Have you ever considered adding real estate to diversify your investments? The widespread popularity of TV shows about residential property rehabbers has recently piqued the interest of many investors. Buying distressed properties and then renovating and reselling them is a direct form of real estate investing that’s very hands-on, with complexities and inherent risks most investors aren’t equipped to navigate. It’s not as easy — or fun — as it looks on TV!
However, there are indirect ways to include real estate in your portfolio that bypass many of the complexities and risks of buying, selling, owning and managing real estate yourself.
Real estate crowdfunding is a recent investing option. A lot of crowdfunding platforms have popped up in recent years since the passing of the Jumpstart Our Business Startups Act, or JOBS Act, in 2012. We’ve reviewed many real estate crowdfunding products. There are crowdfunding sites that specialize in commercial equity funding, including RealtyShares and RealCrowd; commercial debt, including Fundrise and Sharestates; direct ownership, including Crowdstreet and Roofstock; residential debt, including Peerstreet and LendingHome; and many more platforms that offer a mix and match of some or all of these investment options. To see a quick overview comparing many real estate crowdfunding platforms, click here.
A more traditional, indirect approach involves buying shares in a fund of a publicly or privately held company’s REIT (real estate investment trust).
What Is a REIT?
A REIT owns and operates real estate properties such as office buildings, shopping malls, apartments, hotels, resorts, storage facilities and/or related real estate assets like mortgages or commercial property loans. Typically, a REIT doesn’t develop real estate to sell it. Rather, a REIT buys properties to operate them as part of its own investment portfolio.
Buying shares of a REIT equates to investing in an entity’s real estate investing strategy. Instead of directly buying specific properties that you personally vet, you are buying into the expertise of the REIT’s management team and own a share of the individual assets that are bought and sold within the REIT.
Because the REIT pools investment funds from many investors, a REIT allows you to invest in large-scale income-producing real estate. Through REITs, individual investors can earn a share of the income produced through real estate ownership — without actually having to buy or hold the properties themselves. For example, you might invest in a REIT that owns one area of real estate, such as shopping centers.
There are three different kinds of REITs:
- Equity REITs own properties to generate income. The REIT takes in revenue from leasing the space and distributes the “rent” in the form of regular dividends to shareholders. Shareholders also get paid (in the form of dividends) for capital appreciation if and when the REIT sells an owned property.
- Mortgage REITs buy and own property mortgages. They loan money for mortgages to real estate owners and/or purchase existing mortgages. Earnings come from the spread between the interest earned on mortgage loans and the cost of funding the loans.
- Hybrid REITs invest in both properties and mortgages.
There are essentially three types of REITs, categorized by how you buy into them:
|Registered non-traded REIT||Publicly traded REIT||Private-placement REIT|
|Availability||Does not list on national securities exchange. Shares are purchased directly.||Listed on major stock exchange. Shares can be bought and sold through a broker.||Unlisted and available only to accredited investors.|
|Liquidity||Generally illiquid. Shares may be redeemable subject to issuer redemption policies and fees.||Generally liquid but not suitable for short-term trading because of the large front-end load. Shares trade on a major stock exchange.||Generally illiquid. Shares may be redeemable subject to issuer redemption policies and fees.|
|Fees||Front-end load as high as 15% of the share price||Typically 7% or more front-end load plus brokerage commission||Varies|
|Source of return||Investors typically seek income from distributions over a period of years. Upon liquidation, return of capital may be more or less than the original investment depending on the value of assets.||Investors typically seek capital appreciation based on prices at which a REIT’s shares trade on an exchange. The REIT also may pay distributions to shareholders.||Investors typically seek income from distributions over a period of years. Upon liquidation, return of capital may be more or less than the original investment depending on the value of assets.|
|Risk||Not directly correlated to stock market fluctuations; however, economic conditions that affect the stock market, such as rental rates, commercial real estate values and the REIT’s ability to secure financing, may affect share value.||Share value closely correlated to overall stock market fluctuations.||Not directly correlated to stock market. Usually invested in specific properties subject to local economy and real estate risk.|
|Registered investment?||Regulated by FINRA and SEC||Regulated by FINRA and SEC||Not subject to regulation; investor needs to carefully perform due diligence|
|Organization Structure||Typically organized as a trust or LLC||Pools of property owned by the fund’s investors and professionally managed by a fund manager||Private trust|
|Subject to IRS regulations?||Yes, must distribute at least 90% of its taxable income to shareholders annually.||Yes, must distribute at least 90% of its taxable income to shareholders annually.||Not subject to SEC registration.|
All real estate investments, including REITs to a varying degree, carry risks that are unique to owning and managing a physical property. Just like owning real estate properties directly, a REIT’s performance is linked to the risks inherent in the specific properties it holds and the real estate market as a whole. Factors that can weaken the REIT’s operational profits and investor payouts include:
- A downturn in the economic conditions of the location of the real estate
- Delays in filling vacancies
- National disasters (hurricanes, floods, earthquakes, etc.)
- Unanticipated repair costs
- Changes in interest rates and the availability of financing
- Housing bubbles and other fluctuations that affect the ability to buy and sell property at attractive prices
- Legal changes in the real estate industry, property taxes, and environmental and zoning laws
Even if a REIT is not publicly-traded, disruptions in the financial markets and uncertain economic conditions can affect rental rates, real estate values and the REIT’s ability to secure financing, pay debt obligations and/or pay distributions to investors.
Why Consider REITs?
Annual dividends — REIT shareholders collect ongoing dividend income in addition to having the opportunity for capital appreciation of their shares. Of course, like dividends from stocks, the payment of dividends is not guaranteed. There is also no guarantee profits will be earned by your investment.
High yields — Investors are attracted to REITs because of the promised high yields, and many deliver.
Distributions are required — A REIT is required to distribute 90% of its annual profit to shareholders as dividends. That’s why many offer hefty dividend yields that surpass anything you’ll get in the S&P 500.
Diversification — Diversification into different asset classes has been a key strategy of successful investors for many decades. Real estate is an asset class often missed by investors — many financial professionals focus on selling what they know best: market-traded stocks and bonds.
No-hassle real estate investing — REITs provide a way for individual investors to earn a share of the income produced through real estate ownership — without having to go out and buy real estate. Publicly traded REITs make investing in real estate as easy as buying a mutual fund.
Capital appreciation — In addition to paying regular dividends, investors can benefit from the capital appreciation of the REITs holdings.
Why Not to Buy REITs
High investment costs — As you can see in the chart above, higher yields can come with a higher expense. Typically REITs charge front-end load and ongoing investment fees. It’s important to do a cost-benefit analysis as part of your due diligence.
Lack of liquidity — Real estate should never be considered a liquid investment. While the structure of publicly traded REITs makes it possible to buy and sell often, doing so undermines many of the reasons investors diversify by adding real estate holdings to their portfolios. And there’s typically a fee associated with share redemption, a “liquidity premium.”
Dividend distributions may come from other investors — Unlike most publicly traded REITs, non-traded REITs frequently pay distributions in excess of their operating income. This “extra” comes from new investor money, which prompted FINRA to issue a warning a few years ago: “[T]he periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal.” Perhaps you’re reminded of the Ponzi scheme run by Bernie Madoff?
Distributing this cash to existing shareholders reduces the cash available to the company to acquire and manage more properties and take advantage of deals that arise in the marketplace. This practice can also reduce the value of the shares.
Tax considerations — Most REITs pay out 90% of their taxable income to shareholders. You, as a shareholder, are responsible for paying taxes on the dividends and any capital gains received in the year you receive the distributions.
Lack of control — Buying REIT shares means investing in an entity’s broader investment strategy. As an individual investor, you have no control over the individual assets that are bought and sold.
Unintended risk — Some REITs have vast real estate portfolios that include properties in both the U.S. and other countries, such as China and Brazil. This can create the unintended consequence of additional risk, including geopolitical, exchange rate and economic shifts of foreign markets.
Should You Own REITs?
Deciding to invest in a REIT — and choosing what kind and type of REIT is right for you — is as much a personal decision as deciding which dividend-paying stocks you’d like to buy and hold for the long term.
I have my own biases that lead me to invest directly in rental properties and fix-and-flips rather than through a REIT or crowdfunding. Of course, investing directly involves learning the real estate business, learning the specifics of the location where you’ll be holding your properties, negotiating and dealing with third parties such as tenants, property managers contractors, banks, title companies and real estate agents, paying property taxes, keeping track of depreciation, and a longer list of hands-on tasks. I find it fun and challenging, but a lot of investors prefer to invest passively and avoid the hassles — and potential headaches — of directly owning property.
If you invest in a REIT, a lot of these headaches go away. For that reason, REITs are sometimes touted as the real estate cure-all by financial managers and brokers. However, many of the advantages of adding real estate to your investing portfolio disappear when you own shares of a REIT instead of holding real estate directly.
You’ve heard it said, and you’ve read it many times: You should always read the prospectus before buying individual stocks or mutual funds. With REITs, you also need to review the offering documents carefully. You want to understand the intended diversification of the REIT’s portfolio and read ongoing disclosure statements to see how well the REIT is executing its business plan.
You also want to understand the nuances and risks associated with the types of properties held by the REIT you’re considering. There are geographical nuances — a shopping mall in California will have different risk factors than a shopping mall in North Carolina. Also, different types of properties have different risk concerns — for example, a hotel chain is very different from a chain of Jiffy Lubes or personal storage units.
If you do decide to invest in real estate using REITs, you need to consider diversifying between the kinds and types of REITs available to you. Putting all of your real estate investments into one REIT will inevitably result in the under-diversification of your assets.