How Risky are REITs?
By: Olivia Faucher,
How Risky are REITs? An investor rightly may ask that question and this article is intended to provide important insights to prospective investors in real estate investment trusts (REITs).
REITs are unique investments that offer a convenient way for investors to gain exposure to real estate markets, to diversify their portfolios and to earn income. Keep reading to learn about the returns of REITs and the risk of such investments.
How Risky are REITs? REIT Defined
A REIT is a company that owns, operates, or finances income-producing real estate. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.
Generally, REITs follow a simple business model: the company buys or develops properties and then leases them out to collect rent as its primary source of income. However, some REITs do not own any property, choosing instead to finance real estate transactions. These REITs generate income from the interest on the financing.
Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors further can buy publicly traded REIT shares on major stock exchanges such as the NYSE or NASDAQ.
How Risky are REITs? Key Risks Associated with REITs
Like any investment, REITs are faced with a unique set of potential risks. These risks can be highly impactful on the returns that investors will obtain.
REITs are subject to market risk, which is arguably the most prevalent challenge for REIT performance. Fluctuations in interest rates and recessions are common causes for market risk. Rising interest rates create unfavorable economic conditions for REITs, which can become volatile when there are changes in interest rates.
In addition to market risk, REITs face the risk of having an overleveraged balance sheet. REITs commonly borrow money to buy more properties to expand their portfolios. REITs also may rely heavily on debt to have more money available to invest in new properties. REITs that constantly take on more debt may end up in a position where liabilities are far greater than assets, and the company may experience financial distress.
REITs also face property-specific risks. REITs that only hold one type of property may face serious financial distress if an event occurs that decreases the demand for such property. For example, office REITs have taken a hit throughout the Covid-19 pandemic, as long-term work from home policies have diminished the need for leasing office space and some tenants have stopped paying their rent, asked for rent relief, or have gone out of business. Some types of properties are very economically sensitive, while others are regarded as recession-resistant.
How Risky are REITs? REIT Returns: Best in the Long Term
REITs may appear volatile and risky from a short-term perspective, but the long-term returns of REITs are impressive. When looking at five to ten year time frames, it is common to see that stocks outperform REITs, even if it is by a relatively small margin. However, when taking 20 or more years into account, REITs routinely provide better returns than stocks. The longer REIT investments are held for, the more likely it is that they will provide better returns relative to stocks.
The following chart outlines the comparison between stocks and REITs in terms of returns.
The chart clearly demonstrates that REITs do not begin to perform better than stocks until 20 or more years are taken into account.
|TIME PERIOD||S&P 500 (TOTAL ANNUAL RETURN)||FTSE NAREIT ALL EQUITY REITS (TOTAL ANNUAL RETURN)|
|The last 25 years||11.9%||12.6%|
|The last 20 years||7.7%||13.3%|
|The last 10 years||14.2%||13.2%|
|The last 5 years||12.5%||9.0%|
*1972 was the first year that NAREIT began keeping track of REIT return data
Data Source: NAREIT and Slickcharts
Evidently, REITs provide the best returns when they are held onto as a long-term investment. This is important for potential investors to keep in mind.
However, it is important to note that the above comparison takes into account a broad range of stocks and a broad range of REITs. Individual investors may obtain different results depending on which specific stocks and REITs they hold.
Based on historical data, it can be said that it is likely that REITs will outperform stocks over long periods of time, especially lengths of time that exceed 20 years. Before the 20 year mark, stocks may perform better, although both investments could provide relatively similar returns.
How Risky are REITs? How Do REITs Impact Investment Portfolios?
REITs typically do not have a strong correlation to other sectors of the market, and their performance is generally expected to deviate from the major stock indices. Between 1994 and 2018, the correlation between REITs and stocks was 0.45.
Real estate provides great diversification because it is a distinct asset class which does not have a strong correlation with other industries within the stock market. Historically, REIT performance tends to go up when other assets go down and vice versa. This makes REITs a powerful tool for hedging.
REITs can reduce the overall volatility of an investors’ portfolio while increasing its yield at the same time. Plus, REITs may also do better than other investments during periods of inflation because real estate prices typically rise with inflation.
How to Invest in REITs
Investors can easily buy shares in a REIT the same way any other public stock is purchased. REIT shares are bought and sold on major public stock exchanges. Investors also can invest in a REIT mutual fund or a REIT ETF, through the investor would be buying a collection of shares in an entire index of REITs.
These different investment approaches are referred to as passive versus active REIT investing. The passive approach invests in a REIT mutual fund or REIT ETF. The active approach involves doing research, picking specific REITs to invest in and building an individual portfolio of REITs.
The passive and active investment approaches have different levels of risk associated with them. For example, an investor who is hesitant about investing in REITs and wants to minimize risk may opt to invest in a REIT mutual fund or ETF because the diversification of those options can be safer. The active investing approach comes with more risk, but has the potential to give greater returns.
The Bottom Line
REITs provide multiple unique benefits and they have the potential to greatly enhance investment portfolios. However, different REIT investments come along with varying degrees of risk.
How Risky are REITs? Individual investors should decide how much risk they are comfortable with, do research and invest accordingly.
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Olivia Faucher is an editorial intern with Eagle Financial Publications.