A common challenge among investors is determining the best way of investing in real estate. Many consider publicly traded REITs (Real Estate Investment Trusts) as the preferred option for several reasons, which we’ll cover below.
- REITs permit individuals to invest in real estate without the hassles of owning or managing physical properties.
- The majority of REITs trade publicly on exchanges; thus, buying or selling them is easier than traditional real estate.
- Direct real estate provides more tax breaks and allows investors to control decision-making. However, those tax breaks are not large enough for most non-professional real estate investors.
To understand the difference between real estate and REITs, let’s have an in-depth look at each of them, including their pros and cons.
Direct Real Estate
A direct real estate investment requires an investor to take ownership of a specific property. This may be a residential property such as an apartment complex or a commercial property like a shopping center. When an investor buys direct real estate, he or she makes money through appreciation and net income from the property. You’ll need to find, negotiate, purchase, close, and oversee the property and its operations.
Pros of Investing in Direct Real Estate
The opportunity to generate significant tax-deffered cash flow is the most compelling advantage of direct real estate investing. The tax code is quite favorable to real estate investors. Owners can offset income with: ongoing expenses needed to manage the property, interest payments to the lender and property depreciation. Depreciation is a sizable tax break where property owners deduct the building improvement costs over their useful – typically 15 to 39 years depending on the type of property. What’s odd about depreciation is that most real estate actually appreciates in value. Much of that value increase is attributable to land, which cannot be depreciated, but a sizable percentage of the increased value is due to the structure. It’s rare that the value of a building would be zero after it’s depreciation schedule runs out.
Caveat: The depreciation tax benefits of real estate investing are far less impactful if an investor does not have sizable capital gain income to offset. Assuming the investor is not classified as a real estate professional (defined as 750 hours per year dedicated to active management of real estate), paper “losses” from depreciation cannot be used to offset other income (such as W2 income).
Cons of Investing in Direct Real Estate
A major shortcoming of direct real estate investment is the significant time and energy required to achieve success. If you plan to invest in physical properties, you should be comfortable with assuming management and operating risk. You’ll need to handle maintenance emergencies, tenant issues, and assume property liabilities. Some entrepreneurial investors love this level of control and enjoy managing real estate despite these stressors. If that doesn’t sound like you, just realize that property ownership is rarely a passive, low time commitment activity.
Operating real estate (effectively) is a surprisingly time-consuming job if you do not have a large management team in place. This is also true even if you hire a third part property management firm to oversee the asset. They will help with the day-to-day basics, but an investor must remain intimately involved with the property to ensure success. Property management firms do not have the same “skin in the game” as will never be as committed to a property’s success as an owner.
Besides the day-to-day grind of managing the business and simple tenant matters, more dramatic events can and will derail your day (or year) from time to time. Such events might include:
- An emergency maintenance surprise (water leak, gas leak, sewer issue)
- A city violation with stiff penalties
- A weather related event that requires you to stop everything to protect your tenants and investment.
Unless an investor gets extremely lucky, owning real estate will be far more complicated than siting back and watching the rent come in.
Another disadvantage with direct real estate is financing. The majority of investors have few options for securing debt to acquire investment property. Often investors with little experience - and/or smaller balances sheets – will need to turn to regional lenders to finance their purchases. Unfortunately regional lenders typically require personal guarantees in exchange for making loans. If you default, the lender can take unwanted measures to recover the debt.
The illiquidity of direct real estate is another sizable disadvantage. Investment properties typically do not sell quickly. Transactions can often take 3-4 months. But that is only for assets that have a deep pool of willing buyers. If there are far fewer interested buyers, it might take you years to sell a property (at a reasonable price). This is especially true in smaller markets where population growth is stagnate.
In summary, here are the pros and cons of investing in physical properties:
- Significant tax breaks if you have sizable capital gains to offset
- Great control over decision making and the ability to drive returns with your time and skills
- Lots of time and energy are required
- There is a high likelihood of financing default
- The difficulty of buying and selling due to it’s illiquid nature
REITs - or real estate investment trusts - are companies that make equity investments in commercial real estate. In other words, a REIT is a firm that owns, funds, and operates income producing properties on behalf of its investors.
REITs were established in 1960 to offer individual investors the ability to invest in real estate without purchasing an entire property. There are over 200 SEC-registered REITs that trade on the main US stock exchanges. The combined equity market capitalization of these corporations exceeds $1 trillion. REITs are a major asset class, yet they remain underappreciated by most retail investors. Equity REITs have returned a compounded 11.43% return since 1972 when NAREIT first began tracking the REIT index. This outpaces the S&P 500, over that same time period, which returned 10.59%[i].
As detailed above, in addition to above average cash flow, REITs have historically offered individuals a passive way to achieve sizeable returns. Unlike direct real estate, this investment comes with zero responsibility. Once you make the decision to invest, your work is done. You might want to monitor the company to ensure management is still executing, but you won’t be chasing down tenants for late rent payments.
Pros of REITs
REITs main benefit is that individual investors can realize profits from properties without owning, financing, or managing them. This enables investor to buy and hold ownership of real estate for the very long term.
Investors have immediate access to over 200 REITs that specialize in over 15 real estate sectors, who all operate highly-diversified, professional run portfolios with full financial transparency. This is a stark contrast to an investor that decides to invest $250,000 as a downpayment on one property type in one market. If that asset or that market’s economy suffers, the investor might lose the entire downpayment and perhaps more if they guaranteed the loan.
An enticing total return potential is another REIT advantage. REITs are obligated to pay a minimum of 90% of their taxable income to investors. This leads to well above average dividends relative to other equities. The ability to collect recurring dividends reduces the overall risk of the asset. An investor can take its dividends and invest them in other assets, whereas a non-dividend stockholder has to trust that management will allocate profits effectively over the long term.
Another benefit is liquidity. An investor can buy or sell their REIT shares at anytime during market hours, just like stocks on an exchange. Life is unpredictable; sometimes plans change and investors need to access capital faster than anticipated. REITs provide investors with optionality relative to direct real estate owners, who cannot access equity easily.
Cons of REITs
Most individual real estate investment trusts aren’t diversified across sectors. Therefore, REIT investors are advised to not simply purchase one REIT for their full real estate allocation.
REIT prices are also much more volatile than their private counterparts, which – because they are not liquid – are not priced up to the second like publicly traded investments. However, the perceived lack of volatility in private real estate is incorrect. In difficult times, transactions for private properties come to a screeching halt. Therefore it is near impossible to determine what many private deals are worth at such times. This gives private investors a false sense of comfort as to the value of their holdings during recessions.
REITs In summary:
- You realize profits effortlessly, without having to find, finance and manage property
- Potential for high total returns, including appreciation and above-average dividends
- Liquidity, you can sell your publicly traded REIT shares anytime
- There are restricted tax advantages (you will receive a simple 1099-DIV, vs. a K1 partnership tax form each year)
- Investments are prone to property-specific risks if you only purchase shares in one REIT
The Bottom Line
If your main interest in real estate is to offset sizable capital gain tax liabilities, then direct investing is for you. If not, you’re probably better off looking to the public markets. REITs enable investors to instantly diversify their portfolios via liquid securities to achieve high cash flow without lifting a finger or taking on excess risk.
[i] NAREIT & FactSet 2020