Direct Real-Estate Investing or REITs: Which Should You Choose? Before you decide, learn the advantages and disadvantages of both.
By Richard Maize •
Opinions expressed by Entrepreneur contributors are their own.
Direct real-estate investing and investing in real-estate investment trusts (REITs) are two of the most popular ways to invest in real estate. Choosing one over the other requires exploration of their advantages and disadvantages.
Advantages of direct real-estate investing
Direct real-estate investing means buying a specific property, residential or commercial, and receiving subsequent income from it. The income could come from property rent, appreciation or profits generated from business activities conducted at the property. With direct investing, you have greater control and decision-making power. For example, you could choose which and how many properties to buy and decide on rental prices and tenants. Additionally, there is appreciation. Both real estate and stock markets fluctuate, but property prices usually increase with time, and eventually, you could sell at a higher price.
Another great advantage of investing in physical properties is the multitude of available tax reliefs to offset the cost of purchase. For example, ordinary and necessary costs to manage and maintain the property are deductible. Also, there is a large tax break for depreciation. In this case, you gradually decrease your taxable income by deducting the costs of buying and improving the property throughout its serviceable life.
Related: 5 Amazing Tips on Turning Real Estate Into a Real Fortune
Disadvantages of direct real-estate investing
Lack of liquidity is one of the main drawbacks of direct real-estate investing. If you are in urgent need of money, you might not be able to sell the physical property quickly. Another disadvantage is financing. Buying a physical property requires higher initial capital, and many investors resort to taking on a mortgage or other type of financing. If, however, market conditions worsen or you cannot find quality tenants, you run the risk of defaulting on the loan.
Another disadvantage of direct real-estate investing is the higher so-called sweat equity. It takes a significant amount of time and energy to tackle tenant issues and maintenance emergencies. Additionally, you are liable in case of any accidents on the property.
Advantages of REITs
With REITs, on the other hand, investors do not need to buy any physical property. A REIT is a corporation that acts like a mutual fund for real-estate investing. It owns or operates income-generating real estate or real-estate-related assets and pools the capital of multiple investors. Basically, investors have the opportunity to receive income from real estate without having to own or manage property.
REITs offer a high total return, capital-appreciation potential and liquidity. REITs are legally bound to pay at least 90% of taxable income to shareholders, and often the dividend yield could surpass 5%. Meanwhile, the increase in the value of the underlying assets makes for potential capital appreciation. In terms of liquidity, REITs shares are like stocks. As an investor, you can buy or sell them on an exchange when you want or need to.
Related: Can REIT Really Help the Real-Estate Sector?
Disadvantages of REITs
Heavy taxation is one of the main drawbacks of REITs. The majority of REIT dividends are taxed at a higher rate because they aren't deemed "qualified dividends." Furthermore, REITs could be extremely sensitive to interest-rate fluctuations. Generally, a negative correlation exists between REIT prices and Treasury yields: The increase of one leads to the decrease of the other, and vice versa.
Another disadvantage of REITs is the lack of diversification. Usually, they focus on a particular type of property, such as offices or shopping centers, or hotels. Thus, in case of economic decline, REITs investors might be exposed to a higher property-specific risk.
Whether to choose one type of real estate investing over the other depends on the investor's desire or lack of it to own and manage a physical property and his or her initial capital.
