Downside/Cons of REITs

It’s important to be aware of the risks of any investment you’re considering. Real estate investment trusts (REITs) can be profitable investments, but they’re not without risk. Investing in REIT means you’re financing income-producing real estate properties or land with a collection of other investors. Here are some of the downsides/cons to know before investing in REITs.

Value Fluctuates Rapidly

Real estate investment trusts typically follow the trend pattern of the stock market. With real-time price discovery, REITs are capable of moving quickly. If the stock market sells off, the market for REITs often follows suit shortly thereafter. Changing tax rules, debt, and local property values can also affect the value of REITs.

REIT investors often have little control over these fluctuations. Some REITs might also charge high management fees, which can cut into profits. REIT fees can be as high as 15% upfront, making it difficult to earn a return.

High Tax Rates

REITs have the potential for high returns, which subjects investors to higher tax liabilities. Investors must pay high taxes on not only their REIT returns but also their dividends. The tax rate on REITs is much higher than that of other investment opportunities. The specific tax rate you pay depends on your regular income tax rate, which might be quite high for some investors.

The traditional tax rate for most dividend investments is around 15%. The going tax rate for REITs is much higher because it’s considered ordinary income. The REIT tax rate is also higher than the rate for dividends, which are typically taxed at long-term capital gains rates. REITs, however, don’t qualify for the lower capital gains tax rate. Ina nutshell, the higher tax rate can easily cut into REIT profits.

High Payout Requirements

Risky REITs that don’t meet the 90% payout requirement might never pay out. Payout amounts might drop in conjunction with an unstable economy, which could lead to zero returns. This could cause an uneven cash flow for some investors. The high payout requirements might also limit an investor’s ability to use those funds to invest in other projects.

Slow Appreciation Rates

REITs typically don’t appreciate as fast as other investment opportunities. When they do appreciate, however, the payout can be high. Unlike other investments, REITs don’t produce revenue when stock prices increase. Instead, they only provide returns in the form of distribution payouts.

Some REITs are also illiquid, which means you must wait a few years to sell them. While certain REIT investments allow investors to sell before they appreciate, doing so often comes with a high fee. Because REITs are essentially pools of investors’ money, your investment funds might go toward paying out dividends, which limits cash flow and reduces the value of the share.

Prone to Interest Rate Adjustments

The government adjusts interest rates frequently based on the state of the economy. One of the challenges with REITs is they’re prone to interest rate adjustments. As interest rates increase, the value of treasury securities also increases. This pulls funds from REITs, which lowers their share price.

High Operating Costs

Real estate investments require certain operating costs that other investment types don’t. For example, REITs are subject to property taxes. Taxes at the county, state, and federal levels can take up as much as 25% of profits. Local counties and states might also increase property taxes to cover unexpected costs, making it difficult to estimate and budget for these costs accurately.

Other operating costs that can cut into profits include management fees, repairs, and administrative needs. Investors don’t usually have control over these costs. For this reason, some investors prefer investing in single or multifamily homes they own because it gives them more control over operating costs. However, investing in real estate property or land ownership requires more capital upfront.

Prone to Changing Trends

REITs are also subject to changing trends based on location and buying habits. For example, if you buy an REIT portfolio that includes multiple shopping malls, and the number of people visiting malls declines, it will negatively affect the REIT’s value. Changes in living trends, including aging generations moving to or away from big cities, can also influence the value of REITs.

The biggest problem with these trends is they can be difficult to predict. For this reason, REITs are ideal as long-term investments. Local ordinances or changing interest rates can quickly affect the value of REITs, but that value is likely to level out long-term. The good thing is you can choose different REIT types, which gives you more control over where you invest your money.

Difficult to Research

REITs can also be more difficult to research, especially when compared to other investment types. The most affordable REITs are usually the ones that have the highest fees and pay out the least. REITs with more profit potential typically require you to invest more capital.

REITs that aren’t publicly traded can be nearly impossible to research. Some non-traded REITs might not even share information with investors until they have been invested for a minimum of 18 months.

Key Takeaways

Here are a few key takeaways related to the downsides of REITs:

• An REIT is a corporation that invests in real estate using funds from shareholders.
• REITs are hypersensitive to fluctuating interest rates.
• No investment is risk free, but REITs might have a higher-than-average risk.
• Investing in property and land directly might provide a better return than an REIT.
• Publicly traded REITs might be safer investments than non-traded REITs.
• REITs are taxed at an income rate higher than other investment types.
• REITs are prone to changing buying trends that you can’t always predict.
• The high operating costs of REITs can cut into profits.

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