In this article, learn about the different risk factors of investing in REITs. Real estate investment trusts (REITs) refer to investment equities that investors invest in to increase the returns on their portfolio. REITs own and manage various real estate properties such as residential apartments, office buildings, shopping malls, hotels, luxury resorts, etc. The law requires REITs to distribute at least 90% of their net revenues as dividends to shareholders.
REITs do not need to pay corporate income taxes like other public companies, and the revenue is only taxed at the shareholder level after shareholders have received their share of the revenues. As a result, REITs make a great investment opportunity for investors who are looking for a steady income and exposure to real estate properties. However, there are certain risk factors that are associated with REITs that investors should be aware of before putting their money in such companies.
REITs are investment equities that invest in real estate properties such as residential units, office buildings, industrial buildings, hotels, etc.
Compared to other investments such as stocks and bonds, REITs are subject to various risk factors that affect the investor’s returns.
Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.
Risks Associated with Investing in REITs
Investors should know the various risks associated with investing in REITs. When investing in REITs through a broker, the broker is required to disclose all the risks related to the REIT investment. Some of the risks associated with REITs include:
1. Liquidity risk
Although public REITs allow investors to sell their shares on the public exchange market, the investments are less liquid compared to other investments, such as bonds and stocks. There is no secondary market for finding buyers and sellers for the property, and liquidity is only provided through the fund’s repurchase offers.
Also, there is no guarantee that all the shareholders leaving their investments will be able to sell all or part of the shares they desire to sell in the quarterly repurchase offers. Due to this liquidity risk, investors may be unable to convert stocks into cash at the immediate time of need.
2. Leverage risk
Leverage risk arises when investors decide to use borrowed money to purchase securities. The use of leverage causes the REIT to incur additional expenses and increase the fund’s losses in case of underperformance of underlying investments.
The additional expenses of borrowing, i.e., interest payments and other fees incurred in connection with the borrowing will reduce the amount of money available for distribution to the company’s shareholders.
3. Market risk
Real estate investment trusts are traded on major stock exchanges and are subject to price movements in financial markets. This means that investors may receive less than what they originally paid for if they sell their shares in the public exchange.
Some of the causes of market risk may include recession, changes in interest rates, natural disasters, etc. When any of the causes occur, market risk tends to affect the entire financial market simultaneously and, therefore, difficult to eliminate through diversification.
Non-traded REITs carry a higher risk than public REITs because there is no public information that investors can use to research or determine their values. They are illiquid, and investors may not be able to access their funds for a predetermined period of time, sometimes up to seven years. Some non-traded REITs may allow investors to access their money after the first year, but it will come at a cost.
Another risk associated with investing in non-traded REITs is that there is no guarantee that investors will receive their dividend distributions, and if they do receive, it may be derived from sources other than the cash flow from business operations. These sources may include borrowings, sale of offerings, sale of assets, or even other investor’s money. Such sources decrease an investor’s interest.
Non-traded REITs are also subject to significant expenses and commissions that eat into the value of an investor’s stake. For example, REITs charge an upfront fee of 8%-10% or sometimes as high as 15%. Another cost is the external REIT manager’s fees that are paid to a third-party professional manager for managing the REIT’s portfolio of assets. The external manager’s fees include a flat fee and an incentive fee. The expenses reduce the returns that are available for distribution to shareholders.
Private REITs are not listed in the public exchange market and are exempted from registration with the Securities Exchange Commission. Therefore, they are not subject to the same regulations as public REITs and public non-traded REITs.
The lack of government regulation makes it difficult for investors to evaluate them since little to no information is available publicly. Also, they are not required to prepare audited financial statements.
Investors who have invested in REITs are required to declare dividend distributions received from REITs when filing taxes. Dividend distributions from the current or accumulated earnings are taxed as ordinary income, and they are taxed at the investor’s top marginal tax rate. Investors should be aware of these tax implications when investing in REITs since these reduce dividend earnings.