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3 Mistakes Passive Income Investors Make With REITs

Real estate investment trusts (REITs) were created so that individual investors could access institutional-level properties. They are specifically designed to pass income on to shareholders in a tax-efficient manner. But you still have to dig in and understand what you're buying or you could easily make some simple mistakes that will hurt you in the long run.

Here are three things you need to know to make the best investment decisions with REITs.

1. Not paying attention to dividend growth

Inflation is on everyone's mind today because prices for everything from gasoline to food are rising fast. However, inflation is an ever-present issue, and it can materially reduce the value of the income you receive from your investments if your living costs rise but your income stream is static. It's why bonds can be a problematic investment at times of faster inflation, because the interest payments usually don't change.

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There are also REITs where dividends just flatline for years at a time. For example, LTC Properties, which owns senior housing, hasn't increased its dividend since 2016. There are reasons why you might want to own this REIT, including a monthly dividend payment, a relatively high 6.3% yield, and a recovering portfolio.

In fact, some of LTC Properties' larger peers, including Ventas and Welltower, actually ended up cutting their dividends in 2020 as the pandemic hit, so a static dividend perhaps isn't as bad as it sounds. But the buying power of LTC's dividend is still shrinking, which you have to keep in mind when you buy this REIT.

If you are simply looking to maximize current income, it might be fine. If you are looking to hold it for decades, you might need to think a little more carefully about the REIT's dividend policy or wait for an even higher yield to offset the risk inherent in the lack of dividend growth.

2. Focus too much on high yield

Another mistake that's easy to make for income-focused investors is chasing yield. Global Net Lease is a great example of this. This net lease REIT has a yield of more than 10.7% dividend yield. (Net lease REITs own properties, but their tenants are responsible for most of the operating costs.) That's more than twice what you'd get from industry bellwether Realty Income, which sports a yield of just 4.5%.

However, Global Net Lease's dividend was cut in 2020, and Realty Income's was increased. Moreover, Realty Income's low yield actually gives it an advantage, because it can issue stock at more attractive levels. Simplifying the cost of capital a bit, every share Realty Income issues costs it a 4.5% dividend yield, while every share Global Net Lease issues costs it 10.7%. This is a big deal because REITs have to pay out 90% of their taxable earnings as dividends, so they frequently have to tap the capital markets for growth capital.

Global Net Lease's high yield may seem attractive, but it is actually a headwind. Often a lower yield is attached to REITs that are better positioned for long-term success.

3. Forgetting that REITs are companies

REITs are operating companies; they are not simply a collection of properties. For example, VEREIT, which was recently bought by Realty Income, was originally known as American Realty Capital Properties. It was created through a rapid series of acquisitions.

However, management did too much too quickly, leading to accounting issues and an earnings restatement. Although the financial impact was minor in the end, this mistake resulted in a complete turnover of the management team, a dividend cut, and a sweeping portfolio overhaul as new leadership took over. And once back on track, the company sold itself. Essentially, under previous management the company focused so much on getting bigger that the basics of the business were overlooked. And investors ended up getting hurt.

Although this was a particularly noteworthy example, it's not the only one. And it's not the only operating issue that investors need to understand. For example, hotel REITs have an effective lease term of one day. So any economic slowdown tends to pinch results very quickly.

Then there's the issue of location, which is particularly important for mall REITs today. A number of the big names in this niche went bankrupt during the pandemic largely because they own malls in second-tier locations.

All in, REITs are businesses, and you need to understand what you are buying or you could end up sorry you added it to your portfolio.

REITs aren't as simple as they seem

REITs aren't exactly complicated, but they aren't simple either. Some of the big issues you should examine are dividend growth (or the lack thereof), the dividend yield and its long-term impact on the investment you are making, and the actual underlying business you are buying. There are reasons you might want to take on some extra risk in any of these three areas. But going in without examining them could easily mean a bad outcome.

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Reuben Gregg Brewer owns Realty Income and Ventas. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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