In the mid-19th century, Andrew Carnegie said that “90% of millionaires became so through owning real estate.” Almost two hundred years later, it’s still true; real estate remains an unparalleled way to build wealth. But making money off the real estate market doesn’t necessarily mean you have to go out and buy an apartment building. In this era of financial products for everything imaginable, you can park your cash in a REIT (real estate investment trust), and get most of the returns without any of the headaches of being a landlord.
Q4 2019 hedge fund letters, conferences and more
What is a REIT? A REIT is simply a company that owns and operates a portfolio of income-generating real estate. Investors buy into this portfolio and share in the profits. Think of it like a mutual fund, only with real estate instead of stocks. It’s an extraordinarily safe and stable way to invest in the real estate market, but in exchange for that safety, you won’t get returns that are quite as high as if you made savvy property investments yourself. Let’s look at the pros and cons of investing in a REIT versus investing in property.
Investing In A REIT
Real estate is still one of the best investments you can make, especially if you buy in at the right time. Although returns average 8% to 10%, it’s not unusual to hear of investors reaping 20% returns on their rental properties, a number that dwarfs any other type of investment out there. But there are real risks. Let’s look at some of property ownership’s biggest advantages before we discuss its downsides.
The Pros
Tax Advantages
When you own property, you can deduct depreciation from your income at tax time. The IRS uses a somewhat arcane schedule of depreciation for various property types, meaning you’ll be entitled to deduct a certain amount of depreciation each year, regardless of whether that property actually degraded in value or condition. On top of that, you can also deduct business expenses and mortgage interest. Most real estate investors are able to radically reduce their tax obligation just through these two deductions.
Tangibility
Real estate is still the only investment you can live in. It may sound old-fashioned, but for many investors, it means something that they can see and touch and, yes, live in their investments. In an era when a hacked Bitcoin wallet or brokerage account can see years of hard-won profits disappear in an instant, the tangibility of real estate can be immensely comforting.
The Cons
High Effort
There are probably easy, passive ways to make money; being a landlord just isn’t one of them. Whether you invest in a small one or two unit rental, or a huge commercial property, there will be constant issues to deal with. Every landlord has stories about fixing a broken-down boiler at 4AM on Christmas morning, or evicting a non-paying tenant who refuses to leave. Finding and vetting tenants takes time and effort, and if you use a leasing agent, it will typically cost you a month’s rent. Opting for professional property management will take a further chunk out of your profits, as management companies usually work for a percentage of rents collected.
Illiquidity
One great thing about stocks, or shares in a REIT, is that you can sell them with a phone call, a click of a mouse, or a swipe on an app. But if you want to cash in your property, you’re looking at a wait of weeks or months. And it’s not cheap; transaction costs when selling a home can top 10%, even when using discount options like selling FSBO. Real estate agent commission alone typically runs to 6% of the sale price, and on top of that there are staging costs, pre-sale repairs and renovations, and closing costs.
Risk
If you put all your money into one or two properties, you’re exposed to a pretty high level of risk. It’s like the old saying about putting all your eggs in one basket. If those properties lose value, or something happens to them, you could see your investment evaporate pretty quickly.
Breaking Down the REIT
A financial product structured like a stock, that lets you profit from the real estate market? It sounds great—and it is. But like buying actual property, investing in a REIT comes with certain disadvantages. But first, the benefits.
The Pros
Access to Expertise
Most investors know how to identify a good investment—but could you identify thirty good investments, across several different property types? Investing in a REIT means you’re putting your money on a diversified portfolio that was assembled and is managed by elite investment minds. It’s nearly impossible to access that kind of expertise in the regular course of business.
Cash Flow
A REIT is legally required to pay out at least 90% of its taxable income as shareholder dividends each year. That means you’ll get a nice check in the mail at regular intervals for essentially doing nothing. This is the definition of passive income.
Safety
REITs are even safer than stocks, and have historically offered great returns, averaging a very respectable 13% annually. Unlike stocks, your REIT shares aren’t going to rise and fall because of short-term inflation or changes in the interest rate; property appreciation and expenses are fairly predictable, so investing in a REIT is usually a smooth ride.
The Cons
No Control
Let’s say you put your money into a REIT that’s heavily invested in office buildings in the South. If you have a hunch or even inside information that the market for office space in the South is about to nosedive, you won’t have any choices except to pull your money out of the REIT or to cross your fingers. That’s the downside to having your money managed by experts; they aren’t likely to take any suggestions for you. You’re either along for the ride, or out of the car.
Low Growth
Since REITs are legally required to pay out 90% of profits as dividends, they can only reinvest 10% in new properties. This means that REITs are relatively slow in expanding their portfolios. On top of that, investors can only deduct 20% of their REIT dividends on their taxes; the rest is taxable income.
There’s Still Risk
While REITs are considered a safe investment vehicle, they also come with the same risks you expect in traditional real estate rental investing. Property values, interest rates, debt, geography, and tax laws can all impact an REITs returns, so it’s important to do due diligence into the particular REIT you’re exploring.
The Upshot Of Investing In A REIT
In the end, the best choice for individual investors is going to depend on their goals and their temperament. If you have a lot of bandwidth to dedicate to your investments, and a high tolerance for risk, buying rental property could be right up your alley. On the other hand, if you’re looking for truly passive income, and want a safe, stable place to invest your money, a REIT offers that. Whichever choice you make, you’ll be well on your way to prosperity.
Authored by Clever Real Estate
