REIT Investing Is Too Risky – Here’s Why

REIT investing may appeal to you as a way to collect some nice income checks and to diversify your portfolio in order to reduce investment volatility. That makes sense to me – the potential rewards do look juicy. But before you take the plunge, please consider the risks.

What are REITs?

A REIT is a real estate investment trust. It’s similar to a mutual fund in that individual investors pool their money together and a manager decides which real estate to buy and which to sell. Depending on the real estate owned within the trust, investors can collect a nice monthly or quarterly dividend check (and a capital gain if the properties are eventually sold at a profit). Most people who are investing for income have considered REITs at one time or another.

When you first buy a REIT, you know how long the manager is going to hold on to the properties. Unlike a mutual fund, REITs must dissolve at some point. Often these REITs last five to 10 years before they are dissolved and the money is returned to the investors.

What are the problems with REITs?

REIT managers have big bucks, and they are the dominate players in the commercial real estate market. Because they have so much money, they need to focus on big deals, and there are fewer buyers and sellers at these levels.

Because REITs are getting so much investor love (and money), they are competing for properties with one another. REIT managers are crowding out other real estate buyers, and that’s not so good for the overall health of this market.

You may not be a REIT investor yet, but insurance companies, pension funds and foundations are big fans. They’ve increased their positions in REITs dramatically since 2008. Often one firm manages many REITs. If your manager does, there is a high likelihood that she will buy or sell a property to another REIT she also owns. That’s not an arm’s length transaction, so investors involved in those REITs don’t really know if they are buying properties at fair prices.

Again, if you put your money in a variety of REITs managed by the same firm, that means you could be buying and selling the property to yourself. Who gains on these transactions? Maybe the REIT manager because of the transaction fees involved, but you certainly don’t gain when you sell the property to yourself. This is actually a great way to lose your money investing.

And there is plenty of pressure on the mangers to execute these kinds of transactions. They have a flood of new cash to put to work, and that means they have to buy more property.

Other Problems

I already mentioned that REITs typically have a fixed maturity. At some point, the properties must be sold regardless of market conditions (for the most part). You may recall that real estate was pretty hot around 2005 and many REITs came on board at that time. Those same REITs are just about mature right now. That means those properties are going to be sold.

Real estate values are generally lower today than they were five years ago. But if the same person who manages your REIT also manages an old REIT that is dissolving, how do you know you are paying a fair price for the properties you are buying?

That manager doesn’t want to report terrible losses to the old investors. If he does, the old investors won’t reinvest. They might even sue. But you certainly don’t want to pay inflated prices for properties just to make the manager look better. You don’t want to get saddled with someone else’s problems.

When you do the math, you see that there is a great deal of pressure for these managers to sell properties at the highest price possible. That puts pressure on them to overcharge new investors. I’m not saying they are doing this. I am saying this is a possibility you can’t ignore.

REITs often carry high fees, and they can be complicated. If you think understanding a mutual fund prospectus is difficult, try reading a REIT prospectus.

Is there a better way to buy real estate?

I believe there is. Buying real estate through a REIT is expensive (we didn’t even discuss the internal costs associated with these investments) and dangerous for the reasons I explained above. A better way to buy real estate is to do so directly.

I believe that this may be one of the best times ever to purchase real estate. I also believe investors must exercise extreme caution when they go this route. You want to buy the right property in the right market. I love residential real estate in markets that are easy to find renters in. I also like partnering up with others. I feel this way for three reasons:

• I don’t have the time
• I don’t have the expertise
• The real estate market where I live is still too expensive and there are other places in the United States that work much better

I want a partner who is an expert, has time and lives in the market I’m investing in. When I partner with someone else it costs money – sometimes quite a bit. But given the alternatives, I’m much happier having direct control over the real estate and competing with smaller sellers so I can take advantage of opportunities.

Have you invested in REITs? What was your experience? Have you purchased real estate lately? How? Where?