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Invest in REITs for Passive Income?
Here are the Pros and Cons
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1,257 Words | 4 Min 27 Sec Read
Welcome to another issue of Passionate Income.
Today we’ll be discussing Real Estate Investment Trusts (REITs).
In particular, the Pros and Cons of REITS and why - despite the potential for generating passive income - they might not be a such a good idea.
Let’s dive in.
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In investing seminars across the country, it's said:
"Real Estate has created more millionaires than industry on earth."
While it's hard to say if that statement is factually accurate, it's probably not that far off. As an example, my grandfather retired with over $2M in RE properties, $10,000+ per month in passive income and well over $1M in cash.
All this despite him running a gardening company and being illiterate.
And that's just one example.
On a decades long timeline, there are countless stories of homeowners and landlords who've reaped over $1M in equity from their homes/properties.
But as you likely know, home prices in the US are at an all-time high, making it difficult for someone with an average wage to buy their first home (let alone an investment property).
Are there ways to invest by raising capital from investors?
Yes. But we're not going to go there today.
Instead, we'll be discussing a much more affordable way to tap into real estate appreciation without having to raise capital or buy any properties yourself.
How?
By investing into what's known as a Real Estate Investment Trust (aka REIT).
How do they work?
REITs (Real Estate Investment Trusts) operate by pooling funds from multiple investors to buy, manage and sell income-producing RE properties.
When you invest in a REIT, you buy shares of the holding company, much like buying stock. And because those shares trade on major stock exchanges, they're easy to buy and sell.
Except unlike an equity share, the REIT's valuation is not based on predictions regarding the holding company's future revenues. Instead, it's tied to the company's Net Asset Value (NAV), which without getting technical, represents the total value of the holding company's assets (properties) minus its liabilities.
The reason NAV matters is because it helps investors assess whether a REIT is overvalued (or undervalued) compared to the company's holdings.
Which, in turn, helps investors determine whether the price of the REIT is fair, overpriced or a bargain relative to the underlying real estate.
Like any investment, REITs have their pros and cons.
So in today's issue, we'll dive into both sides to help you decide if investing in REITs is the right move for you.
Pros of Investing in REITs
First and foremost, one of the biggest benefits of REITs is that they provide a way to earn passive income.
Mainly because REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. Most of which are paid out on a quarterly basis, allowing investors to cash them out or reinvest and compound them.
Another advantage is how accessible REITs are.
With just a few hundred dollars, you can buy shares of a REIT and start earning income immediately. And because of that, REITs could be a good option for anyone who wants to diversify their investment portfolio (or get exposure to real estate) without having to invest 5-6 figures upfront.
Third, REITs are highly liquid.
Unlike actual real estate, which can take months to sell, shares of these holding companies trade like stocks. Admittedly, people don't day trade REITs the same way they do equities. But generally speaking, you can buy in and cash out on a moment's notice.
Fourth, REITs can benefit from inefficient home valuations in the short term.
For example, during market downturns, REITs might be undervalued, presenting a buying opportunity for savvy investors who recognize their long-term potential.
Lastly, REITs provide exposure to the real estate market without the need to manage properties. Because they trade like stock shares, owners don't have to deal with tenants, squatters, maintenance or property taxes.
Instead, a management team from the holding company takes care of all those headaches for you as part of the management fee they charge.
Sounds like a great deal right?
Like an awesome way to get exposure to real estate without all the headaches and upfront costs?
Well, as it turns out, REITs are arguably one of the worst ways to get exposure to real estate. And here's why.
Cons of Investing in REITs
One significant downside is their sensitivity to interest rates.
When interest rates rise, REIT prices often fall. Mainly because higher interest rates make other income-generating investments (e.g. Treasuries or Bonds) more attractive (thereby reducing demand).
Another con is the potential for market volatility.
While REITs are for the most part stable, they can be affected by broader economic trends. For example, a downturn in the real estate market can negatively impact REIT prices (given how share price are tied to NAV).
REITs also come with fees.
Examples include management fees, transaction fees, and other costs that can eat into your returns. Combine fees with a share price decrease and whatever passive income you generated for the year can quickly disappear.
Additionally, while the dividends from REITs are attractive, they're taxed as earned income. This is one huge drawback relative to stocks or actual real estate, both of which are taxed at capital gains rates as long they're held for 365 days or longer.
Along the same lines, if you have big money invested in a REIT, the higher tax brackets you'd be exposed to can significantly reduce your net ROI.
Lastly, the performance of a REIT depends heavily on the management team.
Poor management decisions can negatively impact the REIT’s performance (e.g. investing in a bad city where prices are declining would lead to a decrease in NAV).
Meaning, it's crucial to research and choose REITs managed by experienced and reputable teams.
Final Thoughts
In conclusion, if you're considering investing into a REIT, you're probably not considering becoming a landlord. And vice versa.
While REITs give you exposure to real estate in a literal sense, fees, sensitivity to interest rates and the fact they trade like stocks make them a totally different investment vehicle when compared to renting out properties.
But if you don't have the capital to become a landlord, have zero interest in managing tenants, or live overseas and want exposure to US RE, REITs can be a great option.
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💡 Takeaway: Like any investment, REITs have their Pros and Cons. Before moving forward, make sure to do deep research into both horror stories and success stories. And choose your holding company wisely.
🎁 Resources:
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