If you want to enter real estate investing, there are two ways to do it: buy rental properties or trade in real estate investment trusts (REITs).
But when it comes to REITs vs rental property, which one should you buy? We made a comparison, and here’s what our research says.
A REIT owns, finances, or operates income-producing real estate through lease rentals.
In a way, REITs are like mutual funds because they pool investor money for investing in a specific sector.
Moreover, since buying an investment property is capital-intensive, a REIT offers investors the chance to enter this sector without spending tons of money.
This makes it possible for individual investors to earn real estate dividends without buying, managing, or financing it themselves.
What Are the Pros and Cons of REITs?
REITs are great for portfolio diversification, regular dividend income, high liquidity, moderate capital gains, and access to commercial real estate.
On the flip side, these trusts are better for long-term growth but not short-term returns. They don’t perform well during rising rates, and their dividends are taxable at a higher rate.
Firstly, REITs let the investor enter into real estate without needing a lot of capital. It also allows them to diversify their portfolio from stocks or bonds.
In times when inflation is high, real estate often does better than the stock market, so adding them to your investment portfolio can be a good idea.
REITs also give regular dividends to investors, and many appreciate getting the cash in hand rather than only watching equity investments grow in value.
Over time, property prices appreciate and so do rental occupancies and incomes, especially if the economy is doing well. So REITs also grow along with a growing economy.
Lastly, commercial property investments are nearly impossible for small investors directly, but REITs let them enter this market.
REIT investors might hold on to REITs for long-term gains, but in the short term, they don’t offer the kind of growth that is possible in securities.
Secondly, when interest rates start to rise, real estate investments often go south.
REIT dividends may be higher than that of securities, but they don’t fall under capital gains, and therefore they are taxed at normal income tax rates.
This means they could potentially be taxed higher than stock dividend distributions.
About Rental Property
Rental property is buying real estate to lease it out for a monthly rental income. Owning real estate directly has dual benefits: price appreciation and a regular cash flow from rents.
However, it is not as simple as just buying any property as there are many factors to consider.
For example, the location of the unit, supply and demand pressures, how the economy is doing, interest rates, and several other factors impact rental income and capital growth.
Also, most individuals must take out a mortgage to finance a property.
This means the income and capital appreciation need to be high enough to cover the mortgage and offer higher returns than other safer investment options (such as bonds).
What Are the Pros and Cons of Rental Property?
There are some benefits of owning property, especially in terms of lower taxation.
However, there are also negatives, such as poor liquidity, the possibility of bad tenants, rising costs of insurance and taxes, maintenance woes, and so on.
One of the benefits of owning rental property is the tax benefits.
For example, housing insurance, mortgage interest, wear and tear, and maintenance costs are all tax deductible.
Depreciation of the property is another thing that can be deducted from the investors’ income when paying taxes.
Another way to benefit is through seasonal rentals; you may use the property for up to 14 days a year or 10% of the time it is rented out to others and still deduct expenses from the income.
Another benefit is avoiding capital gains by exchanging the property, also known as a 1031 exchange.
If a similar enough property is available, it is possible to simply exchange it with your existing one without incurring capital gains.
The first major issue with owning property is that it is nowhere near as liquid as other investment avenues.
It might take several months to find a buyer willing to pay a fair price, and if the market is bad, you might end up with no buyers at all.
Secondly, mortgages might be fixed, but housing taxes and insurance premiums are not. These may increase even if the property cannot command better rentals.
Another major problem is bad tenants. Despite a rental property owner’s best efforts, there is no telling what tenants might turn out to be like.
Starting from small problems such as forgetting to turn off the water to bigger headaches such as overly demanding tenants or destructive ones who may cause damage to your property, there could be several headaches in renting out property.
Local politics of an area might cause a decline in the property value, especially if the neighborhood becomes crime-infested or major amenities get shut down.
Moreover, being a landlord requires a lot of work. From advertising the property to selecting tenants to haggling prices or hiring a broker, they all demand effort or money from the buyer.
Often rental property owners hire a property management company to take care of these issues, which is another cost that cuts down profitability from the investment.
Is Owning a REIT the Same as Owning a Property?
No, REITs are merely a financial instrument that lets investors benefit from the gains in the rentals and asset appreciation of properties. It doesn’t give the ownership of the property to the investor.
It is similar to owning securities – a stock lets you benefit from the company’s growth, but it does not give you any rights to the firm’s assets.
If the business liquidates for some reason, its first liability is to its debtors, not the shareholders.
REITs vs Rental Property: A Comparison
REITs are usually preferable for investors who do not want to spend their time maintaining the property, finding tenants, and running a house.
However, the returns they generate are typically lower than what is possible by investing directly in rental property.
Now let’s dive right into the REITs vs rental property discussion.
Ease of Entry
Buying REITs is no different from buying stocks. It requires almost zero effort on the part of the investor.
Selecting a good rental property may take years as a lot of factors get involved – the location of the property, size, neighborhood, possibility of appreciation, zoning laws, and more.
Investing in REITs costs very little – there are some small management fees and an expense ratio to be paid, apart from the value of the stock.
Buying a property requires huge capital investments, making a down payment, taking out a mortgage loan, paying housing tax, insurance, brokerage fees, and fees for a property manager if you hire one.
Investors can buy and sell REITs nearly immediately. They are tradable on the markets and have thousands of investors buying and selling them at any moment.
Depending on their location, price, and prospects for appreciation, rental properties may take months or even years to find a good buyer.
Investing in REITs is passive; the buyer buys the stock and then gets dividends. It does not require any special effort from the buyer to trade in them.
Neither does the buyer hold any claim over the real estate being invested in and the rentals being charged.
Buying a rental property requires a lot of involvement.
From selecting the property to procuring a mortgage, paying various taxes, looking for tenants, maintaining the property, and so on, a property buyer has to put in a lot of effort.
However, in most cases, with proper due diligence, it is possible to get a lot more capital appreciation through rental property than through REITs.
Do REITs Outperform Real Estate?
Data over nearly three decades (from 1977 to 2010) shows that REIT returns have been about 12%, and in the last five years, they have been nearly 9%.
Direct real estate investment has average returns of below 8%, so investing in REITs appears to outperform buying rental property.
However, the caveat is that rental properties can earn much higher returns in specific cases if the buyer is able to make a particularly good deal, whereas returns from REITs will not exceed a certain figure.
Are REITs a Good Investment?
As mentioned earlier, REITs have been performing nearly at par with the S&P 500 in the past few years.
They are an excellent tool for diversification and a brilliant hedge against inflation. Moreover, they are easy to trade and offer regular dividend cash flow to the investor.
However, it’s important to understand that REITs can only offer moderate appreciation, so if you are looking for explosive growth, there might be better options.
Overall, if you are looking for a steady income and moderate appreciation, REITs are an excellent choice.
Are Rental Properties a Good Investment?
If you are looking for an investment that offers a steady rental income with long-term capital appreciation, then rental properties might be a good option for you.
One good thing about rentals is that investors also get a lot of tax breaks for owning them. Whether it is mortgage interest or property taxes, all are tax deductions.
Moreover, even if the property earns a few hundred dollars in rentals after deducting all costs, that’s additional income that can be reinvested in other places.
However, rental property investing is not for the faint-hearted. A lot of effort and patience is involved in buying and then managing a property.
Keeping track of the maintenance of the house, ensuring tenants are in place, managing the property, and other activities take up a lot of time.
Hence, whether a rental property is a good option depends on your investment goals.
REITs are an excellent way to invest in real estate if you are good with passive investing and aren’t looking for extraordinary growth.
They offer regular dividends, high liquidity, and low investment hassles.
Buying rental properties and letting them out on lease requires a lot of active effort but has a higher potential profit.
Depending on your investing style and objectives, either could be a good choice for you.