REITs and real property offer differing investment risks and rewards
Comparing REITs and real property
- Both are real estate investment opportunities, but come with unique characteristics.
- REITs offer the promise of dependable returns, and shares are easy to buy and sell.
- REITs accumulate new property slowly, and cannot be leveraged like real property.
- By financing real property, owners have the opportunity to quickly accumulate equity.
- Property ownership comes with management headaches and potential tenant problems.
If you're a real estate investor, or thinking about becoming one, you may have considered whether it's better to buy rental property yourself, or invest in a real estate investment trust (REIT). The two investments have some similarities, but there are important differences, especially in the amount of attention they demand from an investor.
First, a couple of definitions are in order. Real property is a house, apartment building or other piece of property that you own and rent out as a means of earning income. A REIT is a company that invests in real estate through the purchase of real property or mortgages. It's like a real estate mutual fund, where you share in the income produced by properties in the REIT’s portfolio, but you do not buy or own them yourself.
REIT pros and cons
Among the advantages of a REIT is that it usually produces a good return on investment. The REIT’s value rises and falls like a stock, but in a healthy real estate market the shares of most REITs appreciate and pay healthy dividends. During the first half of 2016, for instance, REITs produced a total return of 13.7 percent, compared to a 3.8 percent return for the S&P 500, according to the National Association of Real Estate Investment Trusts.
In addition to those potentially strong returns, REITS are more liquid than actual real estate. That is, because interests in REITs are purchased and sold like stocks, it's much easier and faster to unload a REIT investment than it is to sell a rental property. Also, REITs are truly a passive investment, in that you collect the proceeds of your investment without having to find tenants yourself or manage property.
But even when investors are bullish on real estate, REITs are not necessarily built for fast growth. Under Securities and Exchange Commission regulations, REITs must distribute 90 percent of their profits to investors, and with so little being reinvested, REITs accumulate new properties slowly.
Leveraging rental properties
An important difference between REITs and real property is that owners can buy real property with a relatively low down payment, but collect income and appreciation on the full value of the property. Although REIT investors also can use credit to purchase shares in a REIT, through what is known as buying on margin, brokers are limited by Federal Reserve Board regulations in the amount of credit they can provide, and the practice can be very risky in a volatile market.
A mortgage on a rental property comes with financing costs, of course, but it also opens the path to significant equity accumulation when property appreciates. Consider, for instance, an investor who buys a $250,000 rental property with a $50,000 down payment. If the property's value increases by 10 percent, the investor has made $25,000 in equity, or a 50 percent return on the original $50,000 investment (minus interest costs).
In addition to that investment leverage, rental-property owners who keep their property for at least a year obtain tax advantages that include depreciation allowances and a favorable tax treatment of rents, compared to other sources of income. Also, landlords have a level of control over the type of property they buy and how they maintain it, and that is not available to REIT investors.
There are disadvantages to owning real property outright as well, especially for those who own relatively small amounts of property and do not find it economical to hire professional property managers. For those landlords, real estate is a hands-on business, where they are directly responsible for making short-term repairs and long-term property improvements, as well as advertising vacancies and judging whether prospective tenants will actually pay the rent.
There are risks associated with investing in REITs and real property. REIT share prices can be volatile, and their performance is particularly vulnerable to increases in interest rates. Market volatility also affects real-property owners — less so for long-term owners who can weather slumps -- as do problems stemming from bad tenants or management inexperience.
So although REITs and real property are real estate investments, and some people own both, the two often appeal to different types of investors. Real property offers the chance of significant long-term wealth accumulation for those with the time, talent and patience to manage rentals. REITs come with the promise of a steady return on investment for investors seeking passive income without landlord-related headaches.