Risks of Investing in REITs
By: Olivia Faucher,
Risks of investing in REITs gives potential investors an overview of the dangers of such investments.
The biggest risks associated with real estate investment trusts (REITs) are over-leveraged balance sheets, market risk, declining property values and property specific pitfalls. Gain further guidance about these key risks of investing in REITs by reading below.
Risks of Investing in REITs: An Introduction
A REIT is a company that owns, operates, or finances real estate to produce income.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 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 the alternate route of financing 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 can buy REIT shares on major public stock exchanges such as the NYSE or NASDAQ.
Like every investment, REITs come along with their own individual risk factors. The most prevalent risk factors are discussed below.
Risks of Investing in REITs: Over-Leveraged Balance Sheets
REITs are required to pay out 90% of taxable income to shareholders. Therefore, the company is generally only left with 10% of its income to reinvest into the core business each year. Because of this, REITs may rely heavily to have more money available to invest in new properties. Many REIT managers choose to add leverage (take on debt) to expand the number of properties owned in the portfolio.
If a REIT is constantly borrowing money in order to buy new properties, the company may find itself in a position where its liabilities are far greater than its assets. It is important to note that REITs can be expected to have some level of leverage on their balance sheets, however there are scenarios where REITs become overleveraged to a financially unhealthy amount.
Many REITs have strong balance sheets, but their managers still seek to maintain a healthy amount of leverage to maximize the production of income from the properties. Investors should pay attention to the leverage on a REIT’s balance sheet when deciding where to invest because not all REITs have healthy leverage.
Risks of Investing in REITs: Market Risk
REITs are traded on public exchanges, and are therefore subject to market risk. Causes of market risk include changes in interest rates, inflation and recessions.
REITs are usually highly sensitive to fluctuations in interest rates. High interest rates are bad for REITs in more ways than one. Given the REIT business model, and the fact that REIT growth generally stems from raising debt or issuing stock, higher interest rates imply that REITs will face higher borrowing costs. Additionally, rising interest rates can affect property values. Changes in interest rates can make REITs volatile in the short term.
Recessions also can be highly influential for REIT performance. Certain types of properties are more susceptible to the effects of recessions than others. For example, health care REITs generally perform well during recessions because people still prioritize their health and use health care services. On the other hand, hotel REITs underperform during recessions because people cut back on leisure travel in order to save money.
Risks of Investing in REITs: Declining Property Values
Real estate does not always go up in value. Potential REIT investors face the risk that they may choose the wrong REIT and not gain any notable returns. When choosing where to invest, it is important to consider property types, geographical location and the growth prospects of different REIT sectors.
Risks of Investing in REITs: Property-Specific Risks
There are also property-specific risks associated with REITs. Since many REITs may only hold one type of property, they may face serious financial distress if an event occurs that decreases the demand for such property.
For example, office REITs have taken a considerable hit throughout the COVID-19 pandemic, as long-term work from home policies have diminished the need for 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. Individual investors must decide what level of risk they are willing to take on, and research which types of properties fit those risk preferences. Click here to learn more about the various types of REIT properties and risks associated with each type.
The Bottom Line
REITs face key risks that are important for investors to be aware of, however these risks should not scare potential investors away. REITs also come with their fair share of advantages that other investments do not provide. REITs are a unique investment, so it is crucial for potential investors to do their research. Use the links below to conduct further research about REITs.
Olivia Faucher is an editorial intern with Eagle Financial Publications.