REITs vs Real Estate Investments
If you’re considering getting into real estate as an investor, you have a wide range of options at your fingertips. Understanding the different types of real estate investment opportunities before you dive in is essential. And knowing the ups and downs of each, (and where you’ll likely see the greatest returns) can help you make a smart choice.
Read on, as we take a deeper look at two specific ways - REITs vs direct real estate investments - to get into the world of real estate, including the advantages and disadvantages of each.
What Are REITs?
Real Estate Investment Trusts (REITs) are investment opportunities many savvy investors love. REITs allow you to buy shares of income-producing real estate projects. These projects are owned and operated by an individual company that manages all finances and fixed income producing assets associated with the property. REITs can offer investors a way to diversify their overall portfolio to include real estate.
REITs must be registered with the SEC and are subject to market regulations. One of these regulations is the requirement to pay 90 percent of the company’s taxable income in the form of shareholder dividends annually. While some REITs are not publicly traded, these are typically subject to large fines and have more limited options in terms of liquidity.
Advantages of REITs
REITs can be advantageous for a number of reasons. First, they offer access to diverse real estate investment opportunities that average investors typically wouldn’t be able to get on their own.
Simply put, REITs can be an ideal opportunity, even for investors who aren’t experts in real estate. Don’t have a ton of time to learn the ins and outs of the real estate market to track your investment? REITs essentially mean you’re partnering with an expert who does all of the tracking and hard work for you. So you just have to worry about your bottom dollar.
The top advantages of a REIT are:
- DIVERSIFICATION: While technically speaking, REITs are stocks, they offer the potential to diversify your portfolio, as real estate is a different asset class than other equities
- HIGH REWARD POTENTIAL: Chance to earn higher dividends
- LIQUIDITY: Liquid investment, which can be a great safety net for nervous investors
- TAX RATE (POTENTIAL): With some strategy and thought, it’s possible for income from REITs to be taxed at a more favorable rate (REITs investors typically receive profits as ordinary income)
Disadvantages of REITs
While the risk of working with REITs is fairly minimal - especially when compared to some other real estate investment opportunities - fully understanding each of the downsides is important. REITs are complex, so let’s look at some of the common pitfalls investors should be aware of:
- TAX RATE: REITs can be taxed at a higher rate than some other investments - though there are work-arounds, such as holding a REIT in a tax-advantaged Roth IRA account
- INTEREST RATE FLUCTUATION: REITs can be quite sensitive to fluctuations in interest rates - much more sensitive than some other investments
- RISK POTENTIAL (PROPERTY-SPECIFIC): Yes, REITs are a strategic way to diversify your portfolio, but they’re not generally all that diversified within themselves - every commercial property has risk, and REITs tend to focus on one type of property. For a good example of this, think about the hotel sector during economic recessions.
What Are Real Estate Investments?
When looking at a REIT vs real estate funds, a direct real estate investment is a more traditional opportunity, generally a more individual investment. This type of real estate investment involves the purchase of a specific property - think: mall, rental property or office complex - and then through rental income, positive cash flow is generated.
Advantages of Direct Real Estate Investment
Real estate investing can be a much more straightforward process than getting involved in a REIT. It really just involves the purchase of a single property or investment. So the process is a lot more open and shut. There isn’t a lot of confusion regarding who owns what, or who will get what percentage of income from any gain or loss.
Here’s a simple breakdown of the advantages of this form of real estate investment:
- POSITIVE CASH FLOW: There’s a lot of potential to generate high levels of cash flow with a direct real estate investment
- CONTROL: Investors have more control over the money their real estate investment earns, since they own the property outright
- APPRECIATION: Property appreciation means that investors stand to gain a lot in value on the property in the future
Disadvantages of Direct Real Estate Investment
One of the biggest disadvantages of a direct real estate investment is the fact that it is direct, which means it isn’t quite as diverse when looking at REIT vs real estate. If your one investment doesn’t pan out, then there isn’t a lot of wiggle room to offset that loss.
Other disadvantages of direct real estate investment opportunities can include:
- TIME: Managing the total property purchase and ownership can be time consuming
- FINANCING: Getting financing for properties requires working with a lender, which can be stressful and requires having quality credit - you also need capital to get started
- ILLIQUIDITY: Putting your money into a property investment can significantly reduce your liquid asset amount - you’d have to sell to get access to your investment, which can cost you in both time and money
From a direct real estate investment (like the purchase of undeveloped land) to more complex investment options (such as REIT investments - where you use crowdfunding platforms), you can see a great return on your money when investing in real estate is done well.
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