Real Estate investing comes in many different shapes and forms. Many investors are often faced with the dilemma of buying shares in a publicly-traded REIT or purchasing physical real estate.
What is a REIT?
REIT stands for Real Estate Investment Trust. REITs are companies that own, invest, or lend to operators of commercial or residential properties. And not surprisingly, commercial real estate is the 3rd largest asset class, just behind stocks and bonds.
REITs can be traded or non-traded, but the earnings generated by REITs require them to distribute 90% of their income to shareholders to qualify as a REIT.
There are several tax advantages of qualifying as a REIT, the main reason being avoiding double taxation: once at the corporate level and then at the individual level.
There are 3 main types of REITs that can invest in a wide variety of sectors.
Types of REITs
The 3 primary REIT categories are Equity REITs, Mortgage REITs, and Hybrid REITs.
Equity REITs. Are the most common type of REIT. Equity REITs own and operate income-producing real estate, like apartment complexes or retail space. Equity REITs are what most people think of when the term “REIT” comes to mind.
Mortgage REITs. Provide financing to real estate owners and operators through real estate loans, mortgages or even the acquisition of mortgage-backed securities.
Hybrid REITs. Use a combination of Equity and Mortgage REITs.
What is Direct Real Estate?
A Direct real estate investment is a type of real estate investment that most of us already understand. Individuals invest in real estate through the purchase or sale of properties. Most commonly
Direct Real Estate investing typically involves purchasing properties to generate rental income and property appreciation.
Pros of a Physical Real Estate Investment
Direct real estate investing yields a wide range of unique benefits you cannot get through Real Estate Investment Trusts.
Let’s look below…
Generally speaking, real estate investors can deduct the normal maintenance expenses of their properties and other large deductions.
Significant tax deductions may include mortgage interest, property taxes, operating expenses, depreciation, and repairs.
Most individuals can deduct expenses for keeping their rental property in good operating condition. For example, certain materials, supplies, repairs, and general maintenance are usually deductible.
Tax deductions can help make a questionable investment property more appealing to real estate investors.
You Can Build Equity
Building equity in physical real estate is the difference between your property’s value and what you owe on your mortgage. Home equity is a way essentially a “forced savings” and a long-term wealth-building strategy.
While many people can argue that you can make more significant returns investing in the stock market, the “forced savings” of homeownership is still the largest financial asset for middle-income households, according to the Brookings Institute.
And while this article is more directed toward investment properties and not primary residences, the overarching concept still applies.
Because private real estate cannot be easily bought or sold, property valuations will not gyrate to the same extent or frequency of publicly traded REITs.
You Own A Physical Piece of Real Estate
For many individuals, there is a sense of pride when you own physical real estate.
Real Estate is tangible.
You can touch it. Walk through it. Paint it. You have creative control.
Owning physical real estate is a much different experience than seeing a bunch of numbers on a screen. It’s a feeling that cannot be replicated through REIT ownership.
Unless you are a professional investor or money manager, there are not many outlets where individual investors can borrow large sums of money at a reasonable interest rate.
Let’s take an example to illustrate the power of leverage using Cash on Cash Return which your pretax cash flow (after all operating expenses) is divided by your money invested.
If you put 25% down, your cash on cash return would only be 8%. Meanwhile, if you put 10% down, your cash on cash return would be 20%.
That is the power of leverage in real estate investing.
Pros of REITs
The most significant benefit of publicly traded real estate investment trusts is that you can easily buy and sell your shares with no limitations, which, unlike owning physical real estate, has no liquidity; you cannot easily or quickly buy or sell a property.
Liquidity should be strongly considered if you plan on holding your investment for less than 5 years.
Low Transaction Costs
Investing in publicly-traded Real Estate Investment Trusts is cheap. There are low to usually no brokerage costs through most big-name brokerages like TD Ameritrade or Fidelity. You can easily buy and sell REITs without large expenses.
Meanwhile, purchasing real estate often comes with closing costs of 3 – 6% of the property purchase price.
Passive Income and Capital Appreciation
REITs are excellent investments if you are looking for steady dividends that grow faster than inflation while also providing capital appreciation.
As of this writing, the average dividend yield for Equity REITs is 4.3%, according to the Motley Fool. Some REITs can pay significantly more, depending on their investment strategy.
If you invested $10,000 in REITs, you could expect to earn $430 in dividends. Meanwhile, the S&P 500 has a dividend yield of approximately 1.4%.
REITs provide a natural inflation hedge. This is because as inflation increases, real estate owners tend to increase rent on commercial real estate leases as they come due.
REIT dividend increases outpaced inflation in 18 of the last 20 years compared to Consumer Price Index (CPI). Over the twenty years between 2000 and 2020, the annual growth for dividends was 9.4% vs. 2.1% for the Consumer Price Index, according to an analysis done by REIT.com.
Cons of Direct Real Estate Investing
Investing directly in real estate can cost you time and effort.
You must deal with tenant issues, maintenance, and liability if an accident occurs. Finances are another problem. Investors must borrow to purchase a property and are often beholden to the prevailing market interest rates.
Below are some of the main cons of direct real estate investing.
Owning physical real estate means there willEstatesic maintenance costs. If you are unable or unwilling to manage the property yourself, you may need to hire a property management company. Property management companies charge 8% – 12% of your monthly rental income, which certainly isn’t chump change.
It’s important to note that a property management company doesn’t include the cost of repairs but more the management.
Buying a rental property or any piece of real estate is expensive. According to Zillow.com, closing costs can average between 2% – 5% but can vary from state to state.
For example, if you bought a $500,000 rental property, you can expect to pay between $10,000 and $25,000 in closing costs.
Standard closing costs can include:
Lender’s Title Insurance
Loan Origination Fee
Just to name a few.
Most individuals can lump closing costs into their mortgage payment, and it is usually the buyer of the real estate property who pays most of the expenses. Be sure to take into consideration closing costs before deciding if physical real estate is right for you.
Tenant & Liability Risk
When you own rental property, there is always a risk that something catastrophic happens, and you could be sued due to negligence or perhaps you have an ambulance-chasing tenant.
According to a recent article, rental property insurance is about 25% more expensive than traditional homeowners insurance, which costs approximately $1,445, so you can expect to pay about $1,800 for rental property insurance, which eats into your investment property cash flow.
The interest rate you receive on your mortgage can impact your monthly payment and rental income if you plan on operating a rental property.
Sure, most people can deduct mortgage interest on their taxes, but it is not a 1-for-1 deduction. And some people will note that home prices and mortgage rates have an inverse correlation, but that is an imperfect comparison because there are way too many nuances.
As of this writing, the 30-year Fixed Mortgage Rate, which is the benchmark for borrowing, is over 5%. While historically, mortgage rates are still at a historic low, a 1% move in mortgage rates can drastically impact your monthly mortgage payment and cause wild swings in the housing market.
High property taxes means the money being invested in your town, which makes it a more desirable place to live, which subsequently raises the value of your property.
The benefits of a desirable location aren’t always immediately seen, while you sure will notice the property tax bill coming in, so that is why I am listing this as a con.
You can use this property tax calculator to estimate the property taxes in your town.
Cons of REITs
Real Estate Investment Trusts are an attractive way to gain exposure to the real estate market.
However, there are some issues to consider. There are no tax breaks like physical real estate. You also have no artistic control.
Stock Market Correlation & Volatility
Publicly traded REITs tend to correlate highly with the overall stock market. A correlation of 1 means a stock or sector moves exactly with the overall stock market.
According to a Morningstar.com analysis, the FTSE NAREIT Equity REIT had a correlation of 0.59 with the CRSP 1-10 U.S.Estate Market Index, which represents nearly 100% of the investable U.S. Equities Market.
So if the total stock market moves down 10%, the overall Equity REIT market is expected to drop 5.9%.
And if you are a buy-and-hold investor or can not stomach periods of extreme volatility, you may want to think twice before investing in the real estate market through REITs.
Capital Gains Tax
If you sell your REITs for a profit, you are subject to either short- or long-term capital gains taxes.
Long Term Capital Gains are if an investment is held for a year or longer and the tax rate can range between 0% and 20%, depending on your income.
Short Term Capital Gains are if an investment is held less than a year. The rate is your ordinary income tax rate, which can range between 10% and 37%.
Now, capital gains taxes are generally unavoidable in any investment situation. You would also have to pay taxes if you sold your investment property unless you executed a 1031 Exchange, which allows you to defer capital gains by swapping one real estate investment property for another.
No Investor Control
When you invest in a Real Estate Invest Trust (REIT), you do not have control of the investment strategy. Sure, you can put your money towards a REIT that executes a particular strategy or invests in a certain property type, but you don’t have any say in how and when that strategy is executed.
Meanwhile, with direct real estate investing, you are in control of all facets of the property. You control all decisions from property enhancements and how much to charge for rent to tenant screening. And for some pe
Are REITs Better Than Real Estate?
Real estate investments in physical real estate or REITs can be advantageous for your investment portfolio, but you need to be sure which strategy works for you.
REITs are a better option for…
Investors who want a hands-off approach to real estate investing while generating passive income in the form of dividend income.
Physical Real Estate is a better option for…
Investors who prefer a more hands-on approach and have the time and energy to dedicate to managing a physical property, and lastly, want more control over investment decisions.