WHY YOU SHOULD NEVER INVEST IN A REIT

Modern real estate

Real estate investment trusts, REITs, are a convenient way for inexperienced investors to gain exposure to real estate investing, especially for the first time. Modeled after mutual funds, publicly traded REITs purchase, own and manages real estate properties. REITs give individual investors the opportunity to invest in a portfolio of income-producing real estate. Investors do not need a large amount of time or resources to invest in REITs but for the smart, savvy investor, REITs should never be an option.

Recession Vulnerability

REITs are highly vulnerable to recessions on two fronts.  Because publicly traded REITs are highly correlated to the stock market, recessions always lead to an associated drop in REIT prices. In fact, since 2008 REITs have actually proven more volatile than the broader market.  This is because the balance sheets of REITs are very susceptible to external shocks. It is caused by REITs’ inability to retain significant amounts of cash flow and without cash to ride out downturns, they are forced to liquidate assets at bargain prices.  During the 2008 financial crisis, as stock prices fell, equity volatility for REITs increased.  Yuichiro Kawaguchi, J. Sa-Aadu, and James D. Shilling, (December, 2012) REIT Stock Price Volatility during the Financial Crisis, biz.iowa.edu.  Accordingly, not only are REIT share prices susceptible to recessions and downturns but they are hypersensitive to market shocks compared to the broader market.

Economic downturns not only affect REIT share prices, but with the associated reduction in rents, REIT profitability and dividends also suffer as a result.

Limited Upside

A variety of factors limit the upside benefits of investing in REITs.  One of the main downsides of REITs is because they’re highly leveraged, an increase in interest rates and therefore the borrowing rate directly impacts the cost of acquisitions and refinancing.  “Besides, higher interest rates will eventually slow down economic growth and hurt occupancy rates, rents and income payout rates.”  Panos Mourdoukoutas, (August 10, 2017), Good, Bad And Ugly REITs, forbes.com.  In the current environment, with historically low interest rates, the only way is up.  Increases in interest rates will result in downward pressure on the bottom line of REITs, therefore limiting upside potential.

Another factor limiting the upside benefits of REIT investment is the lack of diversification and competition.  Most REITs specialize in a single property type, and a weakness in that particular segment of real estate could limit returns.  This can currently be seen in the residential market.  Because residential REITs have grabbed investor attention in recent years and been flush with investor cash, this has resulted in a glut of supply.  Usually higher supply curtails the landlord’s ability to demand higher rents and leads to lesser absorption. These may keep the growth momentum of rent at check.  Zacks Equity Research (June 15, 2016), Why Investments in REIT Stocks Can Be Risky, zacks.com.

In the 4th quarter of 2006, national effective rent growth increased 2.3% according to early apartment data from AXIOMetrics. This was over 2 percentage points lower than the 4.6% rent growth experienced in the year-ago quarter. Also, occupancy of 94.7% in the fourth quarter was down from 95.1% in the third quarter and 95.0% in fourth-quarter 2015. The lack of diversity and widespread competition can limit a REIT’s upside prospects.

A REITs pre-established term can also limit the upside of its investment.  Because REITs typically have a fixed maturity of 5-10 years, at some point, the properties must be sold regardless of market conditions.  That means if the REIT matures at time when property prices are down, a drop in your investment will be unavoidable.

Finally, because REITs can only reinvest a maximum of 10% of their annual profits back into their core business lines each year, this limits their growth and upside potential as well.

Access to Management

Investors often align their investment philosophy with that of the management who head the companies that they seek to invest in. As with most public companies, access to the management team of REITs is prohibitive.  This limits an investor’s ability to analyze a team’s competence and vision going forward.

Conclusion

For smart investors looking for recession proof returns with unlimited upside and access to management, REITs should never be an option. Join the smartest group of investors we know….here.

Comments (1)

Well said Mauricio. Thank you for giving insight into this topic!

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