Are REITs a good investment? Full disclosure: I sold my Real Estate Investment Trusts (REITs) and I think you may want to consider other opportunities too. Why did I sell off good dividend-paying companies that I’ve held for a long time? We’ll get into that in this article as well as the best way to currently invest in real estate.

But first it makes sense to look into REITs to see their investment characteristics. There are certain traits that REITs have that you need to know prior to putting any of your hard earned capital to work. Knowing the risks inherent with this type of investment is vitally important. There are many ways to invest in real estate and owning equity in REITs is only one.

1) REITs generate capital from tenants, whether they are retail, industrial, residential, or government. Let’s take a look at one of my favorite REITs, Realty Income (Ticker: O) to illustrate this point. Realty income is a triple net stand alone retail REIT. They own the underlying real estate of many large companies like Walgreens, FedEx, Dollar General. The companies that rent from Realty Income pay the property insurance, taxes, and maintenance. Here are Realty Income’s top 20 tenants:

are reits a good investment

Look’s like a pretty decent portfolio, right? Depending on how you feel about retail, you may think this is a pretty good tenant list or a horrible one. That’s the point here. A REIT is only as good as its underlying tenant based. You wouldn’t want to invest in a REIT who’s tenants are about to go bankrupt like a Sear’s Holdings. Realty Income’s tenant base looks pretty strong consider how weak retail is.

Another example is AvalonBay Communities (Ticker: AVB) which is REIT that owns apartment complexes. As of January 31, 2017, AvalonBay owned or held a direct or indirect ownership interest in 260 operating apartment communities with over 75,000 apartments in 10 states.  They also have 27 communities under development, including one right down the street from me.

AvalonBay is a completely different REIT from Realty Income, the main difference being their tenant base. You would invest in AvalonBay over Realty Income if you thought that apartment units would yield better performance (i.e. increasing rents, strong demand, demographic shifts).

2) REITs trade like bonds: their price will go up when interest rates go down and vice versa. Think of it like a seesaw with interest rates on one side and the price of your REIT on the other. America, and the rest of the developed world, has seen low interest rates for almost a decade. That has done nothing but help REITs. The reason behind this is detailed in point #3 below but let’s just focus on the price action of REITs.

reits vs rates

And this is one of the main reasons I have a problem with investing in REITs in today’s low interest rate environment. I’ve been invested in REITs for a long time – since 2008. I’ve had a good run with them as interest rates have gone lower and lower over the years. I’ve held onto them even as people said interest rates would rise in 2011, 2013 and 2015. And I don’t necessarily think that interest rates will rise dramatically going forward. I just believe that REITs face an uphill battle if rates steadily climb. And if rates fall then we have bigger problems. That would signal a recession which would cause underlying REIT fundamentals to deteriorate.

Heads I lose; tails you win. That’s the very technical term for it. You see if rates go up then the price of your REIT will likely drop or at least face resistance. If rates go down then something bad in the economy may cause REIT prices to drop. The goldilocks scenario that we’ve been in over the last few years is a steadily improving economy combined with a steadily decreasing interest rate. All things must come to an end.

3) REITs like easy money – that is cheap low-interest money. This point is related to #2 above. Right now REITs are able to borrow at a low cost of capital which allows them to have more successful projects. Finance nerds like to call this the hurdle rate. If their projects make them a greater return than their capital costs, then they’ve just cleared the hurdle.

reits cost of capital

As interest rates rise and the cost of a REIT’s capital increases, they need to seek better projects to clear the hurdle. Better projects means projects that have a higher internal rate of return (IRR) or net present value (NPV). What happens when managers and executives can’t find projects with a higher return? They invest in projects that actually may lose the company money. This is just human nature. Managers want activity. After all, they need to prove the need for their existence. So they take projects that won’t make a good return or even worse, lose the company money.

4) REITs pay dividends and those dividends are taxed at ordinary income in most cases. REITs have to pay out 90% of their income as dividends, which allows the REIT to avoid high corporate tax rates. Great for the REIT but this means you’ll have to pay tax on dividends as ordinary income, not qualified dividends like a normal C-corp. In some cases, your dividends will be taxed at the lower rate (if the company distributed gains from selling assets) or not taxed at all (if the distribution is considered a return of capital). These instances are rare. You can bet on being taxed on dividends at ordinary rates which means you’ll pay your marginal rate.

Marginal tax rates as shown for a married filing jointly couple by income level:

REIT tax rates

5) REITs generally pay a higher dividend than other marketable securities but overall returns aren’t as good. Most investors buy REITs for one of two reasons: they like relatively large dividend payments or they want to own real estate as a way to diversify their portfolio. Dividend payments are great! A large portion, something like 40% of the stock market’s return since 1982, has come from dividends. And REITs do pay a higher dividend relative to other securities but at what cost? Just because a dividend payment is higher on one security than another doesn’t mean that security will also generate a higher overall return. Take a look at this 5-year chart that shows the Vanguard REIT Index Fund (VNQ) in blue versus the S&P 500 (SPY) in red:

Vanguard REIT index fund versus S&P 500

Source: Google Finance

The S&P 500 crushes the return of the Vanguard REIT Index Fund even after accounting for the dividend payments. The S&P 500 has returned 67.5% over the last five years while the Vanguard REIT Index Fund has returned 29.8%. Although you would have had about 2% more in dividends annually, you would still lag behind the S&P 500.

Even if you were lucky enough to pick one of the best-performing REITs, you’d still have a lower overall return than the S&P 500 over the same period. Let’s take a look at Realty Income’s 5-year stock chart:

are reits good investments

Realty Income has generated a return of 53.7% plus dividends over the last five years. When you include dividends, this comes very close to the S&P 500 overall return but it’s still shy.

High dividend yields are great but they may come at a cost. The cost of a lower overall return. The cost of a dividend yield being cut. The cost of the company paying out too much and having it become a burden on their operations. People look at high dividends and salivate over the juicy yield. The allure of being paid is so strong for some investors that it clouds their fundamental analysis. Don’t worry as much about the yield if you’re buying REITs (I know: easier said than done). Look at the REITs fundamentals, growth trends, and management’s behavior.

6) REITs are only one of many real estate investing options you have. There’s old-school rental real estate – like actually buying a property and placing a tenant in it. There’s hard money lending you could do for house flippers. There’s buy, fix, and flip. Vacation rentals are a fun option. There’s also crowdfunding real estate investing like RealtyShares. There are advantages and disadvantages to all of these methods. But it’s absolutely necessary for anyone with a substantial portfolio to have alternative investments.

REITs do have the advantage of being highly liquid. You can trade them like stocks putting buy and sell orders in as often as you prefer. They also pay dividends on a consistent basis without you having to call a tenant or participate in management in any way. They’re passive. The downside is that they are probably the most price sensitive to changes in interest rates. Being highly liquid makes REITs easier to sell quickly. You won’t get as high a return on REITs as other real estate investments. REITs have a lot of costs associated with them: management, operating expenses, SEC filing expenses, etc.

Buy & Hold investing can make decent returns if you’re in a good market with good properties. Generally it’s a good idea to go after a 10% cap rate or higher. The cap rate is simply the Net Operating Income (NOI) / Property Value. For example, a $10,000 NOI on a $100,000 property would give you a cap rate of 10%. NOI is equal to your rental income minus vacancy loss minus operating expenses. Operating expenses are property tax, insurance, maintenance, and management. Another rule of thumb is to shoot for a 1% rent to value ratio. For example, a $100,000 property should generate $1,000 per month in rents to hit the 1% rule.

The downside of the buy and hold game is, of course, the fact that you have to find it, fund it, tenant it, and hope said tenants don’t create a meth lab in the kitchen. None of this scares me as much as the fact that it’s hard to diversify when you spend so much money on one property. In order to buy a $100,000 rental, you’ll have put at least $20,000 plus closing costs plus a buffer in case you need a new roof or other big item. All said and done and you could be looking at putting $40,000 to work on one property. It’s hard to diversify your assets if you only have a couple hundred thousand to put to work.

Buy, Fix, & Flip – You’ve watched the shows. You know that you can easily make $50,000 a flip in your spare time doing very little and having fun. Wrong! I’ve never done a flip so I can’t speak on this first hand but everyone one I’ve known who’s ever done this runs into a snag. Sometimes they decide to simply rent the house out because it won’t sell. Few investors want to take this active approach to real estate investing. And to me this is kind of like day trading stocks. You’re not really investing. You’re speculating that the house / stock will be worth more in the future. Doesn’t always work out in your favor.

Vacation Rental – I have a friend who lives in northern Virginia and has a vacation home in Ocean City, MD. She uses the property a lot and rents it out through Airbnb when she’s not enjoying it (I actually rent it out from her though Airbnb because it’s so easy to use). Using Airbnb gives her a lot of control over her tenant base unlike if she went with a regular property manager. She plans to retire at this vacation home over the next few years. I wouldn’t exactly consider this an investment but she is able to cover a lot of her costs. What’s also great about my friend’s plan is that she purchased the vacation home years ago, which enabled her to lock in a lower price than if she bought it when she retires. She probably paid $100K less than it’s currently worth based on her purchase date.

Crowdfunded Real Estate – This newcomer to the real estate investing field is quickly becoming my favorite way to invest. In fact, I see this taking over in the future and it will be as prevalent, if not more, than investing in REITs. Some advantages to platforms like RealtyShares is that they source the project for you and you get to decide which project works for you. You can put as little as $2,000 into a project or invest much more. You can invest in the debt side and get a steady high single digit yield or the equity side and get a higher yield. Crowdfunded real estate is put into a LLC so each owner as limited liability but keeps the tax-advantages of a pass through entity. It’s more passive than investing in actual properties yourself yet you have more control what you invest in using the platform.

Are REITs a good investment? The answer depends on interest rates, tenant base, fundamentals, and opportunity costs / other available options. I do not think that REITs represent the best real estate investment option that’s available. I recommend everyone that’s looking at real estate make sure they check out crowdfunding to see if it’s right for them. I see it as the best investing opportunity in 2017 and should make up part of your diversified Triad Portfolio.

Please put your email in below to sign up for my list which gives you access to the steps you need to take to understand and secure your finances in retirement. Remember, I’m here to serve you. If you have any questions or need anything answered in depth, please reply to my introductory email. Chat soon!