The Downside of REITs
In an older post, I mentioned how acquiring REIT shares was one method to invest in real estate without purchasing a property. What makes REITs attractive are the liquidity, DRIP, monthly distribution, and the low barrier to entry. However, there are some issues with REITs that may not be ideal. In an older post I mentioned how acquiring REIT shares was one method to invest in real estate without purchasing a property. What makes REITs attractive are the liquidity, DRIP, monthly distribution, and the low barrier to entry. However, there are some issues with REITs that may not be ideal for an individual's portfolio.
INTEREST RATES AND EFFECTS ON DIVIDEND YIELD
REITs are in some ways similar to fixed income and can become less attractive as other fixed income investment yields increase. Assuming an investor owns a REIT for its monthly distribution, if you have a REIT that gives you a dividend yield of 4% per year and GICs have a yield of 3.5%, the REIT may drop in value. Investors will liquidate their shares since the risk premium no longer fits their portfolio. Why hold a REIT given the risk, in return for only an additional 0.5%? Investors expect higher returns for more risk. If the risk-free return is rising, investors still expect a similar level of risk premium. I made a quick diagram below to show the risk premium and note as you go left on the x-axis the risk level increases.
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In 2022 we see that many REITs still have not recovered and continue to trend downwards as interest rates continue to go higher. As of September of 2022, you can get 1 year GICs as high as 4.55%. You can compare rates yourself by visiting Ratehub.
CORRELATION WITH STOCK MARKET
REITs are correlated with the stock market. If you were looking to diversify your portfolio with a REIT it may or may not be ideal. This brings up the question of why invest in a REIT in the first place if it is correlated with the stock market? Furthermore, S&P500 historically has done very well and is more tax efficient since you are not receiving a monthly distribution. It might be more beneficial to invest in S&P500 and follow the 4% rule.
LOWER RETURNS
Another issue with REITs is the lower returns when compared to purchasing an investment property. Managing your own rental property or having a competent management company can result in better returns. Buying REITs prevents you from taking advantage of leverage. If an investor qualifies, the bank has no problem lending potentially hundreds of thousands of dollars to purchase an investment property. However, you are limited in the amount of leverage when buying REITs.
In the future, I will discuss Real Estate Private Equity and the issues in investing in private organizations.