3 Surprising Drawbacks of REIT Investing You Never Knew About

By Markets Fool.com

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Real estate investment trusts have been a great way for income-seeking investors to generate the portfolio cash flow they need to cover living expenses or fund future investment purchases. With their exposure to the improving real estate market and their reliable income, REITs have grown more popular than ever. But investors need to know some things that might give them a more balanced view of both the pros and the cons of buying shares of REITs for their portfolio.

For information about real estate investment trusts and perspective on investing in real estate, we turned to three Motley Fool contributors for their views on things to watch out for when investing in REITs. Hopefully, you can avoid some of the pitfalls that others fall into when choosing REITs for their portfolios.

Matt Frankel: One big problem with REIT investing is the lack of diversification if you only buy one or two REITs. Most REITs specialize in a single property type, and weakness in that particular segment of real estate could wreak havoc on your portfolio.

For instance, the trend in the U.S. over the past few years has been away from homeownership and toward renting, which has greatly benefited AvalonBay (NYSE: AVB) and other REITs that invest in apartment properties. However, if some of the new lending options targeted at first-time homebuyers catch on, conditions could easily become less favorable for landlords.

The same principle applies to REITs that invest in retail properties, office buildings, or any other specific form of real estate. Realty Income (NYSE: O) is an extremely popular REIT that specializes in freestanding retail properties. If another financial crisis were to occur and one or more of the company's major tenants were to go bankrupt, the profit margin could erode quickly. On top of that, retail property values could plummet if a series of major retailers were to go out of business.

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I'm not saying any of these scenarios are likely to occur anytime soon -- at least to the point at which the stock prices would take a major hit. My point is instead that REITs that invest in a single type of property are each vulnerable to a particular economic weakness, and REIT investors should consider this fact when constructing a portfolio. Instead of investing in several REITs that specialize in one type of property, it's best to spread your money around.

: Real estate investment trusts are known for boring, consistent dividends, but not all REITs are created equal. Some are better positioned to survive economic downturns than others.

For example, some "blue-chip" REITs like Realty Income attract investors because they write very long-term leases. According to its most recent filings, Realty Income's average lease had a remaining life of 10 years. That gives Reality Income substantial visibility into the future. Its tenants will remain in place, paying the same or similar rents through economic thick and thin.

Apartment REITs, however, are very different. The average apartment lease typically falls between 12 and 24 months, exposing these REITs to greater fluctuations in rental revenue. In good years, apartments can raise prices each time a lease is renewed every year or two. However, in down cycles prices locked in at the top will reset quickly at the bottom. Apartments have been good investments over history, but they aren't immune to cycles. As you can see in the chart above from the blogCalculated Risk, vacancy rates swing dramatically with the economy, and because apartments have short-term leases, apartment buildings have greater income volatility.

Dan Caplinger: Income investors rely on real estate investment trusts for their dependable dividend income, but they often don't realize until tax time approaches is that when it comes to REITs, not all dividend distributions are created equal.Specifically, while many ordinary stocks are eligible for favorable lower tax rates on dividends, most REIT distributions are taxed at higher ordinary income rates.

The reason for this involves the tax benefit REITs get at the entity level. By distributing at least 90% of their income to shareholders, REITs don't have to pay corporate-level tax; however, in exchange, their shareholders have to pay taxes on the income they receive, and those taxes have to match up with the type of income the REIT earned. For rent and most other typical real estate income, ordinary tax rates apply. When a REIT sells a property to get a long-term capital gain, though, shareholders get favorable treatment on the corresponding portion of their income allocable to the gain.

Because of their tax treatment, REITs often make good investments for IRAs and other tax-deferred accounts. Real estate investment trusts can be an excellent source of essential income for investors, but if you don't take the potential tax consequences into account, you could get a nasty surprise come next April.

The article 3 Surprising Drawbacks of REIT Investing You Never Knew About originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Matthew Frankel owns shares of Realty Income.. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.