Last Updated on September 15, 2023 by Antony C.
Are you looking to become a real estate investors that build an investment portfolio of various real estate properties without the headache of managing them?
Real Estate Investment Trust or REITs offers you the investment opportunities to invest in real estate without a lot of cash, helping you generate generational wealth. If you are into building passive income through dividend investing, this may be for you.
- Real Estate Industrial Trust (REITs) can be used for dividend investing to generate and build passive income.
- The 3 risk of investing in REITs are; unpredictable, sensitive to interest rates, and sector dependents.
- The 3 benefits of investing in REITs are; high cash flow, diversification, and inflation protection.
What Are Real Estate Investment Trust (REIT)?
Real Estate Investment Trusts (REITs) is a type of property investment trust that provide investors the option to invest in the real estate market by pooling 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:
- Pay out at least 90 percent of their taxable income to their shareholders.
- Shares that are fully transferable.
- No more than 50 percent of its shares held by five or fewer individuals.
- Minimum of 100 shareholders.
- At least 75 percent of its total assets in real estate assets and cash.
- At least 75 percent of its gross income from real estate related sources.
- REITs are required to be managed by a board of directors.
Some REITs pay out their dividend every month, and others every quarter or bi-annually.
Why Do You Need To Know The Risk and Benefits of Investing In REITs
Like all investment, investing in a REIT have their own benefits and risks. By comparing the pros and cons of Investing In REITs, you will know what are the risks associated to investing in commercial real estate and how you can take advantage of REITs for higher return.
Every investment have their own rules and regulations that will impact your bottom-line, things such as:
- Tax treatment associated with the investment.
- Macro economics such as the changes in interest rates that can impact the investment.
- Micro economics that is associated with the investment.
By understanding the risk and benefits of a REIT before making any investment decisions, the REIT investors may make an more informed decision for their financial future.
“If you know the enemy and know yourself, you need not fear the result of a hundred battles.Sun Tzu
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.”
Risks And Cons Of Investing In 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.
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 the price of the REIT can changes drastically within a short period of time.
- REIT can have a 20% drop in value in a day.
- REIT can also have a 20% gain in value in a day.
Like all stocks, REITs can be unpredictability, and it is the nature of most investment vehicles.
Nonetheless, REITs generally fluctuate much less in comparison to penny stocks or stocks in general. Penny stocks can drop 90% of their value within an hour and raises 20% in the next minute.
REITs generally fluctuate less than the general equity market., It is considered less risky but definitely not no risk.
2. Sensitive To Interest Rate
REITs are highly sensitive to change in the interest rate. When the interest rate raises, REITs can become a risky investment as it is often highly leveraged.
“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.”John Laforge, Head of real estate asset strategy at Wells Fargo Investment Institute
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.
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.
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.
3. Sector Dependent
REITs can behave very differently in the same market condition and is highly dependent on various factors:
- REITs act differently for different types of REITs
- REITs can be seasonal dependent
- REITs can be geographical dependent
- REITs can be impacted by the change in government policy
- REITs can be impacted by overall market sentiment that they are operating
There are many factors that can affect REITs and certain 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 gain a deep understanding on the micro and macro economics of the particular sector to be able to determine the future prospect of the REIT.
“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.”Colby Feane, a portfolio strategist at Manning & Napier in Rochester, New York Times
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.
Benefits And Pros Of Investing In 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.
1. 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
Annual dividend = $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
Annual dividend = $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.
REITs are one of the few asset classes that offer diversification.
Research has shown that REITs and stocks have a relatively low correlation, which means REITs and stocks react to market conditions differently.
A correlation of 1 means highly correlated, and any value lower than 1 means less correlated.
Historically, the correlation between REITs and the general equity market has an average of 0.55.
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 why REIT behave differently from stocks, 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.
- 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.
3. Inflation Protection
What do you understand about inflation?
Inflation is the phenomenon where the value of today’s money is lower than the value of money in 10 years time.
It is a scary monster that eats the value of 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.
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.
- 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.
- 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.
How Are REIT Investing Different To Traditional Real Estate Investing?
REITs are a great alternative to traditional real estate, there are many advantages of investing in REITs over traditional real estate investing.
- REITs allows investors to invest in a diversified portfolio of real estate assets without the need to purchase individual properties. On the flipside, getting a diversified portfolio of commercial real estate is very hard to achieve for traditional real estate investing.
- REITs provide investors 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 offer investors regular and stable dividend yields, REIT dividends are a great source of passive income for income-oriented investors. Rental income from traditional real estate investing depends on your ability to rent out your property.
|Aspect||REIT Investing||Traditional Real Estate Investing|
|Ownership||Buy shares in a REIT company||Directly own properties|
|Diversification||Offers diversification across properties||Often limited to one property|
|Liquidity||Easily tradeable on the stock market||Properties can be less liquid|
|Management||Professional management||Requires hands-on property management|
|Income||Steady income from dividends||Income from rent and management|
|Control||Limited control over decisions||Full control over property|
|Capital Entry||Lower initial capital requirements||Typically needs substantial upfront investment|
|Taxation||Taxed as ordinary income||Tax implications vary|
|Risk||Lower risk due to diversification||Higher risk with direct ownership|
|Appreciation||Potential for less capital appreciation||Potential for higher property value growth|
How Are REIT Investing Different To Stocks Investing?
REITs specialize in investment in diversified portfolio of commercial real estate offering investors shares in a real estate trust, 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.
REITs have historically provided an average of annual dividend yield of approx. 5% in REIT dividends, which is much higher than common stocks. (Not including the capital gain you are getting for buying the REITs).
|Factors||REIT Investing||Stock Investing|
|Asset Class||Real estate properties and assets||Ownership of company shares|
|Income Source||Rental income and dividends||Capital gains and dividends|
|Diversification||Real estate sector diversification||Industry and sector diversity|
|Volatility||Generally less volatile||Can be more volatile|
|Liquidity||Liquidity varies by REITs||Liquidity varies by stock|
|Control||Limited control, reliant on REIT management||Minimal control over company decisions|
|Taxation||Taxed as ordinary income, often with tax advantages||Taxed based on capital gains and dividends|
|Investment Entry||Lower capital entry, incremental||Investment amount varies widely|
|Risk Tolerance||Lower risk due to diversification||Risk varies by company and market|
|Dividend Yield||Consistent dividend yield||Varies by company|
|Capital Appreciation||Slower pace||Potential for higher growth|
Time To Invest In Real Estate Investment Trust?
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’.
“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.”Wisdom from the legendary investor Warren Buffett
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Antony C., is an entrepreneur, course creator, published author of the book "Start Small, Dream Big", an investor with +15 years of experience and an accomplished financial writer. Having used and tried many business software and tools in his professional career and personal business, he recognize the need for unbiased, quality information based on real-life experience. Sharing his journey and expertise to assist aspiring entrepreneurs in creating and growing their online business and building wealth, he have created IncomeBuddies.com. Antony has been featured in global news outlet including Yahoo Finance, Nasdaq and Non Fiction Author Association (NFAA).