Real estate investment trusts (REITs) are securities invested in real estate through mortgages or properties. Although this type of investment receives special tax treatment and gives investors a highly liquid way to invest in real estate, investing in REITs also has several pitfalls.

Boom-Bust Real Estate Cycle

Demand for real estate constantly fluctuates, creating buyer’s markets and seller’s markets. During a buyer’s market, low demand makes it easier for buyers to negotiate lower prices. A seller’s market creates the opposite situation; high demand makes it easier for sellers to demand high prices. REITs open investors up to the risk of overdevelopment as builders and developers try to take advantage of high demand for residential, commercial, industrial and mixed-use property. Overdevelopment, combined with reduced demand for property, results in low occupancy rates and lower prices.

Interest Rates

When interest rates increase, REITs have difficulty borrowing the money needed for expansion. High interest rates also affect the properties in a REIT, as higher rates may make it harder to finance the acquisition of properties in the REIT.

Valuation

The stated value of a REIT may be less than its actual value due to the use of current rents to assign value to these investments. The current rents paid by tenants may be less than or more than current market prices. When leases expire, management companies have to negotiate new leases. This may result in increased or decreased rents.

Sector Focus

One of the major pitfalls of investing in REITs is that each one focuses on one real estate sector. If a REIT focuses on a sector like residential real estate and there is an increased demand for residential buildings, the REIT may increase in value. If a REIT focuses on health care facilities and the demand for these facilities decreases, investors may lose money.

Management Issues

The properties in a real estate investment trust must be managed well if they are expected to earn steady income. Poor management may lead to mistakes that reduce the value of the properties in a real estate investment trust.

Additional Risks with REITs