Real Estate Investment Trusts (REITs): Pros and cons

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Could a Real Estate Investment Trust be a useful addition to your investment portfolio? We explore answers to this question and more.

Real estate can be an attractive investment, but it can also be one of the more expensive types of investments to choose.

“An investor might think, ‘You know, I’ve always wanted to own an apartment complex as an investment that generates extra income,’” says John LaForge, head of real asset strategy at Wells Fargo Investment Institute. “But individual investors may have a difficult time getting a loan on such a big property.”

This is where Real Estate Investment Trusts (REITs) come into play. REITs can be purchased like stocks, and they pay investors regular dividends that can serve as income. “REITs are kind of a hybrid of stocks and bonds,” LaForge says. “They have some stock qualities and they trade like a stock, and then they have some income qualities, more like a bond. So adding them to a portfolio can often help diversify your investments.”

In this Q&A, LaForge answers five common questions about REITs to help you weigh the benefits and risks so you can decide if they’re the right fit for your portfolio.

What are REITs?

“A Real Estate Investment Trust (REIT) is a company that owns a number of real estate properties and packages them into a security that you, as an investor, can buy into,” explains LaForge. “It’s packaged so that you can purchase shares of real estate much like you would a public company’s stock. It’s a popular way for investors, especially small- to medium-size investors, to invest in various kinds of real estate to produce income.” Different REITs bundle different types of real estate—everything from apartments and senior care facilities to cell phone towers and industrial warehouses—all over the country.

“There are two main qualifications a company needs to meet to be classified as a REIT,” continues LaForge. “Number one, at least 75% of the business must be involved in real estate. That means they essentially buy and maintain real estate, collect rents, and such. The second qualification: Once they collect those rents, 90% of that income has to be passed on to shareholders.”

What are potential benefits of including REITs in your portfolio?

LaForge says that one of the greatest potential advantages of investing in REITs is easily overlooked: “These trusts are managed by people who know real estate potential, and you get access to their expertise,” he explains.

Secondly, because the trusts pool money from many other investors, REITs have access to a lot of capital to invest in the best properties—properties that would otherwise be out of reach for many individual investors.

And then there’s the income currently they provide (at the time of this publication). “Your average REIT currently pays about a 4% dividend yield,” LaForge says, “which today is anywhere between two and three times what a 10-year government bond is paying. REITs can be a way to diversify your income, particularly when bond yields are low.”

How can you find a good-quality REIT?

There’s a lot that goes into determination, LaForge says. But two key numbers to explore are the dividend yield and the REIT’s price change over time.

“Typically, the REITs with the highest dividend yield are, on average, weaker financially,” LaForge says. “The high yield is there to attract investors, because the REIT needs that capital. The true quality REIT that has great management and great properties typically has a lot of very interested investors, which drives down the dividend yield. In other words, many times the REITs with the lowest dividend yields are the highest quality.”

While it might make REITs seem less beneficial if the highest-quality options pay the lowest dividends, it’s important to remember that a REIT trades like a stock, so the price has the potential to appreciate over time. “Over the long term, the price appreciation of a quality REIT tends to beat out any REIT that has a high dividend,” LaForge says.

What are the income tax implications of REITs?

“When you get your REIT’s dividend payment, it can come in the form of ordinary income, capital gains, or even a return of capital, and that will show up on the 1099 that you get for your tax preparations,” LaForge says. “Usually, that income’s taxed at the individual level, at the marginal tax rate. So if you have a very high tax rate as an investor, you will want to talk to your accountant or tax advisor about the impact of investing in REITs. You might get a 4% yield in a REIT, but by the time you’re done paying your 40% tax—if that’s what your marginal tax rate is—you might have been better off owning a municipal bond that’s tax-free.”

What risks are associated with REITs?

The greatest investment risks with REITs tend to be related to the economy, LaForge says. “There is always a chance in a recession that the REIT has properties that aren’t doing well.”

Another consideration is related to increases in interest rates. “If interest rates rise and your government bond goes from 1.5% to 3%, an investor may look at their REIT paying 4% and say, ‘Maybe it’s not worth it anymore,’ because the government bond is considered lower risk than that REIT. It causes a crowding-out effect, where the increase in interest rates takes money flow and capital away from the REITs.”

LaForge also points to potential changes in the tax code that could come into effect in 2022. “There is some discussion about doing away with the 1031 exchange, which allows the seller of a piece of real estate to defer the tax on the profit if that profit is used to purchase a new piece of real estate,” LaForge says. “This is what a lot of real estate investors do—they take the full profit on a property and roll it into the next property. If that 1031 exchange is taken away, it could take away a big advantage for those who want to invest in real estate.” This change could impact the performance of certain REITs.

While it’s worth being aware of the potential changes to the 1031 exchange, LaForge points out that similar attempts to change the 1031 exchange have never really gained traction. “In my years of investing, I’ve seen similar proposals at least five times, and they haven’t succeeded,” he says. “Still, there is a risk—we just don’t know.”

Wells Fargo Advisors and its affiliates do not provide tax or legal advice.

Wells Fargo Investment Institute, Inc., is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Risk Disclosures:

Different investments offer different levels of potential return and market risk. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Dividends paid by REITs are considered non-qualified and generally taxed at ordinary income tax rates. However, all or a portion of a distribution may consist of a return of capital. There is no guarantee that dividend payments will be made in the future.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.