By Dr. James M. Dahle, WCI Founder
By Joe Dyton, WCI Contributor
Real estate investing has long been a popular solution for putting your dollars to work for you. While investing in real estate can be a good supplement to your retirement accounts and other investments, what happens if you don’t have the money to get started? Do you just have to save up until you have enough to buy your first investment property? You could take that route. Or you could explore real estate investment trusts, aka REITs.
A REIT allows you to be a real estate investor without putting out as much money as you would by purchasing a property outright, and it offers the opportunity for a good return on investment through dividends.
Keep reading to learn more about REITs, the pros and cons, the different types of REITs, and more.
What’s a REIT?
A REIT is a company that owns, operates, or finances income-generating real estate. When successful, REITs provide investors with various steady income streams, portfolio diversification, and long-term capital appreciation. REITs operate similarly to mutual funds, as they take money from various investors. This allows individuals to receive dividends from their real estate investments without having to finance or manage the property themselves.
Once upon a time, WCI wrote an article about private REITS. These are some of the favorite tools of salespeople masquerading as financial advisors (there's a reason they're called “brokers”). They would sell these investments with a promise of high income (8% yields were not uncommon). The value of these REITs was not marked to market. Although you knew you were getting that juicy 8% yield, you had no idea what the actual value of the investment was and, thus, you had no idea of what your total return was. These “investments” (scams would probably be a better description) had heavy front-loads (as high as 15%) and heavy ongoing fees. Primarily due to those fees—as well as similar abuses by management—the long-term returns were often terrible. It turned out a great deal of that juicy yield was really just returning principal to investors.
In contrast are the publicly traded REITS, which are marked to market thousands of times per day when the market is open. These “real estate flavored stocks” provide ready liquidity and transparency, and you can buy them without paying a load. You can also readily diversify at a very low cost by using a mutual fund such as the Vanguard REIT Index Fund.
That fund has a moderately high correlation (0.61 last I checked but it varies over time) with the overall stock market. Sometimes it zigs when the market zags, but sometimes it zags when the market zags. In fact, sometimes it zags really dramatically, like during the Global Financial Crisis when it lost 78% of its value from peak to trough. Since the purpose of diversifying into real estate is to get solid returns and low correlation with the other assets in the portfolio like stocks and bonds, that moderately high correlation turned off a lot of potential real estate investors.
In addition, REITs, by their very structure, are not particularly tax-efficient. By law, they are required to pay out 90% of their return every year to investors. Those distributions are generally fully taxable at your ordinary income tax rates. The investors don't get to benefit from depreciation and 1031 exchanges and the other benefits that direct real estate investors enjoy. High returns plus low tax efficiency meant that these assets really belonged only in the limited tax-protected investment space available to investors.
More information here:
How Do REITs Work?
Investors may buy shares in a REIT portfolio. A given portfolio could include hotels, commercial real estate properties, apartment buildings, healthcare facilities, offices, retail centers, and more. Typically, REITs operate in a specific part of the real estate industry (offices, healthcare, etc.). There are REITs that comprise various property types, however. Either way, a lot of REITs are publicly traded, and they can be bought and sold just like stocks and bonds.
REITs earn money through mortgages underlying real estate development or on rental incomes after the property is developed. The REIT takes its collected income and distributes it as dividends to investors. This is how REITs provide a potentially steady income source for their shareholders.
How to Invest in REITs
REITs can be purchased in a few different ways. Investors can buy shares of publicly traded REITs through their brokerage account, just as they would any other stock. Options include buying a diversified REIT or multiple REITs to have a well-rounded portfolio. Buying a REIT-focused mutual fund or Exchange Traded Fund (ETF) is another way to get involved. While more challenging, public, non-traded REITs can be acquired through financial advisors or real estate crowdfunding portals.
What Are the Different Types of REITs?
Having options is one of the benefits of investing in REITs. There are typically three primary REIT categories:
Publicly Traded REITs
These are found on major stock exchanges, and they can be easily purchased through a brokerage account, just like other stocks or bonds. The US Securities and Exchange Commission (SEC) regulates publicly traded REITs.
Public Non-Traded REITs
These REITs are also available to individual investors and are SEC-regulated, but they do not trade on stock exchanges. Instead, investors can purchase public non-traded REITs through a financial advisor or an online portal. Since they aren’t traded publicly, they are less liquid than their publicly traded counterparts but also not as vulnerable to market fluctuations.
Private Non-Traded REITs
This REIT classification is not available to the public, registered with the SEC, or traded on stock exchanges. Private REITs are primarily sold to high earners, high net worth individuals, or intuitional investors.
Additionally, REITs can be broken out in different subcategories. For example, equity REITs own and operate properties that generate revenue, such as apartment complexes and office buildings. Meanwhile, mortgage REITs offer financing for income-generating properties by acquiring mortgages and earning income from the interest on their investments. Hybrid REITs invest in a combination of the two real estate types.
More information here:
Investing in REITs—Pros and Cons
REIT investing sounds like a great opportunity. Buy into an established fund and earn a steady income through dividends without having to manage or finance a property. No investment is without its downside, however, and it’s important to recognize the good and the bad before parting with your hard-earned money.
Here are the benefits and disadvantages of investing in REITs:
The Pros of REITs
- Affordability/Accessibility: REITs make it possible for people who don’t have vast amounts of money saved for a down payment to still invest in real estate.
- Passive income stream: REITs pay out regular dividends to their shareholders. Investors gain an opportunity to enjoy the benefits of real estate investing without having to do much of the typical upfront work and maintenance.
- Easier access to funds: REITs offer a certain level of flexibility when it comes to accessing cash vs. owning a property outright. Investors can simply sell their REIT shares if they want or need cash quickly. If an investor had to sell an actual investment property to get their hands on cash, the process would be more difficult and take much longer.
- Diversification: Buying REIT shares helps keep an investor’s portfolio more diverse. Doing so also helps offset the risks that can come from other investment assets. Plus, REITs not only allow investors to diversify their overall portfolio but also their real estate holdings. Putting money into individual investment properties does not allow for as much diversification or flexibility that REITs offer.
The Cons of REITs
- Taxes: REIT dividends are great to receive, but they come at a cost in the form of taxes. The payout is tied to investors’ standard income tax rate, and taxes must be paid on the dividend income annually—even if the funds are reinvested. This differs from selling a stock after holding it for more than a year because the investor can save with the long-term capital gains tax rate, which is less than a typical income tax rate.
- Limited control: REITs cost less to buy into than acquiring an individual property, but investors also give up any say in how a REIT invests funds and what happens with the properties.
- Exposure to interest rates: A REITs’ value is tied to the real estate market. When rates go up, property demand could decrease—as would property values, which could hurt investments in the REIT.
Rise of the Crowdfunders
Technology has provided a way for many more investors to get involved in syndicated real estate through “crowdfunded” websites such as Equity Multiple, Fundrise, Realty Mogul, Crowd Street, AcreTrader (all affiliate links), and plenty of others. They all have a different focus. Some invest on the equity side, others invest on the debt side, and still others do both.
However, most of these sites, like most of the syndicated deals available before the existence of these sites, required investors to be accredited. That is, you have to be rich enough (and theoretically also sophisticated enough) that the SEC doesn't have to babysit their investing activities. In general, this meant liquid investments of more than $1 million or an income of over $200,000 ($300,000 married).
The real estate crowdfunding space became very crowded very quickly, and firms tried all kinds of ways to distinguish themselves from their competitors. One of the obvious ways to do that is to go after the non-accredited investors. Since an income of $200,000 gets you into the top 2% or 3% and an investable net worth of over $1 million gets you into the top 10% or so, it was obvious that the group of non-accredited investors was far larger than the accredited investors. Even if their average investment was smaller, the total amount of money to manage was still substantial. As they dissected the regulations, the sites realized one way they could bring crowdfunded investments to the masses was to form the investments into what are really privately traded REITs but which are different from your grandma's broker's REIT.
Some crowdfunded sites offer low minimums ($1,000), no loads, lower ongoing fees, and quarterly liquidity.
Should You Invest in a REIT?
Like with most investment opportunities—it depends. If you’ve wanted to invest in real estate but don’t have tens of thousands of dollars for a down payment on an investment property, REIT investing could be a great alternative. The same is true if you’re interested in real estate investing but not interested in purchasing, financing, and managing a property. REIT investing could also be good if you’re just looking to diversify your portfolio.
On the other hand, you must consider how comfortable you are with yielding control of your investment. After you buy shares of a REIT, you don’t have any say in how the properties in the trust are handled or if and when they are sold. If you want more of a voice in the matter, you may be better served looking into investing in your own real estate properties.
But what about private REITs?
While these properties are more diversified than just buying a few syndicated properties directly from crowdfunded sites, they are dramatically less diversified than buying the Vanguard REIT Index Fund. The Vanguard fund holds about 160 companies. The largest of those 160 companies could own hundreds of its owns properties. With one purchase, you will own a piece of tens of thousands of properties. You also give up significant liquidity with these online private REITs. You can sell that Vanguard REIT Index Fund in seconds any day the market is open. It could take you a full year to liquidate your private REIT holding, and that's after the mandatory one-year holding period and possibly two more years where a 1%-2% fee is assessed to early liquidators (adding up to four years). The management fees of the Vanguard fund are also 1/10th as large as those in these private REITs. Given those downsides, why would anyone buy into these online private REITs?
The main reason is because these online private REITS aren't buying the same properties that the larger, publicly traded REITS are buying. You're not going to find a big mall. It'd be more like some strip malls, a restaurant, and some single-family homes. The investments come from the same place as their other crowdfunded offerings, which are far more Main Street than Wall Street. So, it is a diversification play into a different aspect of the real estate market with smaller properties.
Accredited investors may turn up their noses at these online private REITs, but they are also eligible to invest directly with syndicators or through funds due to their ability to cough up the minimum investments of $50,000-$200,000. Non-accredited investors can't come up with those sums, and they are specifically excluded from those investments. It makes you wonder if Robert Kiyosaki was right when he said the wealthy get to invest in different investments than everyone else.
Critics say that only inexperienced or desperate real estate developers would go to a crowdfunded syndicator for funding, and thus their investments, whether in a REIT form or not, are inferior to those available to a more established syndicator. I suspect there is some truth to that, although both companies screen out the vast majority of projects they are brought.
All of these options can be attractive to busy high-income professionals who are not interested in purchasing, owning, managing, and selling properties themselves. For non-accredited investors, the online private REITs are your only option to invest in these smaller properties that don't make it into the REITs traded on the stock market and found in the Vanguard REIT Index Fund. For accredited investors, there are some who will be willing to pay the 0.85%-1% management fee for the increased convenience, increased diversification, and decreased tax hassle compared to buying individual syndicated properties either directly or through the crowdfunded sites. Other accredited investors who either want to avoid the additional layer of fees, prefer to select their properties themselves, or simply prefer the benefits of a private fund structure will want to avoid online private REITs. Either way, they've come a long way from the private REITs that were used to swindle your grandma.
In a 2021 post about Dr. Jim Dahle's real estate investments, we talked about what he's doing with the 20% of his portfolio that he dedicates to real estate, but for now, you should know that he doesn't have any money invested in online private REITs. However, he has invested directly into properties both with Fundrise and RealtyMogul and enjoyed positive returns.
Overall, REIT investing offers the chance to create a relatively hands-off revenue stream, but it isn’t without its risks. Be sure to look at the benefits and drawbacks closely before you dive into this venture.
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 27 hours of content, and it gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course!
What do you think? Do you invest in REITs? How? Why or why not? Do you expect to see more online, private REITs come onto the market? Comment below!
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