Real Estate Investment Trust (REIT) and Its Risks

REITs or Real Estate Investment Trusts are popular investment companies that generate income for an investor. REITs own and operate income-generating real estate that is paid in dividends.

REITs don’t require to pay corporate income taxes like public companies. The revenue is only taxed after shareholders have received their share of the revenues. REITs make a great investment opportunity for investors as it generates income on real estate properties. But there are certain risk factors connected with REITs that you should know before investing.

Before you consider investing in REITs, you need to know the risks incorporated. When investing in REITs through a broker, the broker needs to disclose the REIT investments’ risks. There are two types of REITS - Publicly traded and Non-traded REITs. Each one has a set of risks.

Risks of Publicly Traded REITs

1. Leverage Risk

When an investor decides to use borrowed money to purchase securities, the leverage risk surfaces. The use of leverage causes the REIT to incite additional expenses while increasing the fund’s losses due to the underperformance of underlying investments. The other costs with the loan or borrowing will lessen the amount of money available for distribution to the company’s shareholders.

2. Market Risk

REITs trade on major stock exchanges and thus are subject to price fluctuations in the markets. This implies that the investors may receive less than what they paid in the first place if they sell their shares in the public exchange. Recession, natural disasters, change in interest rates, etc. maybe some of the risk factors.

3. Interest Rate Risk

When the interest rates rise, investors look for safe income plays such as U.S Treasuries. Treasuries pay a fixed rate of interest and guaranteed by the government. Therefore, when the rate rises, REITs sell-off, and the bond market rallies as investment capital flow into bonds. This reduces the demand for REITs in the market.

4. Tax Treatment

REIT dividends are taxed as ordinary income, which means the ordinary income tax rate is similar to the investor’s income tax rate. These taxes are likely to be higher than dividend tax rates, and capital gains taxes for stock.

Risk of Non-Traded REITs

1.  Liquidity Risk

Non-Traded REITs allow investors to sell their shares on the public exchange market. Despite the allowance, the investments are illiquid compared to the other investments, such as bonds and stocks. There isn’t a secondary market for seeking buyers and sellers for the property you would invest. Also, the liquidity is only provided through the fund’s repurchase offers. There is no guarantee that the shareholders leaving their investments will be able to sell all or fragments of shares they want to sell. For liquidity reasons, investors may not be able to convert stocks into cash whenever they need it.

2. Share Value

Non-traded REITs aren’t publicly traded, and this would mean that the investors won’t be allowed to research their investments. As a result, it becomes relatively difficult to determine the value of REITs. Some non-traded REITs do reveal all assets after 18 months of its offering, but it’s pointless.

3. Upfront Fees

The upfront fee is charged between 9% to 15%. Apart from an upfront fee, non-traded REITs can have external manager fees. Hiring an external manager reduces investor returns. If you choose to invest in such REITs, it’s better to ask the management all the essential questions before you invest.

Investing in REITs can be a passive way to produce income as opposed to buying a property directly. But investors should also keep in mind not to be influenced by more significant dividend rates since REITs can perform low in the market even if the interest rate flare-up.