Risk and Benefit of REITs
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Is Investing in REITs a Good Idea Now? (Benefits and Risks of REITs)

Are you a 9 to 5 working class, earning pay check to pay check?

Feeling tired to a slave of money?

Do you want a change?

What if you can have money going to work for you earning you cash, tirelessly, every single day, 24/7 without a break.

How great will it be, don’t you think?

Introducing Real Estate Investment Trust (REITs), a very different class of investment vehicle you may want to consider. If you want to build a passive income or like dividend investing, this may be for you.

What Are REITs?

Real estate investment trusts, or REITs, are a type of investment that allows investors to pool their money to purchase, finance, and manage income-producing real estate.

REITs can be publicly traded on major exchanges, or they can be private.

Publicly traded REITs must meet certain requirements set forth by the Securities and Exchange Commission (SEC), such as having a minimum of 100 shareholders and being managed by a board of directors.

Some REITs pay out every month, and others every quarter or bi-annually.

How Are REITs Different To Real Estate?

REITs are a greate alternative to traditional real estate, although they have many similarities, investing in REIT is very different in a few key ways.

  • They offer investors the ability to invest in a diversified portfolio of real estate assets without the need to purchase individual properties. While it is very hard to achieve diversification for traditional real estate investing.
  • REITs provide a high level of liquidity, which is important for investors who may need to access their capital on short notice. While traditional real estate investing does not offer any form of liquidity, the sale of real estate will often take months to even years.
  • REITs typically offer high dividend yields, which can provide income-oriented investors with an attractive source of yield. While traditional real estate investing is depending on your ability to rent out your property for rental income.

How Are REITs Different To Stocks?

REIT investors own shares in a trust that owns and manages a collection of real estate properties, while stock investors purchase shares in the ownership of a public company or business.

Unlike stocks, REITs is only investment that by law have to distribute 90% of its taxable income after expenses to their shareholders annually in the form of dividends.

This give an average of annual dividend yield of approx. 5%. (Not including the capital gain you are getting for buying the REITs).

Like all investment, REITs have their own benefits and risks.

By balancing the risk and benefitsof a REIT, you can choose which is the best investment vehicle that suits you.

Sun Tzu once said:

“If you know the enemy and know yourself, you need not fear the result of a hundred battles.

If you know yourself but not the enemy, for every victory gained you will also suffer a defeat.

If you know neither the enemy nor yourself, you will succumb in every battle.”

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Ultimate Guide to Easy REITs Success

What Are The Risks Of REITs?

REITs like every form of investing have their own risk. REITs are a form of investment that is related to real estate, thus REITs face the same risk as all real estate.

Of the many risks it may face, the following are some of the few you may want to consider.

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Unpredictable

Designed and traded similarly to conventional stocks, REITs can be unpredictable and can have price fluctuation from time to time.

You can buy ‘ABC REIT’ today at $1.00 and it can become $0.80 tomorrow.

A 20% drop in value for REITs in a short time may not be common, but it is possible. Like all stocks, REITs can gain 20% in value in a short period of time as well.

Before you buy any REITs, you should understand that unpredictability is the nature of most investment vehicles.

Nonetheless, REITs generally fluctuate much less in comparison to penny stocks or stocks in general. These other investment vehicles can drop 90% of their value in 1 hour and raises 20% in the next minute.

Thus in comparison, REITs generally fluctuate less than the general equity market.

Risk of REITs: Unpredictable
Risk of REITs: Unpredictable

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Sensitive To Interest Rate

John Laforge, head of real estate asset strategy at Wells Fargo Investment Institute, once said:

“I wouldn’t look at REITs as having any more risk than a traditional stock, but since they do have a higher dividend yield, they can be more sensitive to interest rate movements.”

What does he mean?

Let’s illustrate it with an example:

Generally speaking, an average REITs give around a 5.20% dividend yield as shown by current data from dividend.com.

Note: 5.20% dividend return is when not including the capital gain from investing in REITs.

When long-term yields of government bonds such as those on 10-year and 30-year U.S. Treasury rise. These government bonds which generally are considered ‘risk-free’ investments become a competitor for REITs.

Note: No investment is ‘risk-free’, but generally speaking, government bonds are considered ‘risk-free’ by many as unless the government collapse, your principle will be returned to you at the maturity of the bond.

Long-term yields government bonds generally give a low yield of on average 4.55% per year, as reported by ycharts.

Historically, long-term yields of government bonds can be as low as 1.36% per year in July 2016 and as high as 15.82% per year in September 1981. As reported by TradingEconomics.

These long-term yields of government bonds when their interest rate rises to a high of over 10%, this high-interest rate will result in competing against REITs for investors’ money.

This is called the “crowding out effect” in investing.

For instance, today the ‘risk-free’ 10-year Treasury bond rose from 2.5% to 4.0% in the first two months of this year, in contrast, the REIT market fell 5%.

With just a 5.20% yield on a REIT, it will look less appealing. With just a 1.20% more in dividend yield, you are exposed to the risk of market fluctuations.

Since you can get a 4.0% ‘risk-free’ return on a 10-year Treasury bond, many investors will prefer to invest their hard earn money on bonds instead.

This will lead to a further price drop of REITs, and thus your investment return will be impacted.

Risk of REITs: Sensitive to Interest Rate
Risk of REITs: Sensitive to Interest Rate

Sector Dependent

In my other article, we talked about the different common Types of REITs, such as; Commercial, Healthcare, Hospitality, Industrial, Retail and Residential.

Different sectors of the REIT market can behave very differently in the same market condition.

Some REITs are seasonal, some are geographical, while others are dependent on government policy and the overall market they are operating.

There are many factors that can affect REITs and different sector of the REITs tends to be more vulnerable to certain market condition, while others are more resilient or even grow in that same market condition.

You have to know the sector that your REIT is investing in before you can determine what are the factors that will affect your REIT investment.

Types of Real Estate Investment Trust (REITS) by IncomeBuddies.com

As reported in New York Times, Colby Feane, a portfolio strategist at Manning & Napier in Rochester, said:

“When investing in REITs, it’s important to identify the risk factors specific to each company based on their property characteristics, geographic location and the market they operate in.”

As explained in detail in my other post ‘Types of REITs’, there is a trend of focusing on having a balanced lifestyle that allows employees to work from home.

Certain sectors might start to feel the pressure from such a trend and probably you may want to have a look to see, which sector of REITs might suit you more.

Risk of REITs: Sector Dependent
Risk of REITs: Sector Dependent

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What are the Benefits of REITs?

REITs are a unique form of investment vehicle with many advantages that any other investment vehicle does not provide. These amazing benefits of REITs make it a very attractive class of investment that many investors love to invest in.

Let’s dive into a few of these stunning benefits of REITs that you may consider when investing in REITs.

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Cash Flow

Similar to bonds, REITs give the investor a consistent cash flow in the form of a dividend. This means that you as an investor will see money flowing into your bank account from time to time.

Who doesn’t love money right?

But REITs have something that bonds don’t have. REITs have the potential for capital appreciation.

This means that REITs operate like the stock as well.

When you as the investor purchase your REITs at the right price. As the REITs grow, your investment appreciates in value as well.

You don’t only get the benefit of having the opportunity to buy low and sell high, your dividend yield usually becomes higher over time.

Money grow in REITs!

Let’s illustrate it with an example:

You bought “ABC REITs” at the price of $1.00 per share which have a dividend yield of 5%.

  • 5% of $1.00 = $0.05 dividend

This means that you will get an annual dividend of $0.05 per share.

Over the time you have invested, the dividend yield for “ABC REIT” stays the same at the rate of 5% per annual. But in the 10 years of investing in “ABC REIT”, the value of the REIT grow to $2.00 per share.

  • 5% of $2.00 = $0.10 dividend

This means that you will get an annual dividend of $0.10 per share.

You bought “ABC REIT” at the price of $1.00 and it grew to $2.00 giving you a capital appreciation value of over 100%. When calculated using the compounding annual growth rate (CAGR) formula, this is calculated to be 7.2% growth per year for 10 years. In addition, your previous 5% dividend yield grew after 10 years of investing.

  • Bought at $1.00 per share 10 years ago, and getting a $0.10 dividend per share now = 10% dividend yield

You are now getting a 10% dividend yield over cost per year!

Not only do you multiply your initial investment by 2 (Invest at $1.00, now at $2.00) due to capital appreciation, your dividend yield over cost has multiplied by a factor of 2 (Initial dividend at $0.05, now at $0.10)!

This is very different from bonds which the value and the cash payout of bonds don’t grow over time.

Thus if you buy bonds, you will miss out on the income growth that can be found in REITs.

Benefits of REITs: Cash Flow
Benefits of REITs: Cash Flow

Diversification

REITs are one of the few asset classes that offer diversification. This is when your portfolio consists of REITs and other asset classes such as the general equity markets.

Research has shown that REITs and stocks have a relatively low correlation, which means REITs and stocks react to market conditions differently.

Historically, the correlation between REITs and the general equity market has an average of 0.55. A correlation of 1 means highly correlated, and any value lower than 1 means less correlated.

With a correlation of 0.55, having REITs in your portfolio will allow you to smooths out the changes in the value of your whole portfolio.

But why does REITs behave so differently from general equity?

There are a few reasons, and one of the most important reasons is that REITs follow a very different cycle from general equity.

Most stocks are driven by the business cycle, which is dependent on the rise and fall of economic production which is reflected by the GDP of the country.

When the business is growing and the market is optimistic, the price of the stock will generally raise.

But when the business is lacking attractiveness and the market is pessimistic, the price of the stock will fall, eventually, this will lead to a recession.

One early sign before the recession is the GDP growth of the country.

While REITs on the other hand are basically an investment in real estate. And real estate has a completely different cycle from the business cycle. This is generally called the real estate cycle.

  • The business cycle lasts for four to five years on average.
  • The real estate cycle often lasts closer to eighteen years.

This huge difference in the length of the cycle means that even when your stock goes down because of the business cycle, your REITs which follow the real estate cycle may slowly climb up in value.

This makes REITs a particularly great investment vehicle to diversify your portfolio.

Benefits of REITs - Diversification
Benefits of REITs: Diversification

Inflation Protection

Do you know your money decreases in value every single day?

Why?

Because of inflation. That scary monster eats your money over time.

But what causes inflation?

Inflation is caused by the increase in money pumped into the supply which decreases your buying power every now and then.

Simple terms:

A coffee from Starbucks cost $4.00 now may cost $6.00 next year.

And to protect yourself against inflation, investing in REITs might just be the answer!

REITs generally own real tangible assets such as real estate. These assets provide inflation protection in two main ways.

  1. When inflation rises by 3%, the manager of the REITs can raise the rents on office buildings and the prices of hotel rooms by 3% or even a higher percentage to counter the inflation. This in turn will increase the income you receive.
  2. REITs invested in real estate and thus when inflation raises, generally, the price of real estate raises. This appreciation of the prices of the real estate that your REITs own may sometimes even be higher than your inflation rate. This gives you an even higher return on investment for the REITs you bought!

This benefit of having inflation protection is one of the best benefits that REITs have and many other investment vehicles don’t.

Benefits of REITs:  Inflation Protection
Benefits of REITs: Inflation Protection

My Take Away

REITs are indeed an amazing investment vehicle that you may want to consider to be a part of your portfolio.

  • Risk: Unpredictability, Sensitive to interest rate, and Sector dependent
  • Benefits: Cash Flow, Diversification, and Inflation Protection

The risk and benefits discussed in this article, hopefully, will help you in understanding more about REITs. Which in turn helps you in making the investment discussion that will be suited for you 

REITs like all investments, there is a certain level of risk.

Investing should always be done after you understand what you are investing and remember, ‘Never Invest with Borrowed Money’.

Wisdom from the legendary investor Warren Buffett:

“I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. It’s insane to risk what you have and need for something you don’t really need. You will not be way happier if you double your net worth.”

Just knowing the risk and benefits of REITs does not automatically make you a great investor. REITs are one of the many investment vehicles that you can take to success. You have to learn constantly and understand the game of investing. 

Remember the difference between success and failure is what you know, and what actions you take.

Here are some resources that will help in guiding you to your success.

Taking your first step is always hardest, but it is the most important step to greatness.



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