The Problem with REITs

Real estate investment trusts are being extensively used by investors and speculators to bet on the real estate sector. REITs do provide a lot of advantages to investors. For instance, investors with small sums of money can also choose to invest in REIT. This is a major advantage since real estate tends to be very expensive, and many investors cannot afford to take an underlying position in real estate.

Similarly, REITs are easier to liquidate than traditional real estate investments. REITs also allow investors to diversify their holdings. Instead of investing $100 in the same property, they can invest $1 each in a portfolio of 100 properties. Lastly, investors benefit since their liabilities are limited to the extent of investment that they make in the REIT.

However, apart from these advantages, there are a lot of disadvantages associated with investing in REITs as well. Some of them have been listed in this article.

Varying Returns

The returns provided by REITs vary widely depending upon the underlying trust in which the investment has been made. This is because, to the layman, all REITs appear similar. However, in reality, each one has very different risk and return portfolio.

For instance, some REITs make equity investments in the real estate assets that they own. Whereas on the other hand, some REITs loan money to developers to build real estates. Hence, the risk and reward profile of both these REITs will be very different. For instance, if the interest rates in the economy go up, the mortgage based REITs will go down in value since newer funds will be able to provide better returns. On the other hand, equity REITs will appreciate in value. This is because as interest rates increase, so do rents.

Apart from equity and debt investments. The returns provided by REITs are varied based on the industry in which they invest money. For instance, REITs which invest in commercial real estate tend to provide consistent returns. The same in the case with the ones which invest money in hospitals and other medical establishments. This is because the underlying industry in which they invest money is performing well.

At the same time, there are other REITs which invest in hotel properties. There are still other REITs which invest in properties owned by retail establishments. It is a known fact that these industries are not performing well. As such, REITs which have invested their money in such properties are also not performing well.

Hence, investors have to be very careful about the specific investment vehicle that they choose. Many factors influence the returns that they may be able to generate on their investments.

Time Bound

Real estate, as an asset class is illiquid. This means that investors cannot really liquidate real estate as quickly as other asset classes like shares or bonds. This problem arises because of the huge monetary value of real estate assets.

REITs also face the same problem. REITs are time bound. This means that at the end of a specific time period (let’s say ten years), the REIT management is supposed to sell off the property and distribute the returns to the owners. Since many REITs mature at the same time, they can exert downward pressure on the prices. REITs may also be forced to sell at a time when prices are depressed.

A lot of times, when REITs mature, new investors buy the assets being sold by old investors. However, when the prices are down, finding new investors becomes difficult, and the properties actually have to be sold to liquidate money and pay it off to the investors.

Higher Fees

REITs are just like mutual funds. This means that they also collect a wide variety of fees from their clients. This is in addition to the percentage of profits that are earned by REIT investors as commissions. Many investors have complained that the management of many of these REIT trusts have complicated compensation arrangements. They use additional complexity to charge more money from unsuspecting investors.

Limited Growth

REITs do not grow too much in value. This is because they are mostly structured as pass-through entities. About 90% of the rental income that the REITs earn from these properties is paid out to the investors as a dividend. A mere 10% is retained and that too, for emergency purposes and administrative expenses. As a result, REITs are generally unable to increase the number of properties which they manage. Any growth is merely the result of price appreciation.

Tax Implications

Since REITs are pass-through entities, they are seldom taxed at the corporate level. This may vary based on the country where the investments are being made. However, this is generally the case all around the world. The dividend income from REITs is simply added to the other income earned by the individual. In many cases, this means that investors in REITs have to pay as much as 37% tax on the income that they have earned from their investment. Hence, REIT incomes are taxed at a higher rate compared to other investments such as stocks which only have to pay a preferential rate of tax.

The conclusion is that REITs also have many disadvantages. Therefore, like other financial tools, investors need to carefully scrutinize the investments made in REITs as well.