Why Not to Invest in REITs: Major Risks to Know

Real Estate Investment Trusts, commonly known as REITs, represent publicly traded entities that engage in the ownership, operation, or financing of income-producing real estate. These investment vehicles allow individuals to participate in large-scale real estate ventures without the direct ownership and management responsibilities of physical properties. While REITs offer certain characteristics that may appeal to some investors, a thorough understanding of their potential drawbacks is important for an informed investment decision. This article explores specific considerations and risks that may lead an investor to decide against including REITs in their portfolio.

Interest Rate Sensitivity

REITs, particularly those that own and manage properties, exhibit sensitivity to fluctuations in interest rates. An increase in interest rates directly impacts a REIT’s operational costs because these entities frequently rely on borrowed capital to acquire new properties and develop existing ones. Higher borrowing costs can reduce a REIT’s net income and, consequently, the funds available for distribution to shareholders. This increased expense can constrain profit margins, potentially leading to a decline in the REIT’s share price as investors anticipate lower future earnings.

Beyond direct borrowing costs, rising interest rates can also influence investor behavior and asset valuations. When interest rates climb, fixed-income investments, such as bonds, become more attractive due to their higher yields. This can divert capital away from REITs, which are often sought for their relatively high dividend payouts. The competition from more appealing fixed-income alternatives can diminish demand for REIT shares, contributing to downward pressure on their market value.

Taxation Considerations

A significant consideration for investors evaluating REITs involves the tax treatment of their dividend distributions. Unlike qualified dividends from many standard corporations, the majority of dividends paid by REITs are taxed as ordinary income. This means that for many investors, these dividends are subject to their marginal income tax rate, which can be considerably higher than the preferential rates applied to qualified dividends and long-term capital gains.

While a 20% deduction for qualified REIT dividends is available through the end of 2025, which can lower the effective tax rate, the underlying classification as ordinary income remains. This tax treatment makes REITs potentially less tax-efficient when held in taxable brokerage accounts compared to tax-advantaged accounts like Individual Retirement Accounts (IRAs) or 401(k)s, where taxes on distributions may be deferred or eliminated.

Market and Sector Specific Risks

The performance of REITs is closely linked to the overall health of the real estate market and the specific sectors within it. Economic downturns or adverse market conditions can directly impact commercial real estate values, leading to decreased occupancy rates and reduced rental income for REITs. This decline in fundamental performance can translate into lower profitability and reduced dividend distributions for shareholders. For example, a recession might prompt businesses to downsize or close, diminishing demand for office or retail spaces.

Certain real estate sectors face unique vulnerabilities that can disproportionately affect specialized REITs. The growth of e-commerce, for instance, has significantly impacted retail REITs, while the increasing prevalence of remote work trends can pose challenges for office REITs due to reduced demand for physical office space. Even though REITs invest in real estate, their publicly traded nature means their share prices can still exhibit a correlation with the broader stock market. During periods of widespread market stress, REITs may not always provide the diversification benefits investors might expect, as their values can decline in tandem with other equity investments.

Complexity and Underlying Asset Illiquidity

For the average investor, understanding the various types of REITs and their diverse underlying property portfolios can be challenging. REITs come in several forms, including equity REITs that own and operate properties, mortgage REITs that primarily finance real estate, and hybrid REITs that combine both approaches, each carrying distinct investment focuses and risks. Distinguishing between these structures and assessing the specific assets they hold requires a level of due diligence that may be complex for many.

While shares of publicly traded REITs are liquid and can be bought and sold readily on exchanges, the underlying real estate assets they own are inherently illiquid. Real estate transactions involve extensive timeframes for sales or acquisitions, which can limit a REIT’s flexibility to quickly adapt its portfolio to changing market conditions. This underlying illiquidity can influence a REIT’s operational responsiveness, potentially leading to slower asset dispositions or acquisitions even when opportunities arise or changes are necessary. Additionally, REITs commonly utilize leverage, or debt financing, to fund their property investments. While leverage can amplify returns in favorable market conditions, it also magnifies risks during adverse periods, potentially exacerbating losses if the value of the underlying assets declines or interest expenses rise significantly.