How to Invest in Real Estate: REIT vs. Direct Real Estate Investing (2024)

Wondering how to invest in real estate? Many investors who want to tap into the real estate sector compare REITs to actual, tangible real estate. REITs—or real estate investment trusts—are corporations that act like mutual funds for real estate investing. You can invest in a REIT without having to own or manage any property yourself. Alternatively, you can go the direct real estate investing route and buy residential or commercial properties.

Key Takeaways

  • REITs allow individual investors to make money on real estate without having to own or manage physical properties.
  • Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making.
  • Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

Direct Real Estate

With a direct real estate investment, you buy a specific property or a stake in one, such as an apartment complex (residential) or a shopping center (commercial). Direct real estate investors make money through rental income, appreciation, and profits generated from any business activities that depend on the real estate.

Pros of Direct Real Estate Investing

One benefit of investing in physical properties is the potential to generate substantial cash flow—as well as the ability to take advantage of numerous tax breaks to offset that income. For example, you can deduct the ordinary and necessary costs to manage, conserve, and maintain the property. Another large tax break is for depreciation, in which you deduct the costs of buying and improving a property over its useful life (and lower your taxable income in the process).

Of course, there's also the prospect of price appreciation. While the real estate market fluctuates as the stock market does, property prices generally increase over time, so you may be able to sell later at a higher price.

Another perks of direct real estate is that you have more control over decision making than you would with REITs. For example, you can select only properties that match your preferences for location, property type, and financing structure. You can set rental prices, choose tenants, and decide how many properties to buy. You can also refinance your mortgage when interest rates drop, or tap into your home equity through loans or credit lines for other purposes.

Cons of Direct Real Estate Investing

One of the main disadvantages of direct investing is that it requires a significant amount of time and energy (sweat equity) if you plan to be successful. You have to deal with tenant issues, maintenance emergencies, and your liability if there are any accidents on the property.

Financing can be another disadvantage. Many investors need to take on a mortgage or some other type of financing to pay for investments. If the market tanks or you have difficulty finding quality tenants, there's the chance you could default on the loan.

Another negative is that real estate is not a liquid asset. That means you probably won't be able to sell it quickly if you need cash in an emergency.

Pros

  • Positive cash flow and appreciation

  • Tax advantages

  • Control over decisions

Cons

  • Requires time and energy

  • Risk of financing default

  • Illiquid (not easy to buy and sell)

REITs

A REIT is a corporation that owns, operates, or finances income-producing real estate or real estate-related assets. Modeled after mutual funds, REITs pool the capital of numerous investors.

Today, there are more than 225 REITs in the U.S. that trade on major stock exchanges, and that are registered with the Securities and Exchange Commission (SEC). These REITs have a combined equity market capitalization of more than $1 trillion. World-wide, more than 35 countries currently offer REITs.

REITs can be appropriatefor new investors with limited experience in real estate who want to diversify their portfolio without a ton of risk.

Pros of REITs

Perhaps the biggest advantage of REITs is that individual investors can access profits from real estate without the need to own, operate, or directly finance properties. They offer a low-costway to invest in the real estate market. You can invest in a fund with as little as $500—a much lower entry point than direct real estate investing.

Another benefit is that REITs offer enticing total return potential. By law, REITs have to pay at least 90% of taxable income to shareholders, and it's not uncommon to have a 5% dividend yield—or more. REITs also have the potential for capital appreciation as the value of the underlying assets increases.

Another important perk is liquidity. Like stocks, you can buy and sellREITshares on an exchange. In general, REITs trade under heavy volume, which means you can get into or out of a position when you want (or need) to.

Cons of REITs

Of course, there are some drawbacks to REITs. For starters, most REIT dividends aren't considered "qualified dividends," so they're taxed at a higher rate. This is something to pay extra attention to if you own REITs in a taxable brokerage account. Keep in mind that you can hold REITs in a tax-advantaged Roth IRA account.

Another con is that REITs can be very sensitive to interest rate fluctuations, and rising interest rates are bad for REIT prices. In general, REIT prices and Treasury yields have an inverse relationship: when one goes up, the other goes down, and vice versa.

One other drawback is that while REITs can help you diversify your overall investment portfolio, most individual REITs aren't diversified at all. That's because they focus on a specific property type—such as offices or shopping centers. If a REIT invests solely in hotels, for example, and the economy tanks or people stop traveling, you can be exposed to property-specific risks.

Pros

  • Real estate profits without having to own, manage, or finance property

  • Higher than average dividends and potential for appreciation

  • Liquid (easy to buy and sell)

Cons

  • No tax advantages

  • Sensitive to interest rate fluctuations

  • Property-specific risks

The Bottom Line

Direct real estate investing may be a better choice if you want cash flow, tax breaks to offset that income, and great potential for appreciation. It's also good if you want more control over your investments and like a boots-on-the-ground approach.

REITsmake sense for investors who don't want tooperate and manage real estate, as well as for those who don't have the money or can't get the financing to buy real estate. REITs are also a good way for beginner real estate investors to gain some experience with the industry.

How to Invest in Real Estate: REIT vs. Direct Real Estate Investing (2024)

FAQs

Is it better to invest in REITs or real property? ›

Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making. Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

What advantages do REITs offer investors over direct investments in real estate properties? ›

REITs are easy to buy or sell as they trade on a public market. Low-Cost Real Estate Access: The low transaction cost to purchase the units on the stock market is much lower than direct investing. Diversification: Provides a quick and efficient way to invest in a well-diversified portfolio of properties.

What are the disadvantages of direct property investment? ›

Disadvantages of direct property:

Most require a loan from the bank to purchase. When a loan is acquired for investment it magnifies the gains and losses. You need to be risk tolerant as it increases volatility. Property maintenance can be expensive.

Is there a downside to investing in REITs? ›

When investing only in REITs, individuals incur more risk than when they are part of a diversified portfolio. REITs can be sensitive to interest rates and may not be as tax-friendly as other investments.

What is a good return on a REIT? ›

The FTSE Nareit All REITs index, which tracks the performance of all publicly traded REITs in the U.S., had an average annual total return (dividends included) of 3.58% during the five-year period that ended in August 2023. For the 10-year period between 2013 and 2022, the index averaged 7.48% per year.

Do REITs beat S&P 500? ›

REITs are also attractive thanks to their market-beating returns. During the past 25 years, REITs have delivered an 11.4% annual return, crushing the S&P 500's 7.6% annualized total return in the same period. Image source: Getty Images. One reason for REITs' outperformance is their dividends.

Are REITs good for passive income? ›

Since REITs are required by the IRS to pay out 90% of their taxable income to shareholders, REIT dividends are often much higher than the average stock on the S&P 500. One of the best ways to receive passive income from REITs is through the compounding of these high-yield dividends.

How to invest in REITs for beginners? ›

You can buy shares in REITs similar to stock, and you mainly make money from REITs through dividends. REITs often own apartments, warehouses, self-storage facilities, malls and hotels. You can purchase REITs through an investment account, also called a brokerage account, similar to stocks.

How does an investor make money from a REIT? ›

Most REITs operate along a straightforward and easily understandable business model: By leasing space and collecting rent on its real estate, the company generates income which is then paid out to shareholders in the form of dividends.

What are 3 drawbacks to owning rental real estate? ›

The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.

Which of the following is a disadvantage of direct real estate investments? ›

One possible disadvantage of real estate investments is illiquidity. This means that it may be difficult to convert your real estate investment into cash quickly. Unlike stocks or bonds, real estate requires time and effort to sell and find a buyer.

What is the disadvantage of direct investment? ›

FDI can also lead to a loss of control over strategic industries and resources and a potential for cultural and social impacts. Furthermore, there is a risk of economic instability, dependency on foreign investments, and the potential for conflicts and disputes between the investing company and the host country.

What I wish I knew before buying REITs? ›

Must Know #1 - Lower Leverage = Higher Returns

You would think that higher leverage would result in higher returns over time, but it has actually been the opposite in the REIT sector. The conservatively financed REITs have outperformed the aggressively financed REITs in most cases over the long run.

Why I don t invest in REITs? ›

The value of a REIT is based on the real estate market, so if interest rates increase and the demand for properties goes down as a result, it could lead to lower property values, negatively impacting the value of your investment.

Are REITs safe during a recession? ›

By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions. Typically, the upfront costs of investing in a REIT are low, while their risk-adjusted returns tend to be high.

Are REITs a good investment now? ›

There are three key reasons to invest in listed REITs right now, starting with the fact that REITs have outperformed stocks and bonds when yields and growth move lower. Demand is healthy while supply is constrained, and REIT valuations relative to the broader equity market are meaningfully below the historical median.

What is a better investment than rental property? ›

As mentioned above, stocks generally perform better than real estate, with the S&P 500 providing an 8% return over the last 30 years compared with a 5.4% return in the housing market. Still, real estate investors could see additional rental income and tax benefits, which push their earnings higher.

Do REITs do better with higher interest rates? ›

REIT Stock Performance and the Interest Rate Environment

Over longer periods, there has generally been a positive association between periods of rising rates and REIT returns. This is because rising rates generally reflect improvement in the underlying fundamentals.

Are REITs safer than rentals? ›

Most of the time, REITs offer better returns with lower risk for most investors. But especially today, REITs offer far better return prospects and much lower risk because their valuations are so heavily discounted. Investing in REITs provides both a margin of safety and future upside potential.

References

Top Articles
Latest Posts
Article information

Author: Allyn Kozey

Last Updated:

Views: 5471

Rating: 4.2 / 5 (43 voted)

Reviews: 90% of readers found this page helpful

Author information

Name: Allyn Kozey

Birthday: 1993-12-21

Address: Suite 454 40343 Larson Union, Port Melia, TX 16164

Phone: +2456904400762

Job: Investor Administrator

Hobby: Sketching, Puzzles, Pet, Mountaineering, Skydiving, Dowsing, Sports

Introduction: My name is Allyn Kozey, I am a outstanding, colorful, adventurous, encouraging, zealous, tender, helpful person who loves writing and wants to share my knowledge and understanding with you.