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Real estate investment trusts (REITs) vs. rental property investments have benefits and drawbacks. Deciding which kind of property investment you want to make can be a difficult decision.
Here, we will discuss the risks and potential rewards of each so that you can decide which is the better investment for you.
What is a Real Estate Investment Trust (REIT)?
A REIT is a company that owns, runs or flips commercial real estate for profit. A REIT usually owns many different properties and makes money by doing one or some of the following:
- Developing new land.
- Increasing the value of a property to increase rents.
- Holding and managing property.
- Buying properties in a growing real estate market to sell later.
- Buying and renovating properties to sell later.
Some REITs are tradable, while some are not. Traded and non-traded REITs are very different and have disparate benefits and drawbacks.
Just like any other stock, publicly traded REITs can be bought and sold on the stock market. They pay dividends and tend to be more stable than retail stock, but otherwise they are indistinguishable.
Non-traded REITs are different. They are illiquid investments that cannot be bought and sold quickly. In this case, a real estate investor will give the REIT money and receive dividends each year or quarter in return.
Non-traded REITs do not operate like shares or the stock market. You do not “own” part of the company — you simply entrust the company to make profits using your investment.
Additionally, some REITs require you to be an accredited investor to participate.
Examples of REITs
One of the largest REITs around is Prologis Incorporated (NYSE: PLD), worth an estimated $100 billion. As of writing, the stock price of PLD peaked at more than $150 per share.
While many REITs are smaller, PLD owns hundreds of properties worldwide in Europe, Asia and the Americas. Some REITs only own property in the United States, while some only own properties in one city or state.
Additionally, many REITs only invest in certain kinds of property. This specialization gives them expertise that allows them to understand markets better.
However, as they aren’t diverse, they will take a more significant hit if a crash happens. For example, Essex Property Trust invests almost exclusively in residential real estate.
In the real estate crash of February 2020, the Essex REIT’s stock valuation fell about 40 percent. PLD took a similar hit of about 40 percent, but it recovered its pre-crash value by July of the same year.
Essex, which is far less diverse, didn’t fully recover from the hit until September of the following year.
Benefits of REITs
Here are the primary benefits of REITs:
- Low investment minimums: Many traded REIT stocks are valued at about only $30 per share. Non-traded REITs have higher buy-ins but still cost less than purchasing real estate.
- No experience required: Buying a REIT is as simple as picking a company you believe in and putting money down. There is no need for market research or property management.
- Professionally managed: People that run and operate REITs and the properties within them have years of experience and can hire out more difficult tasks involved in commercial real estate.
- Passive investing: After you put money into a REIT, all that’s left to do is wait for dividends or decide when to sell. You do not need to manage tenants or find your own renters.
- High dividend yields: Many REITs can have high yields that will provide you with regular cash flow.
- Tax advantages: You can invest in REITs using your IRA to avoid paying double tax (once on your income and once on your dividends).
- Consistent cash flow: Dividends provide you with a decent amount of cash flow that you can either reinvest or take as cash.
- Diversification: REITs allow you to invest in many different industries simultaneously.
Disadvantages of REITs
Here are the main drawbacks of investing in a REIT:
- Illiquid investments: REITs with high payouts tend to be non-traded, in which case you won’t be able to leave the REIT for a long time.
- Volatility: Market volatility in less diversified REITs can make your investment riskier.
- Some require accreditation: Some REITs can be bought and sold by anyone, but private, high-profit REITs often require accreditation, which necessitates a high net worth and other assets.
- Less ownership: REIT investors don’t own the properties they’re invested in, so while they might be making money, they aren’t building equity.
- Dividends are taxable: While there are ways of avoiding income tax before you put money into a REIT, dividends you make from REIT shares will be taxed.
What are Rental Properties?
Rental properties are income-producing properties under your direct ownership that you lease to tenants.
Property owners have two main goals:
- Rent their properties out at higher rates than they are paying property tax and mortgage and to
- Have their property increase in value.
Typically, landlords will rent out their spaces to tenants with rental rates higher than their mortgage profits, thereby making a profit.
Landlords are responsible for the care and management of their properties. There are strict regulations about which parts of property care are a landlord’s responsibility, especially if the property is residential.
Unless you hire a management company, you will be in charge of almost everything on your property.
Most landlords are in charge of:
- Carrying out repairs that are not the fault of the tenant.
- Maintaining grounds, appliances and equipment.
- Keeping a habitable living space.
- Abiding by local and national housing laws.
If you are considering becoming a landlord, you must consider these responsibilities and research which laws apply in your local area.
You may have to evict tenants or increase rent on your rental property. These kinds of changes can be difficult to ask of tenants and are often strictly regulated by states and local governments.
If you have un-paying tenants who become difficult to evict or have no money to collect, your property can quickly become a money pit rather than an investment.
Examples of Rental Properties
You can own multiple kinds of rental properties, including:
- Single-family homes
- Vacation rentals
- Retail spaces
- Warehouse spaces
Each kind of rental property has benefits and drawbacks. For example, some people buy and rent out residential properties hoping that property values will go up or they can move in one day themselves.
Non-residential properties, mainly warehouse and industrial space, don’t increase in value like residential properties.
Prices on industrial space do rise over time but not as significantly as residential property, so investors tend to buy these properties to make money renting the space, not by selling in the future.
Benefits of Rental Properties
Here are the primary benefits of owning a rental property:
- Asset appreciation: Unless there is a significant market crash, property almost always increases in value. When you own a rental property, you’re making money from your renter and the future sale of your property.
- Consistent cash flow: Rent is almost always paid monthly, which gives you a standard monthly cash flow.
- Tax deductions: If you use your property as a residential space, you may be able to write off certain expenses on the property, such as property tax.
- Tenants build your equity: Having renters allows you to build equity essentially for free. You get equity in your property while someone else pays your mortgage.
- Increasing demand: As housing prices rise, many young people are in the position of being unable to buy homes. While this is unfortunate, it increases the number of renters and drives up rents.
Disadvantages of Rental Properties
The primary disadvantages of running a rental property are:
- Property management: Purchasing an investment property can be a lot of work. Property owners are in charge of almost all maintenance, from renovations to simple repairs.
- Finding tenants: Finding tenants can be difficult during certain economic periods, and you may only make enough money to pay the mortgage.
- Large down payment: Purchasing a property will come with a significant down payment, usually tens of thousands of dollars.
- Higher mortgage rates: Mortgage interest rates are usually higher on rental properties than on primary homes.
- Market uncertainties: While homes are typically very stable investments, there is no guarantee you will find renters or your property will appreciate.
Rentals vs. REITs: How do they compare?
|Flexibility||Capital appreciation||Less control|
|Higher upfront investment||Diversification||Low minimum investment|
|Tax deductions||Tax benefits||Dividends|
|Leverage||Higher mortgage rates||Professionally managed|
Which is The Better Investment?
If you are a less experienced investor, a REIT is the better investment. However, if you have investing experience and want to add another property to your portfolio, purchasing a rental property is the better investment.
Choose a REIT If:
- You are looking for passive income with little day-to-day effort on your part.
- You are a non-accredited investor that wants to invest in commercial properties outside of residential properties.
- You are looking for a hands-off income stream.
- You want to broaden your real estate portfolio to include real estate but can’t afford a property or down payment to own real estate.
- You want a wider range of investment options.
- You are looking for more liquidity.
Choose a Rental Property If:
- You are interested in a hands-on approach to investing.
- You are interested in monthly rental income.
- You are prepared to make a long-term investment.
- You understand and are prepared for the responsibility of real estate assets.
- You are interested in adding property ownership to your investment portfolio.
Whichever investment option you decide, make sure that you understand that investing in real estate is a long-term investment.