Investors have multiple avenues and asset classes where they can allocate capital and build long-term wealth. You can invest in stocks, bonds, cryptocurrencies, gold, commodities as well as in real estate. However, purchasing real estate can be an expensive process as you need significant capital to buy a residential or commercial property. Alternatively, you can look to invest in real estate investment trusts or REITs.
This asset class provides investors an opportunity to generate returns via a steady stream of dividend income as well as long-term capital gains. REITs are similar to stocks and can be bought and sold on any major exchange. So, it means you can gain exposure to the real estate market with just a few hundred dollars.
A real estate investment trust is a company that owns a portfolio of income-generating properties. These companies need to meet certain requirements in order to qualify as a REIT.
However similar to most other investments, even REITs carry certain risks. Let’s take a look at the pros and cons of investing in real estate investment trusts.
Benefits of investing in REITs
Here we consider the most important benefits of having exposure to REITs
Regular dividend payments and capital gains
Real estate investment trusts have a business model that allows them to generate predictable cash flows. This in turn helps them pay attractive dividends to shareholders. There are several REITs trading on the TSX and NYSE that have dividend yields of over 5%. Comparatively, the average yield for a company that trades on the S&P 500 is just over 1%.
So, REITs are an attractive option for those who aim to derive passive income or for investors who want to reinvest dividends and benefit from the power of compounding.
REITs also have the potential to increase your returns via capital gains. Similar to stocks, the value of REITs will also move higher especially if the company focuses on acquiring new properties and increases its base of cash-generating assets. There are multiple REITs that have generated total returns at a higher rate compared to the broader markets.
REITs operate across sectors
There are multiple types of REITs that operate across sectors. The five broader types of REITs include Residential REITs, Mortgage REITs, Commercial REITs, Healthcare REITs, and Retail REITs. While most of us buy a house sometime in our life, we are unlikely to buy a commercial property.
However, by investing in REITs, you can own a piece of a shopping mall, a residential complex, a hospital, or even a class-A office tower.
Provides diversification and liquidity
Investing in multiple asset classes also provides you with diversification and lowers overall risks. While REITs are similar to equities, you get exposure to an entirely different industry that is generally out of reach for most retail investors.
Further, it might take a few months for you to complete a purchase or sale transaction of physical real estate property. However, as REITs are traded on an exchange, you can trade these instruments with the click of a button, making them highly liquid and easy to access.
What are the drawbacks associated with REIT investing?
There are a few drawbacks associated with REIT investing as well that you need to consider.
REIT investments are sensitive to interest rates
Real estate investment trusts and interest rates have an inverse relationship. As a rule of thumb, high-interest rates are not good for REITs. Generally, REITs use leverage in order to acquire properties which means they have to make regular interest payments. In case the interest rate is falling, these payments will also decline which will boost the bottom-line of REITs.
Further, rising interest rates will also move the capital from higher-risk investments such as stocks and REITs towards low-risk asset classes such as bonds.
We have stated that REITs can add diversification to your investment portfolio. However, most individual REITs are not diversified and focus on just a single sector or a particular property type. In the last year, commercial and retail REITs were under the pump as the ongoing pandemic led to economic lockdowns. Alternatively, residential and healthcare REITs outperformed peers in 2020.
So, just as in the case of equities, it makes sense to buy a REIT exchange-traded fund or ETF that will lower your risk significantly. One such ETF is the BMO Equal Weight REITs Index ETF or ZRE.
This ETF aims to replicate the performance of the Solactive Equal Weight Canada REIT Index, net of expenses. It is designed for investors looking for growth solutions giving you exposure to Canadian REITs. The exchange-traded fund has a maximum annual management fee of 0.55% and a management expense ratio of 0.61%.
At the end of April 2021, ZRE had an annualized distribution yield of 4.46%. This means a $10,000 investment in this ETF will help you generate $446 in annual dividend payments. The ETF has also gained 20% in the last five years.
The bottom line
REITs as an asset class have historically derived competitive returns, primarily driven by high yields and long-term capital appreciation. It has a low correlation with most other asset classes making them an attractive asset class to own and lower your overall risk.