Buying Rental Property vs. Investing In a REIT
Over the past few years, both residential and commercial real estate have rewarded investors handsomely yielding average annual returns on the upward of 7-10%. What’s more, residential and commercial vacancy rates are declining and rents are growing, suggesting that investing in real estate—income producing rental property in particular—continues to be a good investment strategy. Historically, investors have achieved this by investing in real estate directly—by buying physical rental property and then acting as landlord.
With the introduction of Real Estate Investment Trusts (REIT), investors now have the option of owning income-producing rental properties indirectly by investing in a large portfolio of real estate assets. If you want to invest in real estate, investing in a REIT as opposed to buying income-producing property directly might be the best investment strategy for you—but then again, it might not.
One of the questions that comes up time and again as I speak with aspiring real estate investors is when does it make sense to invest in a REIT rather than purchase a physical rental property? My answer? “It depends.” When determining whether to buy property directly or invest in real estate via a REIT, there are several factors investors should consider within the context of their overall investment strategy.
Buying Rental Property
For investors willing to take a more active role in their investments, purchasing and owning rental property presents a lucrative opportunity. Direct ownership of rental property provides an array of benefits including immediate and regular cash flow, longer-term appreciation, tax advantages, as well as the potential to substantially increase personal net worth. However, along with these benefits come a myriad of landlord responsibilities that require ongoing time commitment and hands-on attention.
Owning rental property directly offers many benefits for investors who are willing to make the commitment to hands-on management. When a residential or commercial rental property is managed efficiently, it can offer the owner the following benefits:
- Regular and Consistent Cashflow
Direct ownership of rental property yields a steady and reliable stream of monthly cash flow in the form of rental income. Unlike public REIT investments, which are constantly fluctuating, a lease agreement dictates exactly what tenants are expected pay each month in rent. And when a landlord owns multiple properties, with multiple tenants, diversification reduces risk in income volatility even further.
- Hedging Against Stock Market Volatility
While real estate markets and the stock market both experience volatility, they do not typically move in lock-step. There is no direct correlation between volatility in the stock market and volatility in real estate markets. A truly diversified portfolio should hold investments that react differently at any given point in time. Of all the reasons to own real estate directly as opposed to a REIT, this is one of the most compelling. During the great recession of 2007 when the stock market, and consequently public REITs, experienced 30% drops in market value, direct ownership investments in rental property continued to provide above market returns.
- Ability to Use Leverage
One of the biggest reasons that serious real estate investors insist on owning rental property directly is the ability to use leverage. Ownership of rental property canprovide the aility to use a higher level of debt financing than is available through a private or public REIT. Most institutional investors stray away from REITs that employ more than 40% leverage. Conversely, an investor who purchases an investment home can borrow up to 80% of the home’s value via lending programs offered through Fannie Mae and Freddie Mac. Instead of investing $30,000 into a REIT, an investor can take that same $30,000 and use it as down payment on a $120,000 rental property, whereby reaping the entire asset appreciation gain of the $120,000 asset over time. Greater financial leverage provided by direct ownership of rental property leads to a higher return on equity.
- Higher Annual Yields
Most REITs I have experience with provide annualized dividends between 2-3% — sometimes even less. Directly owned rental properties on the other hand can generate distributions of 5-8%, and if properly managed, even higher. Why are dividends lower for REITs? For several reasons. (1) REITs typically hold only institutional quality assets that offer low yields. Investors who purchase rental property directly have the ability to identify and purchase individual rental properties that yield higher returns. (2) REITs have to carry the burden of overhead costs that direct ownership of rental property does not bare. (3) REITs often pay investors lower than necessary dividends in order to stabilize annual returns and avoid lowering dividend payments to investors in the future. While REIT dividends are generally very predictable, on an annualized basis they tend to be lower than then yields provided through direct ownership of rental property.
- Increased Equity and Asset Appreciation
In addition to monthly rental income, rental property produces money through appreciation. Direct ownership of rental property provides investors benefit in the form of equity. As a rental property appreciates, the value of an owner’s equity position increases, and potential for greater profit for the investor upon sale of the property also increases.
- Tax Efficiency and Deductions
Owning rental real estate in the form of an REIT, or through direct ownership, offers various advantages. However, the degree to which these tax advantages can be realized depends on the specifics of the investment vehicle. At the trust level, REITs are exempt from income tax. However, the dividends generated by an REIT are taxable as ordinary income. They may be taxed at a lower rate if characterized as a capital gain, or entirely tax exempt when classified as a return of capital, which reduces the ownership basis. (Consult with a tax attorney or CPA to discuss the specifics of your situation.)
- Control, Freedom and Flexibility
For many investors, the major draw of owning and investing in real estate outright is the control it provides. You’re in charge! You get to make all the decisions. You determine how much rent to charge, what capital improvements to make and when to make them, who you’ll work with, and who you’ll rent to. While direct investing through ownership requires more hands-on involvment in property management, it provides more financial freedom and flexibility than owning shares in an REIT.
REIT investors have the potential to generate capital appreciation gains in share price over time, but direct ownership of rental property allows investors to build equity in a tangible asset. While your tenant is paying the mortgage on your rental property, you’re building valuable equity. As equity grows with time, owners can refinance the property and use the proceeds to purchase new investment assets.
Unlike investing in a REIT, when you invest directly in physical rental property, you’re able to deduct operating expenses and depreciation. This can—and often does—reduce your taxable income. Operating expenses, including legal fees, insurance premiums, property taxes and maintenance costs, can significally reduce what you owe Uncle Sam at the end of the year. While you can’t deduct the costs of improvements from your taxable income in the same year incurred, they can be depreciated over your property’s life expectancy, whereby reducing your ongoing tax liability.
For direct property owners and investors, the 1031 exchange offers a very significant tax advantage over investing in a REIT. The 1031 exchange allows investors to sell appreciated rental property and transfer their original cost basis to a new investment property without paying capital gains. Generally, the sale of real estate triggers a “taxable” event. When you make money from the sale of real estate, and experience a capital gain, Uncle Sam wants his portion of that gain. The 1031 exchange allows real estate investors to defer payment of capital gains tax to a later date, whereby preserving buying power and enabling the reinvestment all sale proceeds into a higher-priced property.
For all its upside, investment in rental property through direct ownership, has its downsides. For many investors, the risks and responsibilities of direct real estate investing may be too great. At the end of the day, the success of a rental property falls squarely on the shoulders of the investor. If managed poorly, a seemingly lucrative investment opportunity can quickly turn south over night. Before investing directly in rental property, investors should consider all the drawbacks.
- Property Management Expertise
There are many steps to acquiring and managing an investment property. One mistep, one wrong turn, and a potentially lucrative investment opportunity can turn into a money pit. Knowing how to identify a good rental property, and having the expertise to manage it once acquired, are key to ensuring a profitable long-term investment. Direct investors are required to determine expected occupancy rate, set monthly rental rates, manage operating costs, prep the property for tenants and stay abreast of Fair Housing laws to avoid discrimination complaints, fines and lawsuits. Successful landlords typically have substantial property management experience or end up hiring an experienced property manager in their stead. Conceding some control of your investment by turning over the reigns to an property manager may be the logical choice, but using a professional property manager adds up, eating away from at your return on investment.
- Active Management
Direct investment in rental property requires 24/7 hands-on management. Once you own a rental property, you are responsible for advertising vacancies, finding and screening tenants, drafting lease agreements, overseeing property maintenance and repairs, checking tenants in and out, processing evictions, and more. Hiring a property manager can alleviate much of the active management burden, but if you hire a poor property manager who drops the ball, you risk loosing tenants and the burden of ongoing management falls back to you.
When it comes to owning rental property directly, the old adage holds true: you need money to make money. Securing a loan to purchase a rental property generally requires a down payment of 10-20% of the purchase price. To finance certain types investment properties, such as multi-family apartments or commercial office buildings, lenders may require as much as 30% down. For a $500,000 investment property that’s $150,000. In addition to coming up with a sizeable down payment, investors who finance their property often have to contend with high interest rates. If an investor is unable to come up with the required down payment, or can’t afford to carry a loan with a high interest rate, direct ownership is not possible. Even investors with cash to buy a property outright need to maintain adequate occupancy rates to ensure profitability. For rental property owners who have have less than favorable financing terms, near-term profitability may be elusive.
Investing in a REIT
On Sept. 14, 1960 President Dwight D. Eisenhower signed into law legislation that combined the best attributes of real estate and stock-based investment to provide all investors, especially small investors, the ability to invest in income producing real estate—and the Real Estate Investment Trust (REIT) was born.
A REIT is a company that purchases real estate via debt or equity investments. REITs enable individual investors to purchase ownership interest in income-producing property without buying the entire property. REITs offer investors a way to passively invest in real estate. Through REITs, investors benefit from higher liquidity and less responsiblity than if they were to own rental property directly.
While direct ownership of income-producing rental property may seem like the most attractive real estate investment option upfront, there are many benefits to purchasing real estate through a REIT that may outway direct ownership.
- Low Investment Minimums
One of the biggest benefits of the REIT, and the reason it was first established by congress, is it’s low capital requirement. With an REIT, an investor can start investing in income producing real estate for as little as $1000. To qualify for financing to purchase a rental property directly, an investor is typically required to put down at least 15-20%. On a $200,000 investment property, the down payment could be as much as $40,000. There are other upfront costs associated with investing in rental property directly, including renovations, repairs, even a contingency “slush fund” that may amount to 1-2% of the purchase price. Public non-traded REITs usually carry lower investment minimums than privately held REITs. For investors who don’t have a lot of extra cash laying around, or spare time on their hands, a REIT is an ideal investment vehicle to start investing in real estate.
- Passive Investing
While investing in real estate through direct ownership provides more control, exposure to hard assets, and the potential for outsized returns, it also requires constant hands-on management. Additionally, the success of the investment falls entirely on the investor. REITs offer a vehicle for real estate investors seeking a hands-off, headache-free solution with predictable returns.
- No Expertise Required
Do you want to be a landlord or just an investor? Most investors who purchase rental property directly have a strong background in property management or hire a professional property manager to manage their rental property for them. REIT investors are not required to manage their real estate investment, nor do the need proficiency in real estate or property management.
One of the single greatest advantages of owning a REIT over a physical rental property is immediate liquidity. Like any other stock, publicly-traded REIT shares can be sold through any brokerage at relatively low cost on a daily, monthly or quarterly basis. A rental property on the other hand, may take weeks, if not months, to liquidate, and can have much higher transaction costs. REIT investment does not require investors to tie up their money for a long period of time. Alternatively, direct investment in rental property typically requires an investor to tie up thousands or millions of dollars in a single property for several years.
When it comes to developing a balanced investment portfolio, diversification is the name of the game. REITs offer asset-level and geographic diversification. Most REITs specialize in a specific type of income property, such as single-family rental homes, multi-family housing, hotels or self-storage. For just $10,000 an investor can own 10 REITs within various asset classes in properties located throughout the United States. Achieving that level of diversification through direct ownership requires substantial capital and is not a realistic strategy for most investors. Diversification through REIT investment also mitigates the financial risk of having all your eggs in one basket. If a single real estate asset underperforms, losses will be offset by profits generated by other assets held by the REIT.
- Regular Cash Flow
REITs provide shareholders monthly or quarterly cash flow in the form of dividends, unlike rental properties that provide their owners monthly cash flow in the form of rental income. REIT dividend payouts vary from fund to fund but are typically based on the success of REIT held properties. A REIT is required by law to distribute at least 90% of its taxable income each year in the form of dividends to its shareholders. REIT dividends are usually stable and predictable from year to year since risk is spread across a diversified pool of income producing properties.
- Tax Benefits
REITS provide investors tax benefits. REIT investors can claim a 20% tax deduction from their earnings from loan interest and rental payments. This is a new tax law that went into effect at the beginning of 2018. The typical REIT pass-through entity also avoids double taxation at the corporate and individual investor level.
While REITs are ideal for investors seeking a low cost way of purchasing real estate without time or money commitment, not all REITs are the same—and there are some inherent drawbacks to investing in REITs over physical rental property. When selecting a REIT investment option, it’s important to determine if a REIT is truly the best investment vehicle for your financial strategy and assess which type of REIT best matches your investing goals.
- Less Control
Owning real estate through a REIT is less economically, physically and emotionally burdensome than owning physical rental property, however, rental property provides a great deal of freedom and flexibility that a REIT does not. REIT investors do not have a say in the management and operation of their real estate holdings. They also don’t have the ability to maximize their ROI. Everything is controlled by the fund manager and REIT team. Investing in real estate through a REIT may be ideal for the passive or inexperienced real estate investor, but it isn’t for everyone. The tradeoffs between investing in real estate via a REIT or owning a rental property directly should be fully assessed before purchasing shares in a REIT.
While REITs do not fluctuate lock-step with the stock market, public REITs are traded on the public exchange and consequently are prone to experience fluctuations in tandem with the rest of the market. When the stock market rises, the value of publicly-traded REITs shares tend to rise. When the stock mark falls, so does the value of publicly-traded REITs. However, this volatility typically only affects publicly-traded REITs. The value of private, or non-traded REITs only changes when the value of the underlying real estate assets change.
Since the value of shares of publicly-traded REITs is correlated to fluctuations of the stock market, they do not provide diversification to a portfolio of stock market investments, such as stocks and bonds. However, since private REITs are not publicly traded, they can provide diversification to a portfolio of stocks and bonds as well as a diversified real estate portfolio.
Most investors recognize the benefit of having income producing real estate in their investment portfolio. When managed efficiently real estate offers consistent and reliable cash flow, a hedge against market volatility and—in some scenarios—a lifetime of financial freedom. However, before investing in real estate, it’s important to evaluate which real estate investment vehicle provides the best path to achieving your personal and financial investment goals. The real question isn’t “which is best?” rather “which is best for me?” For some investors, purchasing real estate directly makes sense. For others, a REIT is the only realistic way to add real estate to their investment portfolio. For a select few, a combination of direct investment and REIT ownership provides the best solution.
When evaluating investment options, ask yourself the following questions.
- Do you simple want to own real estate, or do you want to have a real estate business? Do you have the time, patience, desire, and expertise to actively manage a rental property?
- How much capital do you have to invest in real estate? Can you afford the upfront cost of purchasing and owning a physical rental property? Or is a lower cost REIT more feasible?
- If you’re interested in a REIT, which type is best suited for your investment strategy? Are you simply seeking the best return on your investment, or are you looking to diversify your stock portfolio?
Which ever real estate investment option you choose, rest assured that investing in real estate is a sound and proven way to strengthen your portfolio, generate stable cash flow and achieve sustainable financial freedom.