REITs vs Buying Real Estate: The Pros and Cons of Each
April 20, 2022
Investors have many ways to invest in real estate today, but the two most commonly debated options are REITs vs buying real estate directly. However, both offer the opportunity to invest in real estate, just in different ways.
Here's everything you must know to help you decide if REITs or direct real estate investments are right for you.
Why Invest in Real Estate
Investing in real estate is a great way to have a diversified portfolio. You don't have to rely solely on the stock market and its returns. Real estate often reacts opposite to the stock market, helping you offset any losses you might experience investing in stocks.
Real estate can also be a great hedge against inflation. As companies struggle to stay afloat with higher costs and lower profits, shareholders see smaller or no returns. Real estate prices, on the other hand, often increase with inflation.
The truth is, though, you don't have to invest only in physical real estate to diversify your portfolio. You can invest in real estate investment trusts or crowdfunding to invest in commercial real estate and realize its returns.
REITs vs Real Estate Overview
Understanding the differences between a REIT(real estate investment trust) and physical real estate investments is important. You can invest in one or both to take advantage of income producing real estate.
What Are REITs
REITs are real estate investment trusts or investments in a real estate company that buys, manages, and operates commercial property.
Investors like yourself can buy shares of a REIT, making you a real estate investor without a lot of capital or the need to manage physical real estate. You enjoy the returns and possibly dividends while holding onto the passive investment.
Buying Real Estate
Buying real estate means you own physical real estate. It can be rental properties, like single-family homes, condos, townhomes, or commercial properties, such as office buildings, retail stores, or medical facilities.
You need more capital for a direct real estate investment versus adding REITs to your investment portfolio. When you invest directly in real estate, you either need the full purchase price in cash or the ability to get approved for financing properties.
Buying Real Estate Pros
- You may be eligible for more tax breaks
When you do direct real estate investing, you run a business along with investment. Therefore, the IRS allows certain tax breaks for this type of investment to write off the ordinary costs of managing and owning the property.
- You may earn a larger cash flow
When you own rental property yourself, you earn the rental income, which can be regular monthly cash flow. You also earn all equity buildup and capital appreciation. You don't have to worry about sharing it with anyone if you are the sole owner.
- Real estate often appreciates
There's no guarantee physical real estate will appreciate, but historically, it performs well over the long term. Unfortunately, the same can't always be said about alternative investments you could add to your portfolio.
- You are in control
When you own the real estate yourself, you are in charge of what properties you buy, how you manage them, what rent you charge, and what is allowed or not allowed on the property. You don't need anybody else's input, and even if you hire a property management company, you still call the shots.
- You can leverage your investment
When you invest in real estate, you can borrow money to buy the physical real estate, purchasing a property worth more than the investment capital you have.
Buying Real Estate Cons
- It takes a lot of work (sweat equity)
When you own rental properties, you are in charge of everything from daily maintenance to extensive repairs. In addition, you must screen and choose tenants, collect monthly rent, deal with rowdy tenants, and handle vacancies. It can be financially and physically exhausting.
- You may need financing
While financing can be a great way to leverage your investment, if you can't afford the financing because your tenants defaulted, you may have a financing default and hurt your credit. It might also be hard to get financing since not all lenders like to lend funds for rental properties, especially if the real estate market isn't doing well.
- Real estate isn't liquid
Unlike stocks or bonds, you can't just decide to sell a real estate property today and have cash in hand. Selling property is a process that could take months or longer and involves a lot of costs, especially if you use a real estate agent to sell it.
- You need a lot of capital
Even if you get mortgage financing, you'll still need a lot of capital to buy a rental property. Most lenders require 30% or more down on the home, which is $30,000 for every $100,000 in purchase price.
- You take on a lot of liability risk
When you own a property and rent it out to tenants, you take on the risk that something could happen on the property. There's also the risk that the property value could fall, tenants could default, or something could happen to the property, leaving it all on your shoulders.
- You need little capital
REITs aren't just for wealthy investors. You don't even need to be accredited to buy REIT shares. Some companies offer REIT shares for as little as $100 or less, but you can call yourself a real estate investor because you'll be able to take advantage of the properties' returns and capital gains.
- You don't have to worry about property management
Investing in REITs is an entirely passive investment. You don't have to worry about the maintenance or daily operations of any of the properties the fund owns. Instead, the REIT company chooses the properties and handles all property management while you collect the returns.
- REITs must pay out 90% of their profits to investors
If the properties are profitable, you don't have to worry about receiving dividends or a return on your investment. All REITs are obligated to pay out at least 90% of their profits to shareholders.
- Some REITs are liquid
Publicly traded REITs can be liquid because you can buy and sell them on the regular stock exchange during normal trading hours. While real estate investing does best for the long-term, life happens, and sometimes you need to bail, and with REITs, it may be easier.
- It's easier to have a diversified portfolio
When you invest in REIT shares, you can diversify your investment portfolio easier. For example, you can invest in residential or commercial property that you otherwise might not have invested in, whether it's located abroad, in an industry you know nothing about, or is out of your price range.
- Your dividends are taxable income on a real estate investment trust
This is important because dividends are taxed at the ordinary income tax rate rather than the long-term capital gains tax rate. The ordinary income tax rate is usually much higher than the capital gains rate, which means you might have higher tax liabilities.
- Many REITs aren't diversified
Most real estate companies have a niche that they focus on when buying physical real estate. They focus on office buildings or retail stores, for example, and don't buy different direct real estate investments that could diversify the fund.
- There aren't any tax benefits
When you buy an investment property yourself, you get the tax benefits of owning and running the property. When you invest in REITs, you aren't the one who owns or runs the properties, so you don't get any of the tax deductions.
- You have little (or no) control over the properties
Even though the fund owns physical properties and you're an investor in those properties, you don't have a say in what rental property or properties the fund buys, how they manage them, when they sell them, or in the daily operations of the properties.
- There could be a dip if the stock market crashes
Real estate investing usually isn't tied to the stock market, but REITs, especially publicly traded REITs, usually follow what the stock market does, which could mean if stock prices plummet, REIT prices might follow.
How to Choose Which Investment Is Right for You
It can be a tough decision choosing REITs vs buying real estate. Here are some key factors to consider when you're thinking about real estate investing.
Think about how much money you have to invest upfront. Direct real estate investing requires extensive capital upfront, not to mention the closing costs of buying property. If you don't have a lot of capital upfront, consider REITs with very little (or no) upfront costs, and you can invest with a fraction of the amount needed to buy an investment property directly.
How active do you want to be in your real estate investment? If you want a hands-on experience where you are 100% responsible for the property's management, including managing tenants, maintaining the property, and collecting rents, then buying physical property may be what you want.
If you'd rather have a passive investment in the real estate sector while still collecting monthly rental income, and having real estate exposure, consider a REIT where you invest in real estate. Still, your initial investment is much lower, and you don't have any responsibility regarding property management.
Think about your risk tolerance. There's a risk in investing in almost anything in the real estate market. Assess the risk of a total loss when you use direct real estate investing versus if a REIT were to fail.
How much can you stand to lose and still reach your financial goals?
Most real estate investments have a long timeframe. Therefore, the longer you hold onto real estate you bought, the more time it has to appreciate and the higher your chances are of property appreciation and higher returns.
But, there's always a way out. Find out an investment's required timeframe (if you're investing in REITs) and if there's an early redemption program. If you invest in real estate directly, research the market to determine the demand for the real estate assets to determine how liquid your investment might be.
No returns are guaranteed no matter the type of real estate investing you do. Buying real estate or investing indirectly using REITs can have great returns or significant losses. Do your research on the market, the REIT company, and the potential profits of the real estate investment you're considering to determine if it's right for you.
Investing in Real Estate FAQ
Do REITs Appreciate Like Real Estate?
Yes, REITs invest in commercial properties that can appreciate like any other type of real estate. While there's no guarantee the properties in the fund will appreciate, the chances are high since most real estate appreciates over the long term.
You won't see the same returns on REITs because you invest in a fraction of the commercial building or other real estate asset, but you'll see a prorated return based on your investment.
Are REITs Riskier Than Stocks?
A lot of people like to compare REITs to stocks because some are traded on the stock market, but they have much different risk levels. REITs are often less risky than stocks because they are invested in an appreciating asset versus waiting on the profitability (or not) of a business. Like any investment, though, there are always risks. Just like you could lose money if you invest in a mutual fund or stock, you could also lose money investing in REITs.
Do REITs Pay Dividends?
REITs often pay dividends, but not always. Unfortunately, many investors assume they'll get dividends and don't read the fine print. While REITs must pay out 90% or more of their profits as dividends, there's no guarantee when they'll distribute them, so always make sure before investing.
Are REITs the Same as Real Estate Crowdfunding?
REITs are companies in the business of direct investing in real estate and sharing the wealth with investors like you by selling shares of the company. On the other hand, crowdfunding pools funds together from many investors to raise capital for potential real estate projects.
The Bottom Line: Which Is the Better Investment
When looking at REITs vs buying real estate, there is no right or wrong. The answer is that it depends on your financial situation and financial goals. Consider your risk tolerance, how much you need/want to make, and what type of real estate you want to invest in to choose the right option for you. Learn more by signing up and visiting our blog.
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