Real estate investment trusts, or REITs, are designed to be long-term investments that generate consistent growth and income with relatively low risk. And for the most part, this is true. However, not all REITs make great investments, and even the best-quality REITs only make good investments if they are used the right way.
With that in mind, here are five common mistakes REIT investors often make. If you learn them now, you might be able to avoid learning some expensive lessons down the road.
1. Don't chase a high dividend
There's a concept in investing known as a "yield trap." In a nutshell, this refers to stocks that have a high dividend that looks attractive to investors but for one reason or another is too good to be true. Maybe the company is paying out more than 100% of the money it's earning, or maybe the yield is high because the stock price has collapsed recently.
Yield traps are often seen in the real estate sector, and because REITs generally pay above-average dividends, they can be especially difficult to spot. One good habit to get into is to compare a REIT's yield to peers in the same real estate subsector.
For example, if a medical office REIT seems to have a too-good-to-be-true dividend yield, take a look at what other medical office REITs are paying. If the one you're looking at is by far the highest-yielding, it's worth further investigation to see if something is wrong with the business.
2. Don't panic-sell your REITs
Here's one lesson many REIT investors learned the hard way in 2020: REITs are designed as long-term investments, and it's generally a mistake to sell them as a knee-jerk reaction to temporary headwinds.
To name a couple of examples, hotel REIT Ryman Hospitality Properties (NYSE: RHP) plunged to a low of about $14 as the markets panicked in March 2020 and has since rebounded to above its pre-pandemic highs as investors realized that demand for travel isn't going away permanently.
The point is that when one of your REITs plunges in reaction to certain events, it's important to take a step back and ask yourself if it permanently changes the investment thesis. If it does (like a shift in the company's strategy), it could certainly be a reason to sell. But temporary headwinds are an opportunity to buy, not to sell.
3. Don't avoid 'boring' types of real estate
There are some types of commercial real estate that are just more exciting than others. Data centers are one example, as they invest in a tech-focused form of real estate that often appeals to growth investors for obvious reasons. Infrastructure REITs like American Tower (NYSE: AMT) are often seen as "exciting" by investors as well, as they are a real estate play on one of the clearest tech trends: the 5G rollout.
There's certainly nothing wrong with these types of REITs, and many have delivered fantastic returns. But it's also important not to overlook the long-term potential of seemingly "boring" types of real estate.
Just to name a few examples, Realty Income (NYSE: O) invests in steady, predictable retail properties and has delivered a 4,360% total return since listing on the NYSE in 1994. Self-storage REIT Public Storage (NYSE: PSA) has rewarded shareholders with a 14,730% return in just over 40 years as a public company. The properties might not seem too exciting, but these returns certainly aren't boring.
4. Don't buy a REIT just because it's cheap
Just like most stocks, if a REIT is trading for a single-digit multiple of its funds from operations, or FFO, there's a strong probability that it's cheap for a reason. For example, several mall REITs, including CBL & Associates, PREIT, and Washington Prime Group were trading for ridiculously cheap multiples in 2020 and earlier in 2021 -- and then they all went bankrupt.
Of course, these are extreme examples, but the point is that if a REIT looks like an incredible bargain based on traditional valuation metrics, you should at the very least investigate the situation much more closely.
5. Don't buy REITs as short-term investments
Last but certainly not least, REITs are intended to be long-term investments in commercial real estate assets. It is almost always a losing battle trying to time short-term moves in the real estate sector. There are simply too many factors that influence REIT prices (such as interest rates) that have little or nothing to do with the underlying businesses.
To be sure, if a REIT appears to be a good value to you, it can be a smart idea to be opportunistic. For example, I've never bought more REITs than I did in the April to July 2020 time frame. But I didn't buy them because I thought they'd be higher in a few months or even in a few years -- I bought them to add shares of great long-term investments to my portfolio at a discount.