Many investors understand why they should invest in real estate over the long-term: income-producing real estate can offer a reliable stream of cash flow, and some methods require very little involvement from the investor. However some methods are better suited for some investors over others, so there may not be one single best way to invest in real estate for everyone.
When examining real estate investing options, most investors come down to the choices of rental properties (hands-on) and REITs (hands-off). In this article, we examine the advantages and disadvantages of rental properties and REITs, plus other factors that would behoove investors to consider before choosing how to invest in real estate.
Rental property investments can be lucrative opportunities for those interested in taking a more active role in their real estate investments. They can produce monthly cash flow in addition to long-term appreciation. They also offer the benefit of direct ownership, which presents tax advantages, greater control over the investment, and the potential for the growth of your personal net worth. But, with these benefits comes myriad responsibilities as a landlord that require ongoing, hands-on attention.
Benefits of rental properties
Rental properties can offer many benefits to an investor with the knowledge, time, and capital available to manage them. When a rental property is running according to plan, it can offer:
- Regular cash flow: Rental properties can offer reliable monthly cash flow in the form of rental income. A landlord has peace of mind with their lease agreements, which dictate a rental payment expected from tenants at the beginning of each month. The more units that are leased, the greater the expected monthly income is. Multiple income streams provide diversification of earning power, reducing dependence on a single income source while increasing income.
- Asset appreciation: In addition to monthly payments from tenants, rental properties can earn money through appreciation. Equity ownership gives an investor the right not only to lease a property, but to capture any appreciation earned upon the sale of that property. If a property appreciates, or increases in value, its potential profit for the investor upon sale also increases.
- Tax deductions: Rental property owners can deduct from their taxes the majority of expenses that they incur in managing their investment property. Some examples include legal fees, insurance premiums, taxes, and maintenance costs paid in operating the property. While you can’t deduct the costs of property improvements in a single year on your income tax returns, it is possible to report the ways you improve the property and then depreciate the costs over your property’s life expectancy. So, when you add value to the property in the form of landscaping or new countertops in order to fetch a higher rental price, you can depreciate the costs over several years. With each deduction, you lower your net income and potentially lower the amount of taxes that you will owe annually. Also, if you sell a rental property and buy another one under a 1031 Exchange you can defer capital gain taxes. This can preserve your buying power and strengthen your ability to buy a higher-priced property.
- Freedom and Flexibility: You bear the responsibility of your investment, which means that you are in charge and get to make all of the decisions concerning your investment. You are able to determine how much to charge in rent, what renovations to make and when, who to work with, and the property’s eventual resell cost as well as the timing of the sale.
Drawbacks of rental properties
Rental properties can offer great advantages to investors, but they also come with many responsibilities. Many moving parts must be in good working order for a rental property to offer returns worthy of the time and money commitment. As with any direct investment, the success of a rental property investment falls squarely on the shoulders of the investor. If purchased or managed poorly, a potentially lucrative investment property can quickly devolve into a money pit. Before buying a rental property, an investor should consider inherent obstacles, including:
- Extensive Expertise: Before you buy a rental property, you need to assess the viability of the investment. This means that you need the financial and real estate expertise required to determine the expected occupancy rate, monthly rental income, operational costs, and potential upfront renovation costs; plus the man-hours required from you and/or your employees to operate the property for tenants. Successful landlords are generally either seasoned rental property managers, with experience in each of these areas, or they have access to the services of a team of experts, including property managers, a maintenance crew, a lawyer, and an accountant. Employing a knowledgeable team can help you avoid potential pitfalls. But, experts’ fees can also add up, eating away at take-home total returns. You also concede some control, while fully retaining responsibility.
- Active property management: A rental property is one of the most active real estate investments that you can make. In addition to expertise, you also need to devote time to hands-on management. Once you buy the property, as a landlord, you are responsible for finding tenants, performing background screenings, drafting lease agreements, ensuring that tenants abide by lease agreements, overseeing property maintenance, providing timely repairs, evictions, and more. You can hire a property management company to take some of these responsibilities off of your shoulders, but with this option, you give up some control and a portion of your profits. Regardless of who manages the investment property, if the property manager doesn’t provide repairs in a timely fashion or lets a bad tenant go unchecked, you risk tenants deducting rent, or moving out entirely to a better-managed building in addition to potentially facing legal problems.
- Access to upfront capital for a down payment and/or loan: When it comes to investment properties, the old adage is true: you need money to make money. A rental property investor must be able to produce a down payment for a property (or be able to secure a mortgage loan that does not require a down payment). Some properties, such as commercial office buildings or a multi-family apartment complex, require even greater financing than a single-family home. In general, the smaller portion of the price that the down payment covers, the more interest a mortgage holder pays over time. Additionally, unless you buy a property outright with cash, you must secure a loan with an interest rate that accommodates your expected monthly rental income. High-interest rates can eat away at monthly earnings, especially if the property experiences a lower occupancy rate than expected. Also, because rental properties are generally large purchases, they are a long-term investment by nature.
A real estate investment trust (REIT) is a company that makes debt or equity investments in commercial real estate. REITs were created in 1960 to give individual investors access to invest in income-producing real estate without the commitment that comes with traditionally buying an investment property directly. REITs offer a passive way to earn potentially sizable returns from real estate investing through purchasing shares similar to the way that investors have traditionally bought shares of stock of a company. With this passive approach, investors receive the benefit of higher liquidity and less responsibility.
REITs can be categorized by investor access in three ways: private REITs, publicly traded REITs, and public non-traded REITs. Private REITs generally carry high investment minimums and accreditation requirements, putting them out of reach for the majority of individual investors. As a result, the majority of individual investors can realistically choose between publicly traded REITs and public non-traded REITs.
Benefits of REITs
REITs offer easy access to real estate investing for those not interested in becoming a landlord. REITs can provide investors with returns comparable to those of rental properties without any of the hands-on work or responsibility. When chosen well, a REIT can offer the benefits of:
- Passive investing: Unlike a rental property, where the success of the investment falls entirely on the investor, a REIT offers a way to invest in real estate for those who would rather have no hands-on obligations. Passive real estate investors generally only provide the capital for an investment and let professionals invest on their behalf.
- No expertise needed: Because REIT investors are not involved in the management of the operations of their investments, they do not need extensive real estate or finance expertise in order to ensure that an investment is successful. However, an investor should understand the risks and benefits of any investment before investing.
- Low investment minimums: REITs are one of the most affordable ways to invest in real estate. Investment minimums can vary across REIT types, but publicly traded REITs and public non-traded REITs carry lower investment minimums than private REITs and active real estate investments, such as rental properties. Where rental properties can range from tens of thousands to millions of dollars in acquisition and operational costs, a share of publicly traded REITs and public non-traded REITs can often be purchased with a minimum investment of $1,000 or less.
- Liquidity: Most REITs, particularly publicly traded REITs, offer much greater liquidity than rental properties. A rental property is an illiquid investment that requires an investor to tie up thousands or millions of dollars into a single property for a long period of time. In comparison, REIT shares can be bought and sold easily on a daily, monthly, or quarterly basis (depending on the type of REIT).
- Diversification: Unless you own many different properties throughout the country, you probably won’t be able to achieve the same diversification by investing actively in rental properties as is available through a REIT. A REIT can invest in tens or hundreds of properties across debt and equity, property types, real estate sectors, and geography, which makes the REIT’s success far less reliant on the performance of one or two assets. If a rental property underperforms due to renovation costs or lower than expected tenancy rates, the investment will result in much greater losses for one or a few large active investors versus had the property been one of many properties owned by an array of REIT investors.
- Regular cash flow: REIT shareholders can earn income from both debt and equity investments owned by the REIT. Investors typically receive this income in the form of dividend distributions. Unlike rental properties, which usually provide monthly cash flow in the form of rental income, REIT dividends offer monthly or quarterly cash flow. By law, a REIT must distribute at least 90% of its taxable income each year to its shareholders in the form of dividends. The dividend amount can vary by REIT and over time according to the success of a REIT’s investments.
- Tax benefits: Beginning in 2018, the typical REIT pass-through business structure opened up a new tax deduction for REIT investors. REIT investors can now claim a tax deduction of up to 20% on income earned from loan interest and rental payments. Additionally, REITs are able to eliminate taxation at the company level leaving returns taxed only at the individual investor level.
Drawbacks of REITs
While REITs can help investors invest in real estate with a smaller commitment of resources, the benefits of some REITs are far more attractive than others. When choosing among REIT investment options, it is important to assess each one’s attributes, because they can vary in terms, returns, diversification, duration, and more. It’s also important to evaluate potential disadvantages among REITs, including:
- Volatility: Publicly traded REITs are traded on the stock market, which makes them prone to fluctuate in tandem with the rise and fall of the stock market regardless of whether or not the value of the property owned by the REIT has changed. These changes constantly affect the value of each share. However, it’s important to note that this kind of volatility only affects publicly traded REITs. As their names describe, non-traded REITs are not traded on a stock exchange, which means the value of each share is not subject to volatility in the public market. Changes in share values of non-traded REITs are driven more by underlying real estate and different dynamics in the private market. For example, a share in a Fundrise eREIT (a non-traded REIT), does not change in value in response to a stock market spike or fall because its performance isn’t correlated with that of the stock market. Instead, its value changes in response to changes in the underlying real estate it owns and in the markets where the properties are owned. These changes might involve appreciation, sales, vacancy fluctuations, or neighborhood improvements.
- Correlation: As mentioned above, because publicly traded REITs are just that – publicly traded on a stock exchange – the value of their shares is correlated to the fluctuations of the stock market. While publicly traded REITs can provide access to a portfolio of real estate, they don’t provide diversification for an investor holding a portfolio largely composed of public market investments, such as stocks and bonds. However, because non-traded REITs are not traded publicly, they can provide complementary diversification power to an investment portfolio of stocks and bonds.
- Less control: Rental properties offer investors a great deal of freedom and flexibility, accompanied by full responsibility. REIT investors on the other hand, bear only the burden of potentially losing only the money that they’ve invested. This means that they carry far less risk, but they also have no control. REIT investors do not have a say in the operation of their investment, but they still share in its returns. This may be an ideal arrangement for a passive investor, an inexperienced real estate investor, or even an experienced real estate investor who does not have free time to devote to rental properties. But it’s a tradeoff that should be fully assessed before you choose to place your money in the hands of other managers.
Evaluating your investment options
Many investors understand the benefits of adding real estate to their investment portfolios. It can become a valuable source of cash flow when managed well, creating a reliable income stream. Before beginning, it’s important to assess which option available to you maximizes total return potential for your particular expertise and commitment of time, money, and responsibility.
Ask yourself key questions like these, to help guide you toward the type of real estate investment best suited for you:
- Do you have the time, expertise, and desire to take an active role in making decisions about your property, as in the case of rental property ownership? Or would you rather play a more passive part, opting to invest in a professionally managed option, such as a REIT?
- How much capital do you have available for your initial investment? Can you afford a large down payment, or are the lower cost of REIT shares more feasible?
- If you’re interested in a REIT, which kind is best suited for you? Do you want a publicly traded REIT that offers higher liquidity but is also correlated to the stock market and prone to volatility? Or would a non-traded REIT, like Fundrise’s eREITs, insulated from rises and falls in the stock market, better suit your needs?
No matter what method you choose, investing in real estate is an excellent way to add a new asset class to your portfolio and a potentially useful source of investment income. While real estate has been the asset of choice for wealthy investors for decades, the emergence of new technology and regulations has opened up access to the benefits of real estate like never before.