What Are the Risks of Investing in REITs?

Real estate investment trusts (REITs) offer investors the potential to gain steady income through dividends, as they're required to distribute a significant portion of their taxable income to shareholders. However, like other financial investments , REITs have their own risks that investors should consider before committing their funds. Before you add REITs to your investment portfolio, be sure you weigh their drawbacks against their benefits and consider whether this type of real estate investment aligns with your financial goals and risk tolerance.

If you want to build a real estate portfolio, a financial advisor can help you analyze and manage investments.

What Are REITs?

REITs own, operate or finance income-producing real estate and allow individual investors to invest in large-scale, income-generating real estate without having to buy, manage or finance any properties themselves.

These companies generate revenue primarily by leasing space and collecting rents on the properties they own, which can include commercial properties, residential buildings or industrial facilities. Investors purchase shares in a REIT, and in return, they receive a portion of the income produced by the underlying properties.

Because REITs are typically traded on major stock exchanges , they offer liquidity and the opportunity to diversify a portfolio beyond traditional stocks and bonds.

Here are six general types of REITs that investors can use to diversify their portfolio within the real estate market:

• Equity REITs : Equity REITs are the most common type of REITs and involve owning and operating income-generating properties. Equity REITs earn revenue primarily from leasing space and collecting rent.
• Mortgage REITs: Mortgage REITs (mREITs) offer financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities. Their income is derived from the interest on these financial instruments.
• Hybrid REITs : Hybrid REITs combine the characteristics of both equity and mortgage REITs, investing in both properties and mortgages. This diversification can offer investors a balanced exposure to real estate.
• Public REITs : Public REITs are listed on stock exchanges and can be bought and sold like stocks. They offer high liquidity and transparency.
• Public non-traded REITs : These REITs are registered with the SEC but are not listed on stock exchanges, making them less liquid but often more stable.
• Private REITs : Private REITs are not registered with the SEC and are not publicly traded. They are typically offered to institutional investors and accredited individuals.

Why Not to Invest in REITs

While REITs can offer significant benefits, here are nine common reasons why you should not invest in REITS:

• Inconsistent, variable returns : REITs can be subject to fluctuations in the real estate market, leading to inconsistent returns. Economic recessions , changes in interest rates , or shifts in property values can all impact the performance of REITs, making their returns variable and sometimes unpredictable.
• Sensitive interest rates : REITs are highly susceptible to changes in interest rates. When interest rates rise, the cost of borrowing increases for REITs, which can reduce profitability and lead to lower dividend payouts. Higher interest rates can also make REITs less attractive compared to other income-generating investments , such as bonds .
• Taxed as ordinary income: Dividends from REITs are typically taxed as ordinary income , which can result in a higher tax burden for investors, especially those in higher tax brackets. Unlike qualified dividends, which are taxed at a lower rate, REIT dividends do not benefit from favorable tax treatment. However, the Tax Cuts and Jobs Act (TCJA) allows you to deduct 20% of REIT dividends through 2025.
• Fees : REITs, especially non-traded ones, can have high fees associated with them, including management fees, acquisition fees and transaction fees. These costs can eat into returns and make REITs less attractive to cost-conscious investors.
• Not always liquid : While publicly traded REITs offer liquidity, non-traded and private REITs can be challenging to sell, particularly if the real estate market is sluggish. This lack of liquidity can be a significant disadvantage for investors who may need to access their funds quickly.
• Long-term commitment : Investing in REITs often requires a long-term commitment, particularly for non-traded and private REITs. These investments are not suited for those looking for short-term gains , as they typically require holding periods of several years to realize their full potential.
• Low growth potential : Compared to other investment options, REITs may offer lower growth potential. Because they are required to distribute a large portion of their income as dividends, they may reinvest less in expanding their portfolio or enhancing their properties, limiting their ability to grow.
• Requiring the right management : The success of a REIT is heavily dependent on the management team's ability to effectively operate the properties and make sound investment decisions. Poor management can lead to underperforming assets, lower dividends and ultimately, diminished returns.
• Less ideal for experienced investors : Experienced investors who seek high returns or are comfortable with more complex investment strategies may find REITs less appealing. The relatively stable, income-focused nature of REITs might not align with their more aggressive investment goals.

Alternatives to Investing in REITs

If you determine that REITs are not the right fit, here are five alternatives to consider:

• Real estate syndications : Real estate syndications involve pooling resources with other investors to acquire and manage large real estate projects. This option allows investors to access larger, potentially more profitable properties without directly managing them.
• Private equity real estate : Private equity real estate involves investing in private real estate funds that buy, manage and sell properties. These funds often target higher returns but come with higher risk and longer investment horizons.
• Direct real estate ownership : For those willing to take on the responsibilities of property management, direct real estate investment can offer control over investment decisions and the potential for substantial appreciation and income generation.
• Real estate crowdfunding : Crowdfunding platforms allow investors to pool small amounts of capital to invest in real estate projects. This option offers diversification and the potential for higher returns, although it may also come with higher risks and less liquidity.
• Real estate mutual funds : These funds invest in a diversified portfolio of real estate-related securities, including REITs, but may also include stocks of companies in related industries. They offer professional management and diversification across different types of real estate investments.

Bottom Line

REITs can help investors gain exposure to real estate without directly owning property, but they also carry some drawbacks and risks. Variable returns, sensitivity to interest rates and high fees can make REITs less attractive to certain investors. The tax implications and long-term commitment required can also be deterrents for those seeking more flexible or higher-growth investment opportunities.

Tips for Real Estate Investing

• A financial advisor can help you build a real estate portfolio that fits your goals and level of risk. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to calculate how much your investments could grow over time, SmartAsset's free calculator could help you get an estimate .

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