What Are the Risks of Investing in REITs?

Real estate investment trusts (REITs) have the potential to provide investors with steady income through dividends. This is because they are legally required to distribute a significant portion of their taxable income to shareholders. However, like all other financial investments, REITs have their own risks that investors should consider before committing their funds. If you are considering an investment in REITs, be sure to weigh both the pros and cons so you can decide whether this type of real estate investment aligns with your overall financial goals and risk tolerance.

If you want to build a real estate portfolio, a financial advisor can help you analyze and manage investments.

What Are REITs?

Real estate investment trusts (REITs) own, operate or finance income-producing real estate. They allow individual investors to invest in large-scale, income-generating real estate without having to buy, manage or finance these properties themselves.

REITs generate revenue primarily by leasing space and collecting rent on the properties they own, which can include commercial properties, residential buildings or industrial facilities. Investors purchase shares in a REIT, and in return, they receive a portion of the income produced by the underlying properties.

Because REITs are typically traded on major stock exchanges, they offer liquidity while giving investors the opportunity to diversify their portfolios beyond traditional stocks and bonds.

There are several types of REITs that investors can use to diversify their portfolio within the real estate market.

Equity REITs: Equity REITs are the most common type of REITs. They involve owning and operating income-generating properties, with revenue earned primarily from leasing space and collecting rent.
Mortgage REITs: Mortgage REITs (mREITs) offer financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities. Their income is derived from the interest on these financial instruments.
Hybrid REITs: Hybrid REITs combine the characteristics of both equity and mortgage REITs, investing in both properties and mortgages. This diversification can offer investors a balanced exposure to real estate.
Public REITs: Public REITs are listed on stock exchanges and can be bought and sold like stocks. They offer high liquidity and transparency.
Public non-traded REITs: Non-traded REITs are registered with the SEC but are not listed on stock exchanges, making them less liquid but often more stable.
Private REITs: Private REITs are not registered with the Securities and Exchange Commission (SEC) and are not publicly traded. They are typically offered to institutional investors and accredited individuals.

Why Not to Invest in REITs

While REITs can offer significant benefits, there are several reasons why not to invest in REITS.

Inconsistent, variable returns. REITs can be subject to fluctuations in the real estate market, leading to inconsistent returns. Factors like economic recessions, interest rate changes and shifts in property values can all impact the performance of REITs, making their returns variable and sometimes unpredictable.
Sensitive interest rates. REITs are highly susceptible to changes in interest rates. When interest rates rise, the cost of borrowing increases for REITs. This can reduce profitability and lead to lower dividend payouts. Higher interest rates can also make REITs less attractive compared to other income-generating investments, such as bonds.
Taxed as ordinary income. Dividends from REITs are typically taxed as ordinary income, which can result in a higher tax burden for investors, especially those in higher tax brackets. Unlike qualified dividends that are taxed at a lower rate, REIT dividends do not benefit from favorable tax treatment. However, the Tax Cuts and Jobs Act (TCJA) allows you to deduct 20% of REIT dividends through 2025.
Fees. REITs, especially non-traded ones, can have high fees associated with them, including management fees, acquisition fees and transaction fees. These costs can eat into returns and make REITs less attractive to cost-conscious investors.
Not always liquid. While publicly traded REITs offer liquidity, non-traded and private REITs can be challenging to sell, particularly if the real estate market is sluggish. This lack of liquidity can be a significant disadvantage for investors who may need to access their funds quickly.
Long-term commitment. Investing in REITs often requires a long-term commitment, particularly for non-traded and private REITs. These investments are not suited for those looking for short-term gains, as they typically require holding periods of several years to realize their full potential.
Low growth potential. Compared to other investment options, REITs may offer lower growth potential. Because they are required to distribute a large portion of their income as dividends, they may reinvest less in expanding their portfolio or enhancing their properties, limiting their ability to grow.
Requiring the right management. The success of a REIT is heavily dependent on the management team’s ability to effectively operate the properties and make sound investment decisions. Poor management can lead to underperforming assets, lower dividends and ultimately, diminished returns.
Less ideal for experienced investors. Experienced investors who seek high returns or are comfortable with more complex investment strategies may find REITs less appealing. The relatively stable, income-focused nature of REITs might not align with their more aggressive investment goals.

Alternatives to Investing in REITs

Real estate investors meeting with a financial advisor to review their portfolio.

If you determine that REITs are not the right for your portfolio, these five alternatives may be a better choice.

Real estate syndications. Real estate syndications involve pooling resources with other investors to acquire and manage large real estate projects. This option allows investors to access larger, potentially more profitable properties without directly managing them.
Private equity real estate. Private equity real estate involves investing in private real estate funds that buy, manage and sell properties. These funds often target higher returns but come with higher risk and longer investment horizons.
Direct real estate ownership. For those willing to take on the responsibilities of property management, a direct real estate investment can offer control over investment decisions with the potential for substantial appreciation and income generation.
Real estate crowdfunding. Crowdfunding platforms allow investors to pool small amounts of capital to invest in real estate projects. This option offers diversification and the potential for higher returns, although it may also come with higher risks and less liquidity.
Real estate mutual funds. These funds invest in a diversified portfolio of real estate-related securities, including REITs but may also include stocks of companies in related industries. They offer professional management and diversification across several types of real estate investments.

How to Evaluate a REIT Before Investing

Before investing in a REIT, it is essential to understand the quality of the assets it holds, how well it is managed and its overall financial health. While REITs can offer an attractive stream of income, not all REITs are created equal.

Evaluating certain key metrics can help you identify which REITs are most likely to deliver steady returns while managing risk effectively.

Funds From Operations (FFO) and Adjusted FFO (AFFO)

Funds From Operations (FFO) is a widely used metric to gauge a REIT’s operating performance. It starts with net income and adds back depreciation and amortization, which can distort profitability in real estate. Adjusted FFO (AFFO) goes a step further by subtracting recurring capital expenditures, offering a clearer picture of how much income is available to distribute as dividends.

Be sure to look for REITs with consistently strong and growing FFO and AFFO.

Dividend Yield and Payout Ratio

Since REITs are required to distribute at least 90% of taxable income to shareholders, dividend yield is a crucial consideration. Compare a REIT’s yield to its peers, but do not chase high yields blindly—excessively high yields may signal financial distress. The payout ratio (dividends as a percentage of FFO or AFFO) can indicate how sustainable the dividends are over time.

Debt Levels and Interest Coverage

Real estate is capital-intensive, and REITs often carry significant debt. Look at the REIT’s debt-to-equity ratio or debt-to-assets ratio to understand its leverage. A lower ratio suggests more conservative financing.

Also, check the interest coverage ratio to see if the REIT comfortably earns enough to pay its debt obligations. This is calculated by taking the Earnings Before Interest and Taxes (EBIT) or Earnings Before Interest, Taxes, Depreciation and Amorization (EBITDA) and dividing it by the interest expense.

Occupancy Rates and Lease Terms

A high occupancy rate indicates strong demand for the REIT’s properties and stable cash flow. Additionally, review the average lease term remaining, as longer leases with quality tenants will likely offer more predictable income.

Property and Tenant Diversification

Diversification across property types (e.g., office, residential, industrial), geographic regions and tenants helps reduce risk. A REIT overly reliant on a single industry, region or tenant may be more vulnerable to market downturns or disruptions.

Type of Real Estate Assets Held

Understand what kind of real estate the REIT owns and whether it aligns with your investment goals. For example, retail and office REITs may face more risk in changing economic environments, while industrial or data center REITs might benefit from long-term secular trends, such as e-commerce and cloud computing.

Research Public Disclosures

Before investing, review the REIT’s annual report, investor presentations and SEC filings like the Form 10-K. These documents contain critical insights into financial performance, management strategy, risk factors and property portfolios. The Management Discussion and Analysis (MD&A) section of the 10-K can be particularly useful in understanding how the REIT views its own outlook.

Bottom Line

A financial advisor explaining the benefits and risks of investing in different types of REITs.

REITs can help investors gain exposure to real estate without directly owning property, but they also carry some drawbacks and risks. Be sure to consider the reasons why not to invest in REITs, such as variable returns, sensitivity to interest rates and high fees that can all make REITs less attractive to certain investors. The tax implications and long-term commitment can also be deterrents for those seeking more flexible or higher-growth investment opportunities.

Before deciding whether an REIT is right for you, talk to a financial advisor who can help you create a custom investment strategy based on your long-term financial goals.

Tips for Real Estate Investing

A financial advisor can help you build a real estate portfolio that fits your goals and level of risk. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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