REITs vs Real Estate: Why REITs Are Better Than Direct RE Investing
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If you have money to invest in the real estate market, you might wonder which you should choose between REITs vs real estate.
Both options historically perform well but, like any investment, have pros and cons. Understanding the difference between the types of REIT and physical real estate investments can help you choose what's right for you.
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What Is a REIT?
REIT investing is a way to invest in the real estate market indirectly. If you don't like owning and managing physical real estate, you may find REITs (real estate investment trusts) to invest in that can be a good alternative. Here's everything you should know about REITs vs rental property.
What Are REITs: Real Estate Investment Trusts
A REIT investment or real estate investment trust is a real estate investment trust company that owns, operates, and sometimes finances commercial property. Real estate investment trusts use the funds from multiple private real estate investors to fund the project.
How to Invest in REITs
The REIT can be privately or publicly held, and investors buy shares of the REIT to become 'owners' of the property. REITs pay out at least 90% of their profits to shareholders, and investors don't have to worry about managing physical properties.
Keep in mind private real estate investment trusts don't have a secondary market to liquidate them. You must hold onto the investment until its maturity. Some publicly-traded REITs can be liquidated earlier if necessary, but typically when you buy REITs, you are in it for the long haul.
The REIT companies are the entities that own the real estate, usually commercial real estate. Shareholders just own a portion of the real estate investment trust company but don't have to do anything for the real estate. Once investors choose the REIT, their job is done.
REIT companies, on the other hand, operate and manage the properties. This could mean handling maintenance and repairs, screening tenants, collecting rental income, marketing the property, and selling it. You can find multiple types of REITs, including multifamily REITs, office buildings, hotels, medical buildings, and shopping mall REITs.
Are REITs a Good Investment
Historically, REITs provide a decent return on investment. But, like any investment, there's a risk, especially if you invest in commercial properties with a REIT. The key is to find a reputable REIT company. Look for one with extensive experience handling different properties and whose properties have a good return.
Diversifying your portfolio with various investment types to offset the risk of a total loss should one industry crash is a good investment technique. When you decide which REITs to invest in, research the company's historical performance, goals, beliefs, and the type of properties they will own.
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Here's a simple example of a real estate investment trust.
A real estate owner, which is a company, buys an apartment complex. The company plans to rent the apartments for five years before selling the property. The company issues shares of its company to private real estate investors interested in owning an apartment complex.
The REIT company handles screening tenants, collecting rent, dealing with vacancies, and maintaining properties. The REIT pays its investors monthly dividends from the monthly rental income, and when the company sells the property, the investors earn their principal investment back plus capital gains.
REIT Pros and Cons
REITs, like any investment, has pros and cons, including the following.
- REITs pay regular cash flow with their dividend payments. They are required by law to distribute at least 90% of their profits to shareholders.
- It can be a great way to invest in real estate without much capital. Most real estate investment opportunities require hundreds of thousands of dollars in capital, but you can invest in REITs with as little as $100.
- You don't need a lot of experience to invest in a REIT. You're ready to invest if you can research the REIT companies and choose the one you're most comfortable using.
- Publicly traded REITs can be traded during open market hours, giving you more liquidity for your investment.
- REIT investments don't get the same tax benefits direct real estate investments get, which can mean higher tax liabilities.
- REIT share prices may appreciate slowly because the company only has 10% of its profits to reinvest in the company to grow it.
- Investors don't have control over the properties a REIT owns or how they handle them.
- Many REITs aren't diversified since REIT companies focus on one niche, which can put your investment at risk.
Direct Real Estate Investments
Direct real estate investment requires you to own physical real estate yourself. For example, you can own residential or commercial property, acting as the landlord and handling the rental property. While the profits can be good, there is also the risk of a total loss.
Types of Direct Real Estate Investments
Real estate investors can purchase residential or commercial properties—examples of residential properties include single-family homes, townhomes, and condos. Commercial properties include shopping centers, office buildings, apartment complexes, and hotels. In both cases, you own physical real estate.
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How to Invest
To invest in direct real estate, you must buy the property outright. The good news is that you don't need cash for the entire purchase price.
You can leverage your physical real estate investment by borrowing a portion of the funds with a mortgage. You'll need a down payment, usually at least 30%, sometimes more, and then you can borrow the rest if you qualify for an investment mortgage.
Whether you pay cash or take out financing, you pay the seller at the closing and take possession of the property.
As the owner, you collect the rental income on the rental property and use it as cash flow for the property to cover the cost of your mortgage, property upkeep, and property taxes. The remaining cash is your profit.
Direct real estate investing means you buy and manage property; for example, let's say you purchased a single-family home as an investment.
The property was $150,000, and you put down $50,000, borrowing the rest. Then, you closed on the property and advertised it for rent. You rented the home out within a couple of weeks, charging $1,100 a month in rental income. Your mortgage payment is $540, and the monthly taxes and insurance are $300. This leaves you with $260 a month in cash flow or $3,120 a year plus the home's capital appreciation while you own it.
Real Estate Pros and Cons
Direct real estate investing has pros and cons you should understand before investing too.
- You earn 100% of the cash flow from the rent charged on direct investments.
- You can own as many direct real estate properties as you want, increasing your portfolio and earnings.
- As the single owner of direct real estate, you earn the appreciation the property experiences
- A direct real estate investment has many more tax benefits than investing indirectly with REITs
- You need a large amount of capital for investing directly, even if you leverage your investment with a mortgage
- You instantly become a landlord, on-call 24/7, unless you hire a property management company, but that costs money, which reduces your profits
- You need a lot of knowledge and the ability to research for direct real estate investing
- Investing directly in real estate is an illiquid investment
REITs vs Real Estate - Primary Differences
A REIT investment and direct real estate investment can be an excellent addition to a portfolio, but what are the main differences?
The targeted returns vary greatly between direct investments and real estate investment trusts. Of course, the economy and market play a significant role in your returns, but typically, the REIT average return is 8 - 10%, and direct real estate investing has an average 9.6% targeted return.
The actual returns depend on various factors, including the area's values, vacancy rates, average rents, and how the investor manages the property.
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A major difference between REITs vs real estate is the money required to invest. REITs allow investments as low as $100, whereas direct real estate requires tens or hundreds of thousands of dollars. Most lenders require at least 20% - 30% down on a home or $20,000 - $30,000 for every $100,000 borrowed.
Investors often want to know the correlation of their investment to the stock market. Most investors trying to diversify their portfolios prefer a lower correlation to reduce their risk of a total loss.
REITs have a higher correlation to the stock market, especially if they are publicly traded REITs. If the market crashes, the likelihood of REITs decreasing in value too is high, and vice versa.
Direct real estate investing, however, has a low correlation. In other words, the stock market's increases and decreases don't affect direct investments.
Real estate investing isn't always liquid, so understanding the ability to liquidate your investment can play an important role in your decision.
Owning properties yourself is less liquid than publicly traded REITs but more liquid than private REITs. A publicly traded REIT is the most liquid of the three options because you can trade your shares when the market is open. Conversely, a privately traded REIT is the least liquid because you typically can't liquidate it early.
Owning income-producing real estate outright can be liquid, but selling it could take months or longer.
Public REITs are traded on the open market during regular trading hours. These REITs are highly regulated and may not be available for investment in all asset types. When you invest in private real estate, you completely control what you invest in, how you handle it, and even when you buy or sell it. Therefore, you may not have as many options with public REITs.
REITs vs Real Estate: FAQ
Are REITs a Good Investment Now?
REITs are a good investment to buy and hold. Like any real estate investment, it will have its ups and downs, depending on the economy. However, if you hold onto them, historically, they ride the wave and can make a comeback even if they decline.
Which Type of Real Estate Investment Is Better?
There isn't a type of real estate investment that is better than another. It depends on many factors, including the investor's individual preferences, risk tolerance, and timeline. If you're looking for something steady that requires little to no work on your end, REITs are a good option. But if you like more control and freedom, a direct investment may be a better option.
Which Is Better - Invest in Stocks or Real Estate?
It's not a matter of which is better - stocks or real estate. Instead, it's best to have a diversified investment portfolio. When you have stocks and real estate in your portfolio, you have two uncorrelated assets that don't depend on one another's performance.
What Is Considered Private Real Estate?
Private real estate is real estate you purchased, not a publicly traded asset, such as a REIT. You control when you buy and sell the property and how you handle it. Your private investment isn't subject to regulatory issues like publicly traded REITs have.
REIT vs Real Estate Investments: The Bottom Line
Choosing REITs vs real estate investing is a personal opinion. Decide how to manage your investments, how much input you want, and what sort of tax deductions you want for your investments. You'll increase your taxable income if you have capital gains on either option, but owning physical real estate may offer more deductions.
Consult with your financial advisor to choose the right investment and to decide if buying physical real estate and owning REITs are good options for your real estate portfolio.