Direct Real-Estate Investing or REITs: Which Should You Choose?
Before you decide, learn about the pros and cons of both.
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July 22, 2021 4 min reading time
The opinions of entrepreneurs’ contributors are their own.
Direct real estate investments and real estate investment trusts (REITs) are two of the most popular ways to invest in real estate. Choosing one of the others requires exploring its pros and cons.
Advantages of direct real estate investment
Direct real estate investments mean the purchase of a particular property, residential or commercial property, and income from it. The income can come from renting the property, appreciation in value or profits from business activities carried out in the property. With direct investment, you have more control and decision-making power. For example, you can choose which and how many properties you want to buy and decide on rental prices and tenants. There is also appreciation. Both the real estate and stock markets fluctuate, but house prices usually rise over time, and eventually you could sell at a higher price.
Another great benefit of investing in physical real estate is the variety of tax breaks available to offset the cost of the purchase. For example, normal and necessary costs for the administration and maintenance of the property are deductible. There is also a great tax break for depreciation. In this case, you will gradually reduce your taxable income by deducting the cost of buying and improving the property throughout its useful life.
Related: 5 Amazing Tips on How to Make Real Estate From Real Estate
Disadvantages of a direct real estate investment
The lack of liquidity is one of the main drawbacks of direct investment in real estate. If you are in dire need of cash, you may not be able to sell the physical property quickly. Another disadvantage is the financing. Buying physical property requires higher initial capital, and many investors resort to a mortgage or other type of financing. However, if market conditions deteriorate or you cannot find quality tenants, there is a risk of loan default.
Another disadvantage of direct real estate investments is the higher so-called sweat equity. It takes a lot of time and energy to solve tenant problems and maintenance emergencies. You are also liable for accidents on the property.
Benefits of REITs
With REITs, on the other hand, investors do not have to buy any physical real estate. A REIT is a company that acts like a real estate investment mutual fund. It owns or operates income-generating real estate or real estate-related assets and pools the capital of several investors. In principle, investors have the opportunity to generate income from real estate without having to own or manage real estate.
REITs offer high total returns, potential for appreciation and liquidity. REITs are required by law to pay shareholders at least 90% of taxable income, and often the dividend yield can exceed 5%. Meanwhile, the appreciation of the underlying assets creates potential for capital appreciation. In terms of liquidity, REITs stocks are like stocks. As an investor, you can buy or sell them on an exchange if you want or need to.
Related: Can REIT Really Help The Real Estate Industry?
Disadvantages of REITs
The high taxation is one of the main disadvantages of REITs. The majority of REIT dividends are taxed at a higher rate as they are not considered “qualifying dividends”. In addition, REITs could be extremely sensitive to fluctuations in interest rates. In general, there is a negative correlation between REIT prices and Treasury yields: the increase in one leads to a decrease in the other and vice versa.
Another disadvantage of REITs is the lack of diversification. Usually they focus on a specific type of property such as offices or shopping malls or hotels. Therefore, in the event of an economic decline, REIT investors could face higher property-specific risk.
Deciding on any type of real estate investment depends on the investor’s desire to own and manage physical property and their starting capital.
Related: 8 Proven Ways To Make Money With Real Estate