What are Risks of Real Estate Investment Trusts (REITs)?

Real estate investment trusts (REITs) are appealing for several reasons. One, at least 90% of taxable income must be returned to shareholders in the form of dividends. Two, which ties into point one, dividend yields are usually higher than throughout the broader market. Three, and perhaps most important, you don’t have to invest the money and time in buying a property directly, which is highly likely to lead to surprise expenses and endless headaches.

If you invest in a REIT with a good management team, a proven track record and exposure to good properties, you can sit back and watch your investment grow. Wouldn’t it be nice if it was really that easy? Sometimes it is, but only if you do your homework and get a little lucky. Unfortunately, there are some pitfalls that you will need to avoid. (For more, see: Residential, Healthcare and Office REITs.)

Strongly consider staying away from non-traded REITs. They are not publicly traded which means you will be unable to do research on your investment. This, in turn, will disallow you 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.

Non-traded REITs are also illiquid. In many cases, you can't sell for a minimum of seven years. Some allow you to retrieve a portion of your investment after one year, but there will almost always be a fee. They lock in your money because they need to pool investor money in order to buy and manage properties. 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 – opposed to income that has been generated by a property. This limits cash flow for the REIT and diminishes the value of shares. (For more, see: What are the Potential Pitfalls of Owning REITs?)

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

A final risk for non-traded REITs is external manager fees. If a non-traded REIT is paying an external manager, that eats into 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. (For more, see: Analyzing REITs and REIT Performance.)

This is a much safer playing field. However, there are still risks. The biggest is interest rates moving higher, which will reduce demand for REITs. 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 go up.

The other primary risk is choosing the wrong REIT. This might sound simplistic, but it’s about logic. For instance, at the time of this writing, suburban malls are in decline. You wouldn’t 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 are likely to be a better bet. Trends change, so be sure to do your research on what’s current. (For more, see: Money Habits of the Millennials.)

The last point isn’t a risk, but a point that you should be aware of: REIT dividends are taxed as ordinary income.

Investing in REITs can be a passive, income-producing alternative to buying property directly. Don’t be swayed by massive dividend yields. Instead, choose the right management teams and quality properties based on current trends. Strongly consider publicly-traded REITs over non-traded REITs. Also be sure to pay attention to interest rates. (For more, see: What is the Difference Between a REIT and a Real Estate Fund?)