The Difference Between REITs and Direct Real Estate Investing
By: Olivia Faucher,
The Difference Between REITs and Direct Real Estate Investing Offers important information regarding ways to add real estate to one’s portfolio.
Real estate can be a smart addition to any investment portfolio. Real estate provides great diversification, as it is a distinct asset class which does not have a strong correlation with other industries within the stock market.
The two ways to invest in real estate are to 1) invest in a real estate investment trust (REIT) or 2) make a direct investment into real estate. Read further to learn the differences between these two ways to profit from real estate investing.
The Difference Between REITs and Direct Real Estate Investing: What is a REIT?
A REIT is a company that owns, operates, or finances income-producing real estate. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.
Generally, REITs follow a simple business model: the company buys or develops properties and then leases them out to collect rent as its primary source of income. Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors further can buy publicly traded REIT shares on major stock exchanges such as the NYSE or NASDAQ.
In order to be classified as a REIT, a company must meet the following criteria:
- Invest at least 75% of total assets in real estate.
- Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from real estate sales.
- Have a minimum of 100 shareholders.
- Be an entity that is taxable as a corporation.
- Be managed by a board of directors or trustees.
- Have no more than 50% of its shares held by five or fewer individuals.
- Pay at least 90% of taxable income as shareholder dividends each year
The Difference Between REITs and Direct Real Estate Investing: REIT Pros and Cons
Pros of Investing in REITs:
- REITs provide diversification within an investment portfolio
- REITs have high dividend yields
- REITs are a highly liquid investment; it is easy for investors to buy and sell REITs
- REITs provide exposure to the real estate market without placing any extra responsibility on the investor (the investor does not have to own, operate or finance the property personally)
Cons of Investing in REITs:
- REITs are subject to market risk and they are sensitive to fluctuations in interest rates
- There are property-specific risks associated with any properties that a REIT may own
- The tax rules associated with REIT dividends are not ideal for investors
The Difference Between REITs and Direct Real Estate Investing: What is Direct Real Estate Investing?
With a direct real estate investment, an investor buys tangible real estate and operates it for his or her own financial benefit. For example, the investor may buy an apartment building and manage the property personally, taking on the responsibility of maintaining the property and overseeing the operations. Direct real estate investors make money through rental income and appreciation.
The Difference Between REITs and Direct Real Estate Investing: Pros and Cons of Direct Investing
Pros of Direct Real Estate Investing:
- Appreciation of property values can allow for a direct investor to profit when he or she decides to sell properties
- Tangible real estate has the potential to generate significant cash flow for the owner
- Someone who decides to make a direct real estate investment has more control over decision making than a REIT investor does. Direct real estate investors can tailor the investment to their exact preferences
Cons of Direct Real Estate Investing:
- The investor must take on the responsibility of managing the property. The investor must dedicate time and energy to the property in order to be successful.
- Direct real estate investments are illiquid; it is not easy to buy and sell real estate quickly
- Direct real estate investors are personally responsible for the financing of the properties they own
The Difference Between REITs and Direct Real Estate Investing: Bottom Line
REITs are an easier way to gain exposure to real estate, as there is no personal responsibility to maintain and operate any properties. REITs are also highly liquid, and they can provide high yields. REITs are a great way for new investors to gain experience with the real estate industry.
Direct real estate may be a good choice for investors who have the financial resources to make the investment in tangible real estate, and want significant cash flow. Direct real estate is also great for investors who want to have control over their investments. However, the illiquidity of direct real estate investments and the obligation to manage the properties are drawbacks that should be considered.
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Olivia Faucher is an editorial intern with Eagle Financial Publications.