Should You Invest in Property or REIT? The Debate is Heated
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As a real estate investor, you might be trying to choose between investing in physical properties or opting for the convenience of REITs. Both avenues offer unique advantages and disadvantages, and making the right decision requires you to understand both the market dynamics and your investment goals.
In this article, we’ll delve into the key differences between these two options, providing examples to help you make an informed choice.
Investing in Physical Real Estate Properties
When you invest directly in real estate properties, this means that you’re buying a specific property. You can buy two types of properties—residential, such as a condominium, and commercial, such as a shopping center.
Rental property investors, for example, can generate profit through rental income, appreciation, and any profits generated from any business activities if it’s commercial property.
How to Invest
To invest in direct real estate, you must buy the property outright. You don’t necessarily have to pay the full purchase price in cash when investing.
You can strategically leverage your investment by securing a mortgage for a portion of the required funds. With a mortgage, you’ll have to pay the initial down payment with cash, often set at around 30% or more, and pay the remaining price through a qualifying investment mortgage.
Regardless of whether you choose an all-cash transaction or opt for financing, the property’s ownership transfers to you upon closing.
Once you become the property owner, you can turn it into a rental property to generate income through rental. Then, you can use it as a cash flow to cover the cost of your mortgage, property management, and property taxes. Whatever is left after paying all your dues, is your profit.
For example, let’s say you purchased a single-family home as an investment for $200,000. You paid the initial down payment of $67,000 and borrowed the rest.
After you close the property, you successfully rent the home for $2,100 a month.
So, if your mortgage payment is $600, and the monthly taxes and insurance are $500, this leaves you with a monthly profit of $1,000, or $12,000 a year (a 6% yield), plus the rental property’s capital appreciation while you own it.
Advantages
Here are three advantages of direct real estate investment:
- Tangible Asset Ownership: As a property owner, you have full control over your investment. You can make renovations, manage tenants, and potentially increase its value through strategic improvements.
- Income Potential: Rental income from physical properties provides a steady cash flow stream as you get to keep 100% of it. In a strong rental market, your income can often cover mortgage payments and provide additional profit, like the example above.
- Appreciation: Over time, real estate properties tend to appreciate. If you choose the right location and make smart improvements, you could reap significant returns upon resale.
Disadvantages
In contrast, here are three disadvantages that you have to keep in mind:
- High Capital Requirement: Purchasing a property demands substantial upfront investment, including down payments, maintenance costs, and potential repairs. That’s still a large amount of capital, even if you leverage your investment with a mortgage.
- Active Management: Once you rent your property, you instantly become a landlord who needs to be on call 24/7. You’ll also be responsible for tenant screening, property maintenance, and handling unexpected issues, which can be time-consuming and require expertise. But you can always hire a property management company to do everything for you.
- Market Volatility: The real estate market can be unpredictable, and economic downturns can lead to decreased property values and rental income.
Investing in REITs
REIT, or a Real Estate Investment Trust, is an indirect way of investing in real estate. It’s a good alternative to direct real estate investment if you don’t like owning and managing physical real estate.
A REIT is a specialized company that owns, operates, or finances income-generating real estate properties. They gather money through a mutual fund from various private real estate investors to finance the project. Think of it as a bridge that connects the world of real estate with the convenience of investing in the stock market.
In the U.S., there are over 225 REITs registered with the SEC and a combined equity market capitalization of more than $1 trillion.
REIT companies can either be privately or publicly held, and investors become “owners” of the property by buying shares of the REIT. As per IRC, REITs must pay out 90% of their taxable income to shareholders.
How to Invest
When you invest in REITs, you’re essentially buying shares of a company that owns and operates various real estate properties, usually commercial real estate. Similar to buying stocks, investing in REITs allows you to become a part owner of a diversified real estate portfolio without needing to purchase properties directly.
You can invest in REITs through various channels, such as online trading platforms or financial advisors. Once you invest and become a shareholder of a portion of the REIT company, you don’t have to do anything for the property—your job is basically done after investing. The REIT company will be responsible for operating and managing the properties, which includes screening tenants, collecting rental income, handling maintenance and repairs, and marketing and selling the property.
There are three types of REITs, each focusing on a specific sector of the real estate market:
- 1. Equity REITs: These REITs own and manage income-producing properties, generating revenue primarily from rents.
- 2. Mortgage REITs: These REITs invest in mortgages or mortgage-backed securities, generating income from the interest on these loans.
- 3. Hybrid REITs: As the name suggests, these REITs combine the elements of both equity and mortgage REITs.
Here’s an example: a REIT company buys an urban apartment complex with plans to hold and manage the property for the next five years.
Before they sell the property, the company plans to rent the apartment for the same period.
So, they decided to offer shares of its company to private investors interested in owning an urban apartment complex. This means you can become a partial apartment complex owner without dealing with the intricacies of property management.
As the apartment complex generates monthly rental income, you receive monthly dividends. After five years, the company is selling the urban apartment complex. As a shareholder, on top of the monthly dividends, you’ll be receiving your principal investment + capital gains. And all this without the hassle of managing a property yourself.
Advantages
Here are three advantages of investing in REITs:
- Portfolio Diversification: REITs allow you to invest in a wide range of real estate properties, spreading risk across various sectors and locations.
- Passive Income: The regular dividend distributions from REITs can provide a steady stream of passive income. You only invest at the beginning and wait every month to receive money.
- Accessibility: You can invest in real estate with a much lower initial investment than buying properties outright. Of course, most real estate investment opportunities usually need you to shell out hundreds of thousands of dollars in capital, but you can invest in REITs for as low as a hundred dollars.
Disadvantages
In contrast, here are three disadvantages you need to consider:
- Higher Tax Liability: Unlike direct real estate, REIT investments have few tax benefits. Because of this, you might encounter higher tax liabilities. For example, REIT dividends might be taxed as ordinary income, potentially affecting your after-tax returns.
- Limited Control: As a shareholder, you won’t have a say in property management decisions, leaving them in the hands of the REIT’s management team.
- Market Dependency: The performance of your investment is tied to the real estate market’s overall health and the REIT’s management strategy. For instance, REITs can be very sensitive to interest rate fluctuations as it has an inverse relationship with Treasury yields. In short, when one goes up, the other goes down.
The Bottom Line
As a real estate investor, choosing between REIT and direct real estate investing is subjective and largely depends on what you want. The main considerations when selecting are how you want to manage your investments, how much money you want to shell out for the acquisition, and what kind of tax deductions you want for your assets.
On the one hand, direct real estate investing is a better option if you want cash flow, tax breaks to offset that income, a higher appreciation potential, and more control over your property. On the other hand, it makes more sense to invest in REIT if you don’t want the hassle of property management and operations and still own property. REITs can also be ideal for beginner real estate investors to gain more experience in the industry.
Nonetheless, the two choices, either shares or real estate, are good. What’s more important is to have a diversified real estate investment portfolio. When you decide to invest in both, you’ll have two uncorrelated assets that don’t necessarily depend on each other’s performance.
If you want more insights on choosing the right investment that’s ideal for your real estate portfolio, get in touch with me. I have decades of experience to help you further your real estate investments.
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