Risk Factors of Investing in REITs
Leverage risk, liquidity risk, and market risk etc. risk element making REITs parlous investment.
What are the Risk Factors of Investing in REITs?
Before hopping into the risk factors of REITs, we need to discuss exactly what a REIT is. It stands for real estate investment trusts. It is a company formed solely to invest in, operate, own, or finance income-producing real estate.
These are similar to mutual funds in that they provide investors with a highly liquid way to invest in real estate.
It is a type of asset that offers regular income, portfolio diversification, and long-term capital appreciation to all investors, large and small. Like any other security, these trusts can be listed on a stock exchange.
These organizations are over 50 years old, having been created in the United States in 1960 as part of the Cigar Excise Tax Extension Act. In 1965, the first real estate investment trust was launched on the New York Stock Exchange.
Similar products debuted on the European, Japanese, and Australian stock exchanges in the following decades. For investors who are interested in these, there are numerous benefits. It delivers a steady stream of income, as well as lower portfolio volatility, dividends, and wealth creation.
Due to being a publicly traded company, it can be purchased and sold quickly, offering excellent liquidity. In addition, it is a natural inflation hedge because returns have consistently outpaced Consumer Price Inflation (CPI). Equity and mortgage REITs are the two most common types of REITs.
Real estate investment trusts are immensely advantageous to an economy's development since they allow latent investable money to be channeled into infrastructure projects, such as residential complexes, hospitals, and schools.
Risk Factors Of Investing In REITs
Real estate investment trusts are more vulnerable to certain risk factors than other assets like equities and bonds, which can lower returns for investors. Leverage risk, liquidity risk, and market risk are a few of the primary risk elements related to these funds.
The risk factors listed below are only a few examples and are not meant to be exhaustive.
1. Market Risk
Its prices are susceptible to demand and supply factors, just like any other publicly traded product on stock exchanges. As a result, when selling units in it, there is a chance that investors will receive less money than they put in.
Investor confidence and emotion regarding the property market and its returns, the instruments' management, interest rates, and other associated factors are reflected in these prices.
2. Leverage Risk
When investors decide to buy securities with borrowed money, they run the risk of leverage. When the instrument uses leverage, it incurs additional fees and increases the fund's losses if the underlying investments underperform.
High borrowing expenses, such as interest payments and other fees associated with borrowing, will limit the amount of money available for distribution to the company's shareholders.
3. Concentration Risk
If a large amount of the value of a REIT’s assets is based on only one or a few properties, or if it relies on only a few tenants for most of its lease income, investors face an increased risk of loss.
4. Refinancing Risk
These instruments may enter into new borrowing agreements or issue new bonds to repay existing loans, posing a refinancing risk. As a result, there's a chance that the conditions of any refinancing will be worse than the terms of the original borrowings.
If the trust cannot obtain refinancing, it may be forced to sell some of its properties financed by the loan. As a result, these risks could affect a REIT's price and income distribution.
5. Liquidity Risk
Even though public REITs let investors sell their shares on the open market, they are less liquid than other investments such as bonds and stocks.
There is no secondary market for locating buyers and sellers for the property, and the fund's repurchase offers are the main source of liquidity.
Furthermore, there is no certainty that all shareholders selling their assets will be able to sell all or part of their shares in the quarterly repurchase offers. As a result, investors may be unable to convert equities into cash at the moment of need due to this liquidity risk.
6. Income Risk
If the trust declares an operational loss due to decreased occupancy rates, distributions to unitholders (shareholders of a REIT) may be cut.
Investors should assess if it has adopted any risk-mitigation steps in relation to tenancy arrangements, such as obtaining upfront payments or contractual rental rate lock-ins.
Capital structure can also add to income risk, as a greater cost of debt could result in lower income payments to unitholders.
Now, let’s discuss the risk involved in investing in the two main types of REIT, i.e., publicly-trading REITs and non-trading REITs.
Risks In Non-Trading REITs
Because non-traded REITs, often referred to as non-exchange-traded REITs, are not traded on a stock exchange, their investors face certain risks.
Investors are unable to examine non-traded REITs because they are not publicly listed. As a result, figuring out the REIT's worth is difficult. Although some non-traded REITs would disclose their whole portfolio and valuation 18 months after investing, this is unsettling.
Illiquidity refers to the possibility that there won't be any buyers or sellers in the market when an investor wants to make a deal in non-traded REITs. These are frequently non-transferable for at least seven years.
In order to buy and run properties, these instruments must pool money from investors. However, this combined money can have a darker side.
Things can get dicey when a property distributes dividends from other investors' funds rather than from profits generated by the property.
These also permit external manager fees. A non-traded REIT pays external management, which lowers investor returns.
If you choose to invest in one of these private trusts, be careful to inquire about each of the risks mentioned above. The more openness, the better.
Risks In Publicly-Trading REITs
These publicly-listed instruments allow investors to add real estate to their portfolio while also earning a healthy dividend. Although publicly traded instruments are safer than non-exchange instruments, there are always hazards.
The largest threat to such trusts is a rise in interest rates, which diminishes demand. As a result, investors tend to gravitate toward safer income investments like US Treasuries in a rising-rate environment.
Treasury bonds are government-backed and pay a set rate of interest. As a result, when interest rates rise, these fall in value, and the bond market rise as money flows into bonds.
However, rising interest rates can be interpreted as a sign of a strong economy, implying greater rentals and occupancy rates. Ultimately, such instruments have generally underperformed when interest rates rise.
The other significant risk is choosing the wrong fund, which may seem obvious, but it all comes down to logic. For instance, malls have been declining. Investors may be reluctant to invest because of their exposure to suburban malls.
Urban shopping malls might be a better option for millennials who like city life due to their ease and cost-efficiency.
Since trends change, it's important to look into such holdings to ensure they're still relevant and able to produce rental income.
Although not a danger in and of itself, the fact that dividends from these instruments are taxed as regular income can be a significant concern for some investors.
Put another way, the ordinary income tax rate is the same as an investor's income tax rate, which is likely greater than dividend tax rates or stock capital gains taxes.
Summary
Investing in these instruments can be a low-risk, high-return alternative to buying real estate directly. However, large dividend payments should not influence investors, as such instruments might underperform the market in a rising interest-rate environment.
Instead, investors should look for publicly listed instruments with strong management teams and high-quality properties that align with current market trends. Working with a qualified tax accountant to figure out how to get the best tax treatment should also be considered.
The most popular claim is that such instruments are "simply" income investments that are overpriced, overleveraged, and excessively interest rate sensitive: In actuality, these funds have consistently outperformed the market in terms of total returns for decades.
In comparison to equities and bonds, their prices are heavily depressed.
- Real estate investment trusts invest in residential, office, industrial, and hotel properties, among other things.
- Unlike other investments, like equities and bonds, REITs are exposed to various risk variables that affect returns.
- Leverage, liquidity, and market risks are some of the most significant risks connected with these.
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