The Motley Fool

The Pros and Cons of Investing in REITs

Unsure whether to invest in real estate investment trusts (REITs) or stocks? Well, before you make a decision, it is important that you know the differences between the two.

In this two-part series, I will run through some of the pros and cons of investing in REITs and stocks. For this first article, I will focus on REITs, and in the next, I will dive into the pros and cons of investing in stocks.

What is a REIT?

REITs are investment vehicles that have a portfolio of real estate. REITs, like stocks, raise money through an initial public offering. The money is subsequently allocated to buy, develop and manage real estate.

REITs generate money through income from renting and selling assets. The money earned is paid to its unitholders (similar to shareholders of stocks) through quarterly distributions. Unlike stocks, REITs are required to pay out at least 90% of their taxable income to unitholders yearly to enjoy tax-exempt status by the tax authority. They must also have at least 75% of their total assets in real estate to be considered and listed as a REIT in Singapore.

Key advantages as compared to stocks

  • Predictable cash flow and dividends

Because REITs are required to give out 90% of their income as dividends, investors should be fairly certain that they would consistently get dividends as long as the REIT continues to be profitable. REITs also tend to sign long-term leases with their tenants. Because of this, investors are able to predict the long-term revenue of a REIT accurately.

  • History of outperforming the market index

In the last five years, Singapore REITs as a whole have returned more than the Straits Times Index (SGX: ^STI). Even in the United States, REITs have had a history of outperforming the S&P 500, Dow Jones Industrials and NASDAQ Composite indexes.

  • REIT prices are less volatile

The beta of REITs, a measure of volatility, and consequently, risk, has been historically much lower than stocks at most times. This is because of the predictable nature of REITs’ cash flows and business.

  • There are many types of REITs to choose from

There are 32 REITs to choose from in Singapore that can be further divided into different categories. These include healthcare, residential, commercial, retail and mixed REITs. Investors who are looking for overseas exposure also have the option of choosing REITs that have a portfolio of properties located outside of Singapore.

Key disadvantages as compared to stocks

  • Highly leveraged

REITs are usually highly leveraged investment vehicles. This works as a double-edged sword. Leveraging allows REITs to purchase more assets than they have in unitholders’ equity. At the same time, leverage poses additional risks as REITs may face difficulty paying off its debt in difficult times. As such, investors need to find REIT investments that have lower leverage to survive through any exigencies.

  • Unable to reinvest and grow

The fact that REITs are required to pay out 90% of their income to unitholders works as a double-edged sword too. Although unit holders can sleep easy knowing they can earn consistent dividends, REITs are not able to reinvest in their portfolio, hence can remain stagnant for many years. The two ways to grow are through issuing new units that will dilute current unitholders’ equity or by increasing its borrowings from banks.

  • Concentration risk

Naturally, REITs, because of their focus on properties, will be affected when the property market faces a downturn.

The Foolish bottom line

REITs and stocks can be good long-term investment vehicles for investors. However, knowing the pros and cons of each instrument is important for investors who are deciding between the two. In the next article, I will look into the advantages of investing in stocks as compared to REITs.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.