Disadvantages of REITs
Disadvantages of investing in real estate through publicly traded securities relate to taxes, lack of control, and conflicts of interest. On this page, we discuss the main disadvantages of investing in real estate investment trusts (REITs) and real estate operating companies (REOCs). The advantages of investing in REITs are discussed in more detail here.
Disadvantages of investing in real estate through publicly traded securities (both REITs and REOCs) include:
- Taxes versus direct ownership. Depending on local laws, investors that make direct investments in properties may be able to deduct losses on real estate from taxable income or replace one property for a similar property (referred to as a “like-kind exchange” in the U.S.) without any taxation on the gains. For investors in REITs or REOCs, these specific tax benefits are typically not available.
- A lack of control. REIT investors have little to say on the investment decisions compared to investors that make a direct investment in real estate.
- Costs of publicly traded corporate structure. There are clear benefits from using a publicly traded REIT structure. However, there are also costs related to this structure, which may not be worthwhile for smaller REITs.
- Price is determined by the stock market. While the appraisal-based value of a REIT may be relatively stable, the (market-determined) price of a REIT share is likely much more volatile. While this relationship may suggest that a direct real estate investment is less risky, in reality much of this effect results from the underestimation of volatility that is associated with appraised values. Appraisals are typically done infrequently and are backward-looking, while the stock market is continuous and reflects forward-looking expectations of future discounted cash flows.
- Structural conflicts of interest. When a REIT is structured as an UPREIT or a DOWNREIT there is a potential for conflict of interest. When the opportunity arises to sell properties or take on additional borrowing, such an action may have different tax implications for REIT shareholders and for the general partners, which may tempt the general partners to act in their own interest and not in the interest of the shareholders.
UPREIT vs DOWNREIT
What is an UPREIT and a DOWNREIT?
- An UPREIT is an “umbrella partnership” REIT structure, where the REIT is the general partner and holds a controlling interest in a partnership that owns and operates the properties. UPREITs are the most common REIT structure in the United States.
- In a DOWNREIT, the REIT has an ownership interest in more than one partnership and can own properties both at the partnership level and at the REIT level.
Disadvantages specific to REITs
There are also a number of disadvantages that apply to REITs but not to REOCs:
- Limited potential for income growth. REITs’ high rates of income payouts limit REITs’ ability to generate future growth through reinvestment. This limits future income growth and may dampen the share price of REITs.
- Forced equity issuance. In order to maintain financial leverage, REITs frequently participate in bond markets to refinance maturing debt. When it is difficult to obtain credit, a REIT may be forced to issue debt at a disadvantageous price.
- Lack of flexibility. The rules that qualify RETIs for favourable taxation also have a downside: REITs are prevented from making certain kinds of investments and from retaining most of their income. These limits may prevent REITs from being as profitable as they might otherwise be. REOCs do not have to meet these requirements, and thus are free to retain income and devote those funds to property developments when the REOC managers see attractive opportunities. REOCs are also not restricted in their use of leverage.
We discussed the disadvantages of investing in REITs and REOCs. For more details on the advantages of REITs, see advantages of REITs.