REITs vs. Real Estate: Which Investment Will Win the Battle for Your Wallet?
Real estate is the third largest asset class, behind stocks and bonds, and the most popular alternative investment by a long shot – it’s easy to see why.
With consistent appreciation and investment potential, and often income-generating when leased or rented, real estate is a sound addition to any portfolio.
Most beneficial, to many investors, is real estate’s diversification potential because diversification is a critical part of any investing strategy.
But many new investors find themselves torn between the many options, wondering: is it better to invest in real estate or a REIT?
REITs and Real Estate: How they are the same
Inflation Hedge
Both real estate and REITs provide an inflation hedge to help maintain your capital’s purchasing power. As inflation increases, real estate and REIT managers often increase rent and lease costs to keep pace. A study by industry giant Nareit backs up that thesis, demonstrating that REIT dividend increases outpaced inflation for 18 of the last 20 years – between 2000 and 2020, REIT dividend annual growth was 9.4%, compared to a 2.1% inflation rate measured by Consumer Price Index.
How Are They Different?
Capital Requirements
REIT investments require FAR less capital than buying real estate outright. You can buy shares of Vanguard’s flagship REIT ETF, VNQ, for around $80 a share. With only $500, you can still get a piece of many properties.
On the other hand, if you put down a measly 5% on a rental property, you’re still facing a hefty $20,000 bill – assuming an average duplex cost of around $400,000.
Liquidity
REITs also enjoy substantial liquidity benefits over typical real estate offerings. You can easily buy and sell your REIT shares without limitations, much like any other stock in your portfolio.
But flipping real estate on the open market is tough, and doing so quickly is nearly impossible. In real estate terms, “quick sales,” funds sit in escrow for as much as 45 days… if all goes according to plan! In the end, cashing out a property sale can take between 75 – 180 days.
Management
REITs are professionally managed, with a team of experts behind the scenes acquiring, financing, and managing the properties in your portfolio. Physically owning real estate requires constant hands-on management by you, the owner. Alternately, you can outsource to a management company but that’s going to eat into your profits and still demand far more of your time than a REIT.
Ultimately, with real estate, you’re responsible for all decisions related to the property including repairs, improvements, rent increases, and inevitable tenant disputes.
Investor Control
On the other hand, if you invest directly in real estate, you’re in charge of all decisions ranging from capital improvements to what color you should paint the bathroom and how much to charge for rent.
Meanwhile, when you invest in a REIT, you have basically no say in the REIT’s strategic direction, and all decisions are left to the management team.
Diversification
REITs offer greater diversification options compared to real estate investments. When you invest in an individual REIT or REIT ETF, you can easily diversify across multiple sectors of the overall industry. Meanwhile, diversification across multiple real estate sectors for individual investors is difficult, expensive, and compounds the management problem.
Leverage
Another critical difference between REITs and direct real estate investment is leverage. When you buy real estate, you can use borrowed money to amplify your returns but generally cannot use comparable leverage when buying publicly-traded REITs.
Sure, you can use margin loans and introduce leverage when investing in REITs, but margin loans are far more expensive than a mortgage and introduce a new level of risk.
The average margin loan ranges between 8 -12% with big name brokers, with preferred rates usually set aside for clients with $1,000,000 or more in assets. Margin loans also cannot be amortized over 30 years like a mortgage.
Meanwhile, the 30-year fixed mortgage is around 6.50% as of this writing, making it substantially cheaper to attain leverage through a mortgage.
Let’s take an example to illustrate the power of leverage using Cash on Cash Return, which is your pretax cash flow (after all operating expenses) divided by money invested.
If you put 25% down, your cash-on-cash return would only be 8% whereas, with 10% down, you hit 20%.
That is the oft-overlooked power of leverage in real estate investing.
Volatility
Since many REITs are publicly traded, they’re subject to overall market gyrations and related volatility.
Meanwhile, since real estate is illiquid and cannot be easily bought or sold, property valuations tend to be more stable than REIT pricing.
One quick note about volatility: many people argue that lower volatility in REITs is a myth because of the way real estate is priced.
It’s partially true.
You only know the price of your real estate when it’s marked to market (and even then, only for certain when it is eventually sold) but you know the price of your REIT every second that the stock market is open.
If you had REIT-like price transparency on your real estate, many argue it would be as volatile as the stock market, if not more – possibly, but maybe not.
The reality is that you can’t get REIT-like transparency on your real estate and, until that happens, the argument for reduced volatility in real estate will continue to hold true despite what any myth busters may say.
Correlation
Real estate is less correlated to the overall stock market than publicly traded REITs.
A correlation of 1 means a stock or sector moves exactly with the overall stock market.
According to Morningstar analysis, the FTSE NAREIT Equity REIT has 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, in other words, if the total stock market moves down 10% you can reasonably expect the equity REIT market to drop 5.9%.
Some also say the correlation argument is a myth which, again, is only partially true.
Real estate prices are a lagging indicator, which means their values tend to change after other economic indicators like inflation and interest rates go live.
If unfavorable economic data comes out, REITs prices usually react immediately. Meanwhile, real estate prices remain static because the trickle-down effect takes time to reflect in the property market.
Some claim that if you look only at REIT prices annually using an average price, you’ll see less correlation.
But that’s simply a thought experiment, and the reality is that REIT prices don’t lag and don’t use average prices – so it’s a weak argument.
Transaction Costs
Another substantial difference between REITs and real estate are transaction costs. Buying and selling REITs through most online brokers like M1 Finance comes with no transaction cost when buying or selling REITs. Meanwhile, buying real estate comes with huge transaction costs.
Purchasing or selling a property often comes with closing costs around 3 -6% of the property purchase price. With a national average of a duplex of about $388,000, you’re facing nearly $11,500 – $23,000 in closing costs alone.
In numbers terms, the Vanguard VNQ REIT ETF trades at around $75 a share historically. Assuming the closing price is 6% of $388,000, you’re looking at $23,000 in closing costs.
That means you could have bought approximately 300 shares of VNQ, yielding a dividend return of around 4.2%, so you’re effectively giving up almost $1,000 in annual income distributions from paying closing costs.
PROs of Real Estate
Passive Income
REITs are truly passive income opportunities. A significant advantage to REIT investing is the generating passive income. Investing in REITs doesn’t demand tenant management, maintenance, insurance, or unexpected expenses which makes them a passive income strategy.
As of this writing, according to Motley Fool, the average dividend yield for Equity REITs is 4.3%. Some REITs pay significantly more, depending on their investment strategy and structure.
If you invested $10,000 in REITs, you could reasonably expect to earn $430 annually in dividends. Meanwhile, the S&P 500’s dividend yield is approximately 1.4%.
Tax Deductions
Generally speaking, real estate investors deduct normal maintenance expenses of properties, as well as other large expenditures.
Common tax deductions include mortgage interest, property taxes, operating expenses, depreciation, and repairs.
Most owners can deduct expenses for keeping their rental property in good operating condition; for example, certain materials, supplies, repairs, and general maintenance are often deductible.
Tax deductions can help make a questionable investment property more appealing to real estate investors.
You Can Build Equity
Equity in physical real estate is the difference between the property’s value and what you owe on the mortgage loan. Home equity is, in a way, essentially a “forced savings” long-term wealth building strategy.
While many can argue that you can generate greater returns investing in the stock market, the “forced savings” of homeownership is still middle America’s best financial asset according to the Brookings Institute.
And, while this article is directed toward investment properties rather than primary residences, the concept still applies.
You Own A Physical Piece of Real Estate
For many owners, there’s a unique sense of pride in owning physical real estate.
Real estate is tangible.
You can touch it. Walk through it. Paint it.
You have total creative control.
Owning physical real estate is a much different experience than seeing a bunch of numbers on a screen and cannot be replicated through REIT investing.
Leverage
Unless you’re a professional investor or money manager, there aren’t many options to borrow large sums of money at a reasonable interest rate compared to mortgage lending, like we saw in our cash-on-cash example.
To reiterate, 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%.
CONs of Real Estate
Investing directly in real estate costs time and effort.
You must deal with tenant issues, maintenance, and imminent liability if an accident occurs. Finances are another thorny issue. Investors must borrow to purchase a property and are thus beholden to prevailing market interest rates.
There are other downsides, too:
Property Maintenance
Owning physical real estate means there are unavoidable maintenance costs. If you’re 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. That certainly isn’t chump change.
It’s important to note that a property management company doesn’t include the cost of repairs, but rather serve an oversight and managerial function, so you’re still on the hook for peripheral costs.
Closing Costs
Buying a rental property or any piece of property is expensive. According to Zillow.com, closing costs average between 2% – 5% although they vary regionally.
For example, if you buy a $500,000 rental property, you can expect to pay between $10,000 and $25,000 in closing costs.
Standard closing costs usually include:
- Application Fee
- Appraisal
- Lender’s Title Insurance
- Loan Origination Fee
Most individuals lump closing costs into their mortgage payment, and it’s usually the buyer paying most of the expenses. Still, be sure to research and consider closing costs before deciding if physical real estate is right for you.
Tenant & Liability Risk
When you own rental property, there’s always the risk that something catastrophic could happen, leading to lawsuits based on negligence or if you’re renting to an ambulance-chasing tenant.
According to a recent article, rental property insurance is about 25% more expensive than traditional homeowners insurance. The latter costs approximately $1,445, so you can expect to pay about $1,800 annually for rental property insurance which, again, eats into your investment property cash flow.
Mortgage Interest
The interest rate you get on your mortgage can impact your monthly payment and income if you plan on running a rental property.
Most people can deduct mortgage interest on their taxes, but it’s not a 1-for-1 transaction. Some experts also note that home prices and mortgage rates have an inverse correlation, although that’s an imperfect comparison because there are many variables at play.
As of this writing, the average 30-year fixed mortgage rate, a common benchmark for borrowing, is over 5%. Historically, mortgage rates are still near all-time lows, but a 1% move in rates can drastically impact your monthly payment and cause wild swings in the housing market.
Property Taxes
High property taxes means your money is invested locally, making it a more desirable place to live which, in turn, raises property values.
But the benefits of a desirable location aren’t always immediately seen, although you definitely notice the property tax bill coming in each year – that’s why we’re marking property taxes as a drawback to real estate investing.
You can use this property tax calculator to estimate local property taxes.
PROs of REITs
Passive Income
REITs are truly passive income opportunities. A significant advantage to REIT investing is the generating passive income. Investing in REITs doesn’t demand tenant management, maintenance, insurance, or unexpected expenses which makes them a passive income strategy.
As of this writing, according to Motley Fool, the average dividend yield for Equity REITs is 4.3%. Some REITs pay significantly more, depending on their investment strategy and structure.
If you invested $10,000 in REITs, you could reasonably expect to earn $430 annually in dividends. Meanwhile, the S&P 500’s dividend yield is approximately 1.4%.
Less Capital Required
Investing in REITs requires MUCH less capital. You can buy shares of Vanguard’s VNQ REIT ETF for around $80 a share. So even if you only had $500 or $5,000 you could still invest in real estate through REITs.
Less Stress
A significant but hard to quantify benefit to REITs is their stress reduction, since they’re truly a passive income investment.
REITs will never call you at 3 a.m. to fix a leaky faucet.
There is no risk of tenants not paying on time, a water pipe bursting, or neighbors complaining.
Liquidity
The most significant benefit to publicly traded real estate investment trusts is that you can easily buy and sell your shares with no limitations. Unlike owning physical real estate, you cannot easily or quickly buy or sell a property – there’s much less liquidity in the market compared to REITs.
Liquidity should be a primary consideration if you plan on holding your investment for fewer than five years.
Low Transaction Costs
Investing in publicly-traded REITs is cheap. Big-name brokerages like TD Ameritrade or Fidelity often offer zero or low brokerage costs, so you can easily buy and sell REITs without large peripheral expenses.
Meanwhile, purchasing real estate often comes with closing costs of 3 – 6% of the property purchase price.
CONs of REITs
REITs are an attractive way to diversify your portfolio through exposure to the real estate market.
But there are some issues to consider. There are no tax breaks like you’d enjoy investing in 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 equity REIT market can be expected to drop 5.9%.
And, if you’re a buy-and-hold investor or can’t 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’re subject to either short- or long-term capital gains taxes.
Long Term Capital Gains kick in when an investment is held for a year or longer. The tax rate can range between 0% and 20%, depending on your income.
Short Term Capital Gains apply if an investment is held less than a year. The rate is your ordinary income tax rate, ranging between 10% and 37%.
Capital gains taxes are generally unavoidable in any investment situation, and you would also have to pay taxes if you sold your investment property. The exception is when you execute a 1031 Exchange, if eligible, which lets you defer capital gains by swapping one real estate investment property for another.
No Investor Control
When you invest in a REIT, you don’t 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 direct say in how and when that strategy is executed.
Meanwhile, directly investing in real estate, you’re in control of all aspects. You manage all decisions, from property improvements and how much to charge for rent, all the way down to individual tenant screening.
Are REITs better than Real Estate?
Real estate investment through physical real estate or REITs can be beneficial for your investment portfolio, but you need to narrow down which strategy works for you.
REITs are good for…
Investors who want a hands-off approach to real estate investing and prefer generating passive income in the form of decent dividends.
Real Estate is good for…
Investors who prefer a more managerial approach and have the time and energy to dedicate to managing a physical property and, ultimately, want more direct control over investment decisions.
