Investors seeking exposure to real estate can look for investment properties to purchase and rent out, or they can buy shares of a real estate investment trust (REIT). Becoming a landlord offers greater leverage and a better chance of realizing big returns, but it comes with a long list of hassles, such as collecting rent and responding to maintenance issues. REITs provide a much simpler way to invest in real estate and earn consistent income through dividends, but they confer less control, and their upside tends to be lower than that of rental properties.
Landlord Pros
Becoming a landlord offers several advantages. Perhaps the biggest advantage is leverage. Investors with good credit can buy rental property with as little as 20% down, financing the rest. Therefore, the investor's cash outlay on a $100,000 property is only $20,000. If the value of the property increases by 20% in the first year, an amount not unheard of in a hot real estate market, then the investor enjoys a 100% return.
Although mortgage payments must be made on the financed amount, a smart real estate investor earns enough money in rental income to cover the mortgage, with money left over as profit. This allows the investor to earn money from both property appreciation and rent payments from tenants.
Landlord Cons
Being a landlord is a much more hands-on investment than owning shares of a REIT. Many people who have gotten into the business of purchasing rental properties have quickly learned that the time required to manage all of their properties becomes another full-time job. A person considering buying rental properties should brace themselves for a huge time commitment, or be prepared to pay a professional property manager to handle the minutiae involved, such as advertising vacancies, collecting rent and dealing with delinquent tenants.
Then there are the myriad expenses involved with owning property. Depending on how the lease agreement is written, a landlord could be financially responsible for everything from a leaky faucet to a broken refrigerator. This can eat into an investor's profit quickly. Moreover, dealing with frantic late-night phone calls every time a tenant's toilet does not flush properly can impede quality of life.
REIT Pros
Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit. Building a diversified portfolio of one's own rental properties requires a hefty budget and a lot of time and expertise. Investing in the right REIT offers done-for-you diversification in one simple purchase. Furthermore, while rental properties are potentially lucrative investments, they can be highly illiquid, particularly when the real estate market turns soft. REIT shares, on the other hand, can be redeemed for cash in one five-minute phone call.
REIT Cons
REITs lack the leverage advantage offered by financing rental properties. Because a REIT is required by law to distribute 90% of its profits to investors, that leaves only 10% to grow the company by investing in additional properties. Consequently, REIT share prices rarely grow as fast as, say, Silicon Valley tech companies, which rarely pay dividends and usually invest every penny of their profits into growth and innovation.
REIT investing offers less control than being a landlord. When an investor buys rental properties, the investor can see, touch and smell each property before owning it. The investor can research the local rental market and examine data on how similar properties have fared recently. Buying REIT shares means ceding that control to someone else. This can be ideal for investors not wanting to make such decisions, but those who prefer a hands-on approach might be better off as landlords.
FAQs
Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.
What is a disadvantage of a REIT? ›
Benefits of investing in REITs include tax advantages, tangibility of assets, and relative liquidity compared to owning physical properties. • Risks of investing in REITs include higher dividend taxes, sensitivity to interest rates, and exposure to specific property trends.
What are 3 drawbacks to owning rental real estate? ›
The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.
Why are REITs low risk? ›
REITs historically have delivered competitive total returns, based on high, steady dividend income and long-term capital appreciation. Their comparatively low correlation with other assets also makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns.
Can REITs lose value? ›
Well-managed REITs may contribute to a diversified portfolio and can deliver stable dividends with attractive tax benefits. However, REITs can drop in value and cause investor losses if they are not managed well.
Why high interest rates are bad for REITs? ›
In addition, higher interest rates make the relatively high dividend yields generated by REITs less attractive when compared with lower-risk, fixed income securities, which reduces their appeal to income-seeking investors.
What I wish I knew before buying REITs? ›
REITs must prioritize short-term income for investors
In exchange for more ongoing income, REITs have less to invest for future returns than a growth mutual fund or stock. “REITs are better for short-term cash flow and income versus long-term upside,” says Stivers.
Why are REITs not popular? ›
Risks of Publicly Traded REITs
Publicly traded REITs allow for more transparency but still come with risks like: Interest Rates: A rise in interest rates may reduce demand for REITs, as investors choose other vehicles like U.S. Treasuries that are government-guaranteed, and pay a fixed interest rate.
What is bad income for REITs? ›
For purposes of the REIT income tests, a non-qualified hedge will produce income that is included in the denominator, but not the numerator. This is generally referred to as “bad” REIT income because it reduces the fraction and makes it more difficult to meet the tests.
What is the biggest risk of owning a rental property? ›
One of the biggest financial risks of owning rental property is vacancy and turnover. When your property is vacant, you are not generating any income, but you still have to pay for the mortgage, taxes, insurance, maintenance, and utilities.
In general, if you want to build greater wealth, the best plan is to hold your investment property for as long as possible. In 20 years, it is highly likely your investment property will be worth much, much more. Just think about what your kids and grandkids will say about prices today.
Is rental property a good asset? ›
Investing in a rental property is a great way to generate steady, ongoing income. And if you hold on to a rental property for many years, it could appreciate quite nicely in value over time. But investing in real estate isn't the same thing as investing in assets like stocks.
What is the downside of REITs? ›
Here are some of the main disadvantages of investing in a REIT. Market volatility: Value can fluctuate based on economic and market conditions. Interest rate risk: Changes in interest rates can affect the value of a REIT.
What are the dangers of REITs? ›
Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.
Can REITs go broke? ›
REITs can offer a good way for retail investors to diversify their investment portfolios and access real estate markets without costly financial outlays or taking on the risk of owning property themselves. Cons: No investment is without risk, and REITs can and do go bankrupt – so it's important to do your own research.
What is one advantage of investing in a REIT? ›
Benefits of REITs
REITs typically pay higher dividends than common equities. REITs are able to generate higher yields due in part to the favorable tax structure. These trusts own cash-generating real estate properties. REITs are typically listed on a national exchange and provide investors considerable liquidity.
Why are REITs good in a recession? ›
REITs allow investors to pool their money and purchase real estate properties. By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions.
How do REITs differ from other real estate property investments? ›
A real estate fund is typically a mutual fund that invests in public real estate companies (which can include REITs). Whereas REITs pay dividends to investors, real estate funds aim to generate value through the appreciation of the securities they own.
Why do REITs earn higher returns? ›
Because of their lower volatility, REIT returns are less correlated with the stock market. That makes REITs an excellent way for investors to build a diversified portfolio and improve their risk and return profile.
