Real Estate Investment Trusts (REITs)

Many investors whose incomes are suffering from low interest rates have begun to seek investment alternatives to help supplement those incomes. One possibility often suggested is a real estate investment trust (REIT). REITs are a way to invest in commercial real estate without the responsibility of managing a property yourself, and with a much smaller investment than might otherwise be needed. However, REITs aren’t suitable for every investor, and there are many factors to consider carefully before you buy.

Types of REITs

REITs can be classified based on their holdings. Equity REITs typically buy, sell, renovate, manage, and maintain real estate properties, and their return comes primarily from tenants’ rents. Equity REITs may specialize in a specific type of property, such as warehouses, office or apartment buildings, health-care facilities, or shopping centers, or diversify across a variety of holdings. Mortgage REITs, which are less common than equity REITs, invest in mortgages and mortgage-backed securities or lend money to real estate owners or developers. Their income is derived largely from interest on those loans or securities plus any change in the value of those securities. Hybrid REITs employ both strategies.

REITs can be publicly traded on an exchange like stocks, or publicly registered but not publicly traded. They also can be private placements, which are not subject to the same disclosure or SEC registration requirements as either exchange-traded or nontraded REITs, and are only available to high-net-worth individuals. However, remember that even registration with the Securities and Exchange Commission doesn’t necessarily mean that a REIT will be a good investment or appropriate for you.

Why invest in a REIT?

Diversification: Because the performance of REITs may not be highly correlated with the performance of stocks or bonds, they may offer another way to broaden your investment portfolio. Though diversification alone can’t guarantee a profit or protect against the possibility of loss, it can potentially help you manage your portfolio’s overall level of risk.

Income: As long as it pays out at least 90% of its net income, a REIT can deduct dividends paid to shareholders from its corporate taxable income. That lack of a tax burden can increase the amount available to distribute to shareholders, potentially making a REIT a source of ongoing income.

Potential tax advantages: The legal structure of some REITs allows them to use depreciation and deductions to offset or eliminate current tax liability on their cash distributions, essentially creating a tax-deferred income stream for shareholders. The tax code treats those distributions as a return of capital rather than corporate dividends, and they are used to adjust the shareholder’s cost basis when the shares are sold.

Potential for keeping pace with inflation: Though current inflation is low, some experts worry that the Federal Reserve’s efforts to stimulate the economy could eventually change that. Because landlords may be able to raise rents to keep pace with rising costs, real estate has traditionally been considered to be more inflation-resistant than bonds.

Factors to be aware of

Potential liquidity issues: In the past, individual rather than institutional investors have been the primary market for some types of REITs. Because institutions represent such a large percentage of the investing universe, that could potentially affect your ability to sell your shares at the price you expect. And be aware that non-exchange-traded and private-placement REITs are often extremely illiquid (see sidebar).

Valuations: Investors who have sought out REIT dividends as an alternative to the low interest being paid by U.S. Treasury bonds have helped drive up prices on many REITs in recent months, potentially increasing the danger that you could pay too much for shares. Before investing in a REIT, make sure you’ve carefully assessed its potential for further price appreciation along with other factors such as the stability of the rents on which a REIT’s dividends are based. You also should compare the share price to the actual market value of the underlying properties minus any outstanding debt, though this can be extremely difficult in the case of a nontraded REIT or private placement. Remember that REIT securities’ value can be affected by declines in rental income, changes in interest rates, property management, environmental issues, uninsured damage, competitive factors, or changes in real estate laws.

Potential tax complexity: Even though some REITs may provide a current tax benefit, they may require more attention at tax time. You’ll also need to consider the type of account in which you plan to hold a REIT. The potential tax benefits mentioned above for certain REITs can be negated if they’re held in a tax-advantaged retirement account.