Real estate investment trusts (REITs) are popular investment vehicles that generate income for their investors. A REIT is a company that owns and operates various real estate properties in which 90% of the income it generates is paid to shareholders in the form of dividends.

As a result, REITs can offer investors a steady stream of income that is particularly attractive in a low interest-rate environment. Still, there are REIT risks you should understand before making an investment.

Key Takeaways

  • Real estate investment trusts (REITs) are popular investment vehicles that pay dividends to investors.
  • One risk of non-traded REITs (those that aren't publicly traded on an exchange) is that it can be difficult for investors to research them.
  • Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them.
  • Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.

How Real Estate Investment Trusts Work

Since REITs return at least 90% of their taxable income to shareholders, they usually offer a higher yield relative to the rest of the market. REITs pay their shareholders through dividends, which are cash payments from corporations to their investors. Although many corporations also pay dividends to their shareholders, the dividend return from REITs exceeds that of most dividend-paying companies. 

REITs have to pay out 90% of taxable income as shareholder dividends, so they typically pay more than most dividend-paying companies.

Some REITs specialize in a particular real estate sector while others are more diverse in their holdings. REITs can hold many different types of properties, including:

  • Apartment complexes
  • Healthcare facilities
  • Hotels
  • Office buildings
  • Self-storage facilities
  • Retail centers, such as malls

REITs are attractive to investors because they offer the opportunity to earn dividend-based income from these properties while not owning any of the properties. In other words, investors don’t have to invest the money and time in buying a property directly, which can lead to surprise expenses and endless headaches.

If a REIT has a good management team, a proven track record, and exposure to good properties, it's tempting to think that investors can sit back and watch their investment grow. Unfortunately, there are some pitfalls and risks to REITs that investors need to know before making any investment decisions.

Risks of Non-Traded REITs

Non-traded REITs or non-exchange traded REITs do not trade on a stock exchange, which opens up investors to special risks.

Share Value

Non-traded REITs are not publicly traded, which means investors are unable to perform research on their investment. As a result, it's difficult to determine the REIT's value. Some non-traded REITs will reveal all assets and value after 18 months of its offering, but that’s still not comforting.

Lack of Liquidity

Non-traded REITs are also illiquid, which means there may not be buyers or sellers in the market available when an investor wants to transact. In many cases, non-traded REITs can't be sold for a minimum of seven years. However, some allow investors to retrieve a portion of the investment after one year, but there's typically a fee.

Distributions

Non-traded REITs need to pool money to buy and manage properties, which locks in investor money. But there can also be a darker side to this pooled money. That darker side pertains to sometimes paying out dividends from other investors’ money—as opposed to income that has been generated by a property. This process limits cash flow for the REIT and diminishes the value of shares.

Fees

Another con for non-traded REITs is upfront fees. Most charge an upfront fee between 9% and 10%—and sometimes as high as 15%. There are cases where non-traded REITs have good management and excellent properties, leading to stellar returns, but this is also the case with publicly traded REITs.

Non-traded REITs can also have external manager fees. If a non-traded REIT is paying an external manager, that expense reduces investor returns. If you choose to invest in a non-traded REIT, it’s imperative to ask management all necessary questions related to the above risks. The more transparency, the better.

Risks of Publicly Traded REITs

Publicly traded REITs offer investors a way to add real estate to an investment portfolio and earn an attractive dividend. Publicly traded REITs are a safer play than their non-exchange counterparts, but there are still risks.

Interest Rate Risk

The biggest risk to REITs is when interest rates rise, which reduces demand for REITs. In a rising-rate environment, investors typically opt for safer income plays, such as U.S. Treasuries. Treasuries are government-guaranteed, and most pay a fixed rate of interest. As a result, when rates rise, REITs sell-off, and the bond market rallies as investment capital flows into bonds.

However, an argument can be made that rising interests rates indicate a strong economy, which will then mean higher rents and occupancy rates. But historically, REITs don’t perform well when interest rates rise.

Choosing the Wrong REIT

The other primary risk is choosing the wrong REIT, which might sound simplistic, but it’s about logic. For example, suburban malls have been in decline. As a result, investors might not want to invest in a REIT with exposure to a suburban mall. With Millennials preferring urban living for convenience and cost-saving purposes, urban shopping centers could be a better play.

Trends change, so it's important to research the properties or holdings within the REIT to be sure that they're still relevant and can generate rental income.

Tax Treatment

Although not a risk per se, it can be a significant factor for some investors that REIT dividends are taxed as ordinary income. In other words, the ordinary income tax rate is the same as an investor's income tax rate, which is likely higher than dividend tax rates or capital gains taxes for stocks.

The Bottom Line

Investing in REITs can be a passive, income-producing alternative to buying property directly. However, investors shouldn't be swayed by large dividend payments since REITs can underperform the market in a rising interest-rate environment.

Instead, it's important for investors to choose REITs that have solid management teams, quality properties based on current trends, and are publicly-traded. It's also a good idea to work with a trusted tax accountant to determine ways to achieve the most favorable tax treatment. For example, it's possible to hold REITs in a tax-advantaged account, such as a Roth IRA.