REIT vs. Real Estate
You’re looking into real estate investment opportunities and thinking about plunging into the market.
Before you make any sudden moves, it’s a good idea to have a solid working knowledge of the two main real estate investing options: real estate investment trusts (REITs) and direct real estate acquisitions.
Real estate investment trusts: an overview
In the not-so-distant past, you had to buy physical property to invest in real estate. You might buy an office building or other commercial real estate property or you might buy a multi-family home or apartment building. Either way, it was much riskier and more expensive to enter into the real estate market.
But that all changed in 1960 with the introduction of REIT investments. Congress created REITs to provide all investors easier access to real estate investment opportunities. And since that time, REITs have become a very popular option for investors of all types.
What is a REIT?
A REIT is a publicly-traded organization that funds, owns, or operates income-producing real estate assets. It’s sort of like a mutual fund — but just for real estate.
When you invest in real estate, your money goes into a fund along with capital from other investors. REITs are typically comprised of stocks, making them much more liquid than direct real estate investments. REITs can therefore be used as short-term or long-term investments. Plus, you get regular payouts in the form of dividends based on the number of REIT shares you own.
Believe it or not, the Securities and Exchange Commission requires REITs to pay out at least 90 percent of their taxable income in dividends. On the downside, that means that you’ll have to pay taxes on it.
You can buy publicly-traded REITs on the stock market through brokerages like Schwab or TD Ameritrade.
Three main types of REITs
There are three main types of REITs:
1. Equity REITs
Equity REITs are the most popular type, accounting for 90% of all REITs. Equity REITs generate revenue from physical real estate, including office, residential, retail, or healthcare properties. Property types tend to vary from fund to fund.
2. Mortgage REITs
Mortgage REITs invest in property mortgages instead of actual properties. As a result, shareholders are paid through interest payments on individual loans on the properties that are in the fund.
3. Hybrid REITs
Hybrid REITs provide a combination of mortgage and equity financing for investors. In other words, if you invest in a hybrid REIT, you can collect interest and rental income.
How REITs are different from direct real estate
Buying REITs is a lot different than buying physical properties. Here are some reasons why.
REITs have a lower barrier to entry
Investing in physical property requires a base level of knowledge. For example, you have to know the local market where you’re buying so that you can have a sense of your potential ROI when renting or flipping.
You should also possess knowledge about home repair or have a strong network of contractors and property managers to maintain your property or get it into shape for resale. You might also have to brush up on things like depreciation and potential tax deductions.
On the flipside, you don’t have to know any of these things to invest in REITs. All you need is a desire to own real estate and enough money to invest.
- Check out our post on the Top Real Estate Investment Strategies
REITs cost less
Investing in direct property can be exorbitantly expensive. New real estate investors are often surprised to see many of the fees associated with investing in real estate.
For example, to buy a property, you typically need to secure a mortgage loan — and absorb the associated interest rates. You also need a significant amount of money for a down payment.
To avoid paying mortgage insurance (PMI), you might have to put down 20% or more. And this is all before closing costs enter the equation, which tack on thousands of extra dollars that you must pay upfront or over the course of a loan.
The high costs of real estate investments are enough to deter many investors away from the get-go.
REITs, on the other hand, tend to be much more affordable. Most REITs typically come with a minimum investment of just $1,000 to $2,500 or more.
At the same time, you won’t have to go through the process of securing a mortgage or making monthly loan payments.
REITs require much less effort
Investing in REITs can lead to passive income, meaning you can make money without having to do any work. In other words, you won’t have to worry about broken appliances, lawn care, roofing repair, monthly cash flow, or anything of that nature.
This makes REITs ideal for people who lack the time or desire to take on the responsibility of a traditional real estate investment. All you have to do is research and buy a fund, sit back, and make sure that it performs up to standards.
Buying physical real estate can lead to passive income, too, but not always.
Turning a physical property into passive income often involves working with a property management company that manages all aspects related to property maintenance and renter relations.
To be sure, property management companies can make life easier for investors. But they can also be very expensive, costing hundreds or thousands of dollars every month depending on the services they provide.
No dealing with tenants
In addition to not having to worry about maintenance, you also don’t have to worry about dealing with tenants. This means you will be spared from finding people to rent or lease your space, collecting payments, fielding complaints, and dealing with evictions if people stop paying.
The latter scenario happens more than you might think. On top of that, some states have very strict laws protecting tenants when they stop paying rent — making it very difficult for landlords to take action. Despite what you might think, evictions are not always a cut-and-dried process.
REITs offer much greater liquidity
Direct properties can be very difficult to move and can take months or even years to sell.
One of the best parts about REITs is they are highly liquid. You have the freedom to buy or sell them just like you would any other stock.
Just make sure to watch out for any potential fees when selling REITs. Funds can sometimes contain hidden fees. My long-time readers know what I think about fees. (Spoiler: Not a fan!)
How risk factors in
All real estate investments come with an inherent amount of risk. There is no getting around the volatility of the market.
If you buy REITs, your investments depend heavily on the state of the housing or commercial real estate market. However, not all locations tend to be impacted by market fluctuations. It largely depends on what you are investing in, and where it’s located.
Investing in a single real estate property can also expose you to a lot of risks, especially when considering that your investment will not lead to as much diversification as putting your money into an index fund. For example, there is risk from being illiquid, risk of damage, and tenant risk — in addition to market risk.
Review your investment portfolio before making a decision on a specific property or REIT, and assess your risk tolerance. Try to determine your ability to withstand a bad investment before making any big moves.
Frequently Asked Questions
How much of my portfolio should go toward real estate?
Before you invest in real estate, it’s a good idea to take a look at your portfolio and see how your investments are allocated.
Keep in mind that real estate should only be part of your overall portfolio. To protect yourself, avoid putting too much into any one particular area. Unless you’ve got your sights set on being a legit tycoon, real estate should only take up 5% to 10% of your overall portfolio.
As such, if you’re considering investing in real estate, you may want to start by allocating your money at a brokerage fund across a range of individual stocks, exchange-traded funds (ETFs), index funds, and bonds — alongside your REIT investments. You don’t want to be too focused on a single asset class.
Similarly, only put a down payment on a physical property once you are in a position to do so. This way, you can spread risk around and protect yourself should your investment property fail to pan out.
- Check out our post on ETF vs. Index Funds
Is it hard to flip a house?
Flipping a house can be very difficult — especially if you have never done it before.
Oftentimes, new investors buy a home thinking they can turn around and renovate for a quick sale only to find out that the process is much more complicated. For example, they might find out the hard way that a house won’t sell for what they had originally hoped. On top of that, people often put too much money into repairs and upgrades.
If you’re considering flipping a house, make sure you have a team of experts to guide you through the process. You need a savvy real estate agent and contractors who know what they’re doing — and are willing to charge you a fair price.
Should I carry two mortgages?
Carrying two mortgages can be risky. However, it’s often necessary when buying an investment property.
If you’re considering taking on a second mortgage for your rental property, make sure you have a steady cash flow and plenty of emergency savings stashed away in case your second property does not rent or sell quickly. Most likely, your lender will require you to have a big pile of cash saved up.
The last thing you (and your lender) want to do is get into a situation where you have a second mortgage and not enough income to cover unforeseen expenses.
What is a foreclosure?
When a homeowner falls behind on their mortgage payments, the property becomes distressed. Once a home becomes distressed, a bank will usually start exploring its options. This may include trying to arrange a short sale and encouraging the homeowner to sell.
If further payments are not made and a short sale is not arranged, the bank can step in and seize the home. At this point, the house becomes foreclosed.
Lenders will then put the house on the market. In some cases, it will go to auction and to the highest bidder.
Foreclosures can be great buying opportunities for investors. However, they can also be risky. These types of sales can come with structural or cosmetic damage due to neglect.
Some investors feel uncomfortable about buying foreclosed properties. However, it’s important to separate emotion from real estate investing and look at all opportunities purely as business transactions. Otherwise, you could miss out on some great money-making chances.
What is a 1031 exchange?
One of the top reasons that people invest in direct real estate is because of the tax advantages that a 1031 exchange can provide. In short, the process involves deferring taxes on capital gains that you earn from the sale of your investment property — if you reinvest those funds into a subsequent investment property.
A 1031 exchange can occur when the following things happen:
1. You sell an investment property for a profit.
2. You purchase a subsequent investment property of equal or greater value as your prior property.
3. Both transactions must occur under a specific time frame, and under certain conditions.
For example, you may sell a multi-family house, and purchase several investment properties that are worth the same amount or more.
The Bottom Line
There is a lot to consider when deciding between REITs and direct properties. At the end of the day, it all comes down to which direction you prefer, and what makes sense for your specific situation.
A direct investment can provide access to a property that appreciates over time and generates steady cash flow. Or you could flip a house for a nice profit gain and pocket the proceeds (after paying capital gains taxes, of course). But to do either of those things successfully, it’s going to require lots of time and effort.
On the flipside, REITs may even outperform direct real estate investments, and they come with far less expenses and little-to-no hassle. Making the right moves now could lead to awesome profits down the road. But as with any investment, you could also lose money. Do your research before jumping into any real estate sector and you’ll be a few steps ahead.