Real estate investment trusts (REITs) and direct real estate investing both offer investors the potential to earn income and capital appreciation from real estate. However, there are some key differences between the two investment options that investors should consider before making a decision.
Like any investment opportunity, there are benefits and risks to putting your money in REITs versus real estate. Your investment goals and circumstances should guide what is right for you.
Real estate is often a great investment. However, dealing with real estate can be tedious and illiquid. For many, the barriers to entry in the real estate market are too high for them to consider investing. To meet the needs of active and passive real estate investors, real estate investment trusts (REITs) were created.
REITs vs. Real Estate: Which is Best for You?
Appreciation and Loss Potential
- REITS: REITs can provide consistent returns but historically are less likely to increase in value by a large amount than direct real estate investments. In a down market, REITs are more volatile than the underlying real estate they invest in.
- Real estate: Real estate investments have the potential for higher returns relative to REITs. However, there is also the potential for greater losses.
Income generation
- REITs: REITs are required to distribute 90% of their taxable income in the form of dividends, which can provide consistent income. REIT dividends in recent years have averaged between 2.5% and 5.5%.
- Real estate: Rental income is not guaranteed. Rental income is subject to market conditions, property maintenance costs, and the ability to keep good long-term tenants.
Liquidity
- REITs: REITs trade on public exchanges. Shares can be bought and sold through a broker like stocks. This means REIT investments can be converted into cash relatively easily, generally, within a few days.
- Real estate: Real estate is not easily liquidated. Selling real estate typically takes months and requires the assistance of a real estate agent and other professionals like lawyers or escrow officers.
Management
- REITs: REITs are professionally managed by experienced real estate investors. Professional management can provide advantages like access to greater buying power or complex investments like REITs with healthcare real estate.
- Real estate: Rental properties require significant time and effort to manage. This includes marketing the property, screening and placing tenants, collecting rent, responding to repairs and maintenance, and dealing with complaints.
Diversification
- REITs: REITs allow investors to diversify their portfolio across a variety of real estate property types and geographic locations. Some larger REITs have hundreds or thousands of properties.
- Real estate: Rental portfolios usually consist of a small number of properties in a specific geographic location.
Taxes
- REITs: REITs can be tax-advantaged investments. Qualified REIT dividends are not taxed until the investor sells their shares. In contrast, rental income is typically taxed annually as ordinary income. Depending on your tax bracket, this could mean paying taxes as high as 37%.
- Real estate: Selling real estate investments is subject to capital gains tax. If the property was held less than a year, capital gains are taxed as ordinary income. After a year, capital gains rates can be as high as 20%.
Conclusion
Ultimately, the decision of whether to invest in REITs or real estate depends on your financial goals, risk tolerance, and investment horizon. If you are looking for a passive investment with consistent income, REITs may be a good option. If you are willing to take on more risk in exchange for the potential for higher returns, direct real estate investment may be a better choice.
