One of the most common questions I get from aspiring real estate investors is whether to buy property directly or purchase shares in a real estate investment trust, commonly referred to as a REIT.
For those who aren’t familiar with REITs, these vehicles allow individuals to buy shares in companies that own real estate as their primary business activity. While some REITs are private or non-traded, in this article we’ll focus on the publicly traded REITs, which are the most visible and can be purchased by any investor with a brokerage account. I used to run one of the largest publicly traded single-family rental REITs called Starwood Waypoint (now part of Invitation Homes), which I took public in 2014. Today, I’m the CEO and co-founder of a marketplace for buying, owning and selling single-family rental investment properties — so I’m pretty familiar with both sides of the argument.
While both methods of investment allow investors to achieve real estate exposure, it’s a bit like comparing apples and oranges. One represents direct ownership, while the other is characterized by owning shares in a company whose sole purpose is to own and operate a portfolio of real estate assets. I own shares in several REITs as part of my personal equity portfolio, as well as some real estate directly. I view both of those investments differently and see the advantages and disadvantages to each.
To help you better understand the appeal of investing in brick and mortar real estate versus a publicly traded REIT, here is a list of considerations. In the first half of this two-part series, we’ll explore situations when direct investing comes out on top:
Investing Goal: Hedge Against Stock Market Risk
Real estate is cyclical, as is the stock market. But the two do not generally move in lock-step — meaning they are not directly correlated. In order to have a diversified portfolio, by definition, it is important to hold investments that react differently at the same point in time. This is perhaps the most compelling reason to own real estate directly as opposed to owning REIT stock, especially during periods where equities may be fully-priced and potentially facing more near-term downside risk than upside potential.
Investing Goal: Greater Ability To Use Leverage
Buying property directly often gives you the ability to use a higher level of debt financing than is typical in the REIT universe, as institutional investors frown on REITs that employ more than 40% leverage. By contrast, an individual investor buying an investment home can borrow up to 80% of its value through Fannie and Freddie programs. So instead of putting $20,000 into a REIT, you could use it as a down payment and obtain $80,000 in financing for a $100,000 investment property and reap the gains of the entire asset appreciating in value over time. All things being equal, greater leverage can lead to higher returns on equity in upside scenarios.
Investing Goal: Dividend Potential
Many equity REITs have annual dividends in the range of 2-3% or less, while owning individual properties could generate annual distributions of 5-8%. This disparity results from the fact that REITs: 1) often focus on institutional quality assets and markets that have relatively low yields; 2) have corporate overhead costs to cover; and 3) want to avoid the risk of having to lower their dividends in the future — and thus only pay out a conservative level they believe to be sustainable. As a result, REIT dividends tend to be lower but also highly predictable.
Investing Goal: Building Equity
While REIT investors can generate capital gains as the share price ideally increases over time, when you buy an investment property, you’re continuously building equity in a tangible asset. All the while, the tenant is paying your mortgage and your equity stake can increase as the value of the asset typically appreciates over the long term. Having more equity in your asset also gives you the ability to refinance over time and use the proceeds to buy additional assets and grow your portfolio.
Investing goal: Tax Efficiency
Both investing in REITs and investing directly in real property have tax advantages, many of which are nuanced and depend on the specifics. At a high level, REITs are exempt from income tax at the trust level, but a good portion of their dividends are taxed as ordinary income (some may be taxed at a lower rate as capital gains or exempt if characterized as a return of capital, which reduces your basis). However, when you invest directly in real property, you are able to deduct operating expenses and depreciate the asset, which can significantly reduce your taxable income. Another very significant tax advantage of investing in real estate directly is the ability to defer capital gains through a 1031 exchange, which allows investors to sell appreciated property and transfer their original cost basis over to new investment properties without triggering any taxes. Keep your eyes on the tax reform bill to see if this provision remains, as it represents one of the most significant tax advantages for long-term real estate investors.
Investing Goal: Control Over Your Investment Strategy
For many investors, having full control and owning the asset outright holds major appeal. You decide what markets and assets to invest in, how much debt to employ, whether to manage yourself or use a professional property manager, and you sign off on big decisions such as when to make capital improvements or sell properties. While direct investing can take a bit more effort, the payoff could be higher returns and some insulation from the volatility of the stock market.
This concludes Part I of our series on investing in real estate directly versus buying shares in a REIT. In the next section, we’ll discover the benefits of investing in publicly traded REITs.