to invest in real estate without a large upfront capital.
- You don’t have to deal with maintenance — e.g., answer midnight phone calls to go fix the toilet.
- You don’t have to deal with bad tenants and worry about collecting rent.
- You earn regular income in the form of dividends and capital gains distributions.
- REITs add another level of diversification to your investment portfolio.
- Buying and selling REITs is as simple as buying and selling stocks — much easier and faster than buying and selling houses.
Before you invest, make sure you understand the risks involved, and consider what portion of your portfolio you want in real estate related investments. If you are looking for a way to add a little diversity to your portfolio, with the help of real estate, a REIT can be worth considering. However, carefully think about your risk tolerance, and be sure you understand your target asset allocation. As always, consider your investment goals avoid investing too much in any one asset class.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.