Should you invest in real estate investment trusts?

If you've been thinking seriously about your investments, you've probably heard about opportunities to add real estate to your portfolio. While this addition can be valuable from a diversification standpoint, not everyone can afford the initial costs or deal with the required maintenance.

Real estate investment trusts, or REITs, provide a useful entry to real estate investing. Because they allow for partial ownership and multiple holdings to distribute risk, they can help you achieve strong returns while potentially being better suited to your needs and goals than traditional real estate investments.

What are REITs?

Real estate investment trusts are companies that develop and run income-producing properties. Examples of these properties include apartment complexes, strip malls, storage facilities and hotels. The REIT develops and maintains the property to earn from it, as opposed to selling it for a profit.

There are two types of REITs: an equity REIT and a mortgage REIT. The former refers to a trust that owns physical properties. A mortgage REIT invests in mortgages or mortgage-backed securities, or it loans money to real estate developers. Mortgage REITs are less common than equity REITs. You can also invest in hybrid REITs, which combine both equity and mortgage assets, though these are also less common than equity REITs.

How do REITs work?

When you invest in a REIT, you're entitled to a percentage of the profits generated by the property. The advantage of investing in a REIT, especially if you're in a lucrative market, is that you can diversify your portfolio without having to buy any properties yourself.

There are a couple ways you can buy into REITs. One is to hand-select the REITs you want to invest in. The other option is to invest in an exchange-traded fund, or ETF, that has numerous REITs in its portfolio. You get to take advantage of the ETF's diversification without needing to choose real estate projects on your own.

Pros and cons of REITs

Why are REITs attractive to investors?

• Ease of investing: When you invest in a REIT, you buy a certain share in the property, and you don't have to worry about paying maintenance expenses or taking care of the building. You earn on it without putting in the work that would be required if you purchased a rental property on your own.
• Cost: Buying residential or commercial real estate as an individual can be quite costly, since it includes the purchase price plus taxes, management and upkeep expenses. With a REIT, on the other hand, you may be able to buy into the property or portfolio for a few thousand dollars. It's important to keep in mind that some REITs may require a minimum investment.
• Diversification: Investing in real estate can be a great way to diversify your portfolio, especially if you own shares in several different projects.
• Strong returns: REIT owners must pay 90% of the trust's taxable income as dividends to shareholders, which is good news for investors. Perhaps more significantly, REITs have outperformed stocks and bonds in many cases during the past several decades, making them even more attractive.

Why are REITs not for everyone?

• Sensitivity to federal interest rates: If the Federal Reserve raises interest rates, that could detract from profits, and therefore from what you earn as a shareholder. Like bonds, as interest rates go up, prices often go down, because buyers are able to find higher producing equivalents in the marketplace. Vice versa, as interest rates decline, prices often go up, because buyers often pay a premium for a higher-yielding asset.
• Changes based on real estate trends and occupancy: Your REIT returns could shrink if the local market changes and the companies struggle to keep their buildings occupied. In a renter's market, REITs may need to adjust their prices to maintain their occupancy rates, which will also affect your profits.
• Variations in transparency and liquidity: Publicly traded REITs tend to be more easily liquefied, and their value is more transparent. A non-traded REIT may not disclose its value for some time after you've invested, which you may not be comfortable with if you're eager to follow your potential earnings and the performance of your investments. Liquidity often drives price fluctuations, because lower trading volumes can mean greater variation between buy and sell prices.

Are REITs right for you?

Real estate investment trusts can be a valuable investment, although you have to consider your priorities and investing style. Would you prefer to be more hands-on with a real estate investment? Are you comfortable with the possibility of not being able to sell your assets quickly? A trusted financial advisor can help you think through the pros and cons to determine whether REITs are a fit for your portfolio.