Investing in real estate can pay off, but not everyone has the time or cash to manage properties. With real estate investment trusts (REITs), you can grow your money through real estate without buying a building or becoming a landlord.
However, it’s important to understand REITs before committing your funds. Here’s what you should know about them, including how they work, their pros and cons, and how to start investing in them.
Understanding Real Estate Investment Trusts and How They Work
REITs are companies that purchase, manage, or finance income-producing real estate. They generally pool money from investors to fund commercial, residential, or industrial deals.
As a result, REIT investors technically own shares of the company, not its underlying properties. When a REIT’s deals earn money, such as through rent or interest, the REIT pays part of that money back to the investor in the form of dividends.
Many beginners like REITs because they don’t have to know anything about property management. It also gives you a chance to invest in real estate without needing a huge budget. You simply invest what you can, and the REIT handles everything behind the scenes.
For example, if you invest $500 in a REIT, you will get a share of the income the properties bring in. You don’t deal with tenants or repairs. Instead, the REIT handles everything. You just collect dividends based on how well the properties perform.
Pros and Cons of REITs
Investing in REITs has a lot of benefits, but there are also some notable drawbacks. Here are some of the most significant pros and cons.
Why REITs Can Be a Smart Investment Choice
1. You Can Start With Low Upfront Costs
Investing in real estate usually requires a large down payment and a strong credit profile, but REITs let you get started for the cost of a single share. Since you don’t have to shell out thousands of dollars upfront, the barriers to entry are much lower.
2. You Don’t Have to Manage Anything
REITs offer you exposure to real estate without the stress of property management. You don’t have to deal with the headaches of repairs, tenant complaints, or late-night emergency calls. The REIT handles it all.
3. Dividends Offer a Steady Income Stream
One of the biggest perks of REITs is the regular income they pay. By law, REITs must pay out at least 90% of their taxable income to investors as dividends. That means more consistent dividend payments than many other investments.
4. You Can Buy and Sell Easily
Traditional real estate investments can take months to sell, and there are significant closing costs involved. By contrast, REIT shares can typically be sold as quickly as any stock in your brokerage account.
5. They Offer a Simple Way to Diversify Your Portfolio
REITs give you a way to diversify your portfolio outside of traditional stocks and bonds. They can also help you invest across multiple real estate sectors. This helps reduce risk because your returns don’t rely on a single asset class or property type.
Where REITs Fall Short and What to Watch For
Here are some other drawbacks to keep in mind:
1. Guaranteed Dividends Can Slow Growth
Because REITs must pay out so much of their income, they keep less cash for expansion. That can limit their growth potential compared to tech stocks or companies that reinvest heavily in themselves.
2. Interest Rates Can Impact Returns
Because real estate deals often rely heavily on leverage, REITs tend to have outsized reactions to changes in interest rates. When rates rise, it can significantly impact your returns.
3. Fees Can Eat Into Your Earnings
REITs generally come with management or transaction fees. These fees can vary significantly, but they tend to add up over time.
4. Market Ups and Downs Still Apply
REITs may be more stable than some stocks, but they’re not immune to downturns. After all, though they’re tied to real estate investments, they trade on exchanges. That means they can rise and fall based on market trends, investor sentiment, and economic cycles.
5. Dividend Taxes Can Be Higher
In most cases, the IRS treats REIT dividends like regular income. That means you could pay more in taxes on your earnings compared to the lower rates assessed on stock dividends. However, holding REITs in a tax-advantaged account like an IRA can help you avoid this issue.
How Do You Invest in REITs as a Beginner?
Typically, REITs should just be one aspect of a well-diversified portfolio, not the only asset class you invest in. If you’re a beginner planning on investing in REITs, here are some simple steps to help you get started safely:
- Research the REIT’s history, dividend record, and investments
- Consider whether to invest in a brokerage or tax-advantaged account
- Allocate a small portion of your portfolio to REITs before increasing contributions
By investing intentionally, REITs can help you build wealth, create consistent income, and diversify your investment strategy without excessive risk. Just make sure to avoid overconcentration in the asset class.
When REITs Might Not Be the Right Fit
For many people, real estate investment trusts can be a valuable piece of a long-term financial plan. They can bring in a steady income, diversify your portfolio, and reduce the pressure of managing a property yourself.
However, they aren’t a perfect substitute for stocks and bonds. In many cases, experts recommend establishing the core of your portfolio in these more traditional asset classes before diversifying into REITs.
Similarly, REITs are subject to risk and volatility, making them a poor substitute for short-term investments. For example, you should still keep your emergency fund in something more stable and liquid, like a high-yield savings account.
Lastly, like with any investment, it’s important to deal with more urgent financial needs before investing your money in REITs. For example, you should avoid tying up your money in these assets when you don’t have a cash reserve or are struggling to keep up with debt.
If you’re in the latter category, consider reaching out to a trusted debt relief provider and exploring options that may lighten the load.
Final Thoughts
REITS offer many real estate investing perks without the need to to buy, renovate, or manage actual properties. As a result, they can be an attractive option for those who want to avoid the downsides of traditional real estate strategies, like high upfront costs and low liquidity.
However, REITs aren’t without their risks. Before investing, it’s important to weigh the pros and cons and make sure they’re a good choice for your financial plans. If you’re a beginner investor, consider speaking with a trusted financial advisor before committing your funds.