Real estate investment trusts (REITs) are popular among investors who want to earn income from real estate without owning or managing properties. REITs are companies that own and operate various types of real estate, such as apartments, offices, malls, hotels, etc.
They are required by law to distribute at least 90% of their taxable income as dividends to shareholders, which makes them attractive in a low-interest rate environment.
However, investing in REITs is not without risks. One of the main risks of investing in REITS factors that can affect the performance and profitability of REITs is leverage risk. In this article, we will explain what leverage risk is, how it impacts REITs, and how you can reduce it.
What is Leverage Risk?
Leverage risk arises when an investor or a company uses borrowed money to purchase securities or assets. The use of leverage can amplify the returns on investment when the underlying assets perform well, but it can also magnify the losses when they perform poorly.
For example, suppose you have $100,000 and want to invest in a REIT that pays a 10% dividend yield. You can either buy $100,000 worth of shares with your own money or borrow another $100,000 at a 5% interest rate and buy $200,000 worth of shares. The table below shows the difference in your annual income from the two scenarios:
| Scenario | Investment | Dividend Income | Interest Expense | Net Income |
| No leverage | $100,000 | $10,000 | $0 | $10,000 |
| Leverage | $200,000 | $20,000 | $5,000 | $15,000 |
As you can see, by using leverage, you can increase your net income by 50%, from $10,000 to $15,000. However, this also means that you are exposed to more risk. If the REIT’s dividend yield drops to 5%, your net income will be:
| Scenario | Investment | Dividend Income | Interest Expense | Net Income |
| No leverage | $100,000 | $5,000 | $0 | $5,000 |
| Leverage | $200,000 | $10,000 | $5,000 | $5,000 |
In this case, your net income is the same whether you use leverage or not. But if the REIT’s dividend yield drops further to 2%, your net income will be:
| Scenario | Investment | Dividend Income | Interest Expense | Net Income |
| No leverage | $100,000 | $2,000 | $0 | $2,000 |
| Leverage | $200,000 | $4,000 | $5,000 | -$1,000 |
Now you are losing money by using leverage. You have to pay more interest than you receive in dividends. This is an example of leverage risk.
How Does Leverage Risk Affect REITs?
REITs often use leverage to finance their property acquisitions and other investments. They can increase their profitability and dividend payout by borrowing money at a lower interest rate than their expected return on investment.
However, leverage also exposes REITs to various risks that can negatively affect their performance and profitability. Some of these risks are:
- Interest rate risk: This is the risk that changes in interest rates will affect the cost of borrowing and the value of assets. When interest rates rise, the cost of borrowing increases & the value of fixed-income assets decreases. This can reduce REITs’ net income and cash flow and force them to cut their dividends or sell their assets at a loss.
- Refinancing risk: This is the risk that REITs will not be able to refinance their debt when it matures or that they will have to refinance at unfavorable terms. This can happen when credit markets tighten or when REITs face financial difficulties. If REITs cannot refinance their debt, they may default on their obligations or liquidate their assets at a loss.
- Asset value risk: This is the risk that the value of the properties owned by REITs will decline due to market conditions, such as oversupply, low demand, or economic downturn. This can reduce REITs’ net asset value and equity and impair their ability to borrow or raise capital.
These risks can create a vicious cycle for REITs that use leverage. Their credit ratings and stock prices may also decline when their performance and profitability deteriorate.
This can make it harder for them to access capital markets or obtain favorable financing terms. This can further reduce their income and cash flow and increase their leverage risk.
How to Reduce Leverage Risk When Investing in REITs?
As an investor, you can reduce your exposure to leverage risk when investing in REITs by following some of these tips:
- Do your research: Before investing in a REIT, you should do your due diligence and analyze its financial statements, debt levels, interest coverage, debt maturity profile, asset quality, and growth prospects. You should also compare its performance and valuation with its peers and the industry average. You should avoid investing in REITs that have excessive leverage, high-interest costs, low-interest coverage, short-term debt, poor asset quality, or negative growth prospects.
- Diversify your portfolio: You should not put all your eggs in one basket and invest in only one or a few REITs. You should diversify your portfolio across different types of REITs, such as equity REITs, mortgage REITs, hybrid REITs, and specialty REITs. You should also diversify across different real estate sectors, such as residential, office, retail, industrial, healthcare, hospitality, etc. This can help you reduce your exposure to sector-specific risks and benefit from the different characteristics and performance of each type of REIT.
- Monitor your investments: You should not invest in REITs and forget about them. You should monitor your investments regularly and keep track of any changes in the market conditions, interest rates, credit ratings, dividend policies, earnings reports, and other relevant factors that may affect the performance and profitability of REITs. You should also review your portfolio periodically and rebalance it if necessary to maintain your desired risk-return profile.
Conclusion
Investing in REITs can be a great way to earn income from real estate without owning or managing properties. However, you should also be aware of the risks involved, especially leverage risk. Leverage risk arises when an investor or a company uses borrowed money to purchase securities or assets. It can amplify the returns on investment when the underlying assets perform well, but it can also magnify the losses when they perform poorly.
