With so many different options for investing in real estate, which type of investment should a real estate investor go for? Real estate investors often find themselves faced with the choice of buying rental property vs. REIT investing.
Many real estate experts say that to compare buying rental property vs. REIT investing shouldn’t even be a topic of discussion. This is because of how different the two types of real estate investments are. A well-rounded real estate investment portfolio should have both, further down the line in a real estate career. Beginner real estate investors, however, have to make the decision of which real estate investment to choose, buying rental property vs. REIT investing.
The choice is a clear one: buying rental property is the better real estate investment, and we’ll show you all of the reasons why.
Related: 7 Steps to Buying a Rental Property
Buying Rental Property vs. REIT Investing: The Risk of Real Estate Investing
The risk of real estate investing can’t be ignored, and a successful real estate investor knows to study the risk and fully understand it. When it comes to the risk of buying rental property vs. REIT investing, rental properties will have a real estate investor taking on less risk.
While there are many elements that go into choosing low-risk rental properties from the housing market, the major element at play for causing risk in REIT investing is the stock market. With REIT investing, a real estate investor is purchasing shares/stocks in a company that owns real estate assets. Dealing with real estate assets and the stock market brings on greater risk as the stock market is subject to more fluctuations than the housing market.
Buying Rental Property vs. REIT Investing: Financing and Return on Investment
When applying for financing for buying rental property vs. REIT investing, banks will lend up to 80% of the value of rental properties, while providing no more than 40% for REITs. How does this get a real estate investor a better return on investment? Let’s take a look:
80% of a $200,000 rental property is $160,000. This means that this real estate investor will pay $40,000 in cash for the real estate investment. Selling the property for $220,000 will get a return on investment of $20,000. Essentially, this is a return on investment of 50% of the actual cash paid from the pocket of the real estate investor.
While REITs are in reality less expensive real estate assets, let’s stick to the same numbers for the sake of this example. 40% of $200,000 is $80,000, leaving the real estate investor to pay $120,000. Selling the real estate investment for the mentioned price will amount to a return on investment of 25%. As you can see, buying property will give you a better return on investment because of the leverage.
Buying Rental Property vs. REIT Investing: Annual Real Estate Investment Return
If you look at the annual return on investment of buying rental property vs. REIT investing, again owning a rental property comes out on top. The annual dividends of REIT investing are generally 2-3% (or less) for a real estate investor. Buying rental property in the housing market can bring an annual return on investment in the range of 5-8%. There are a few reasons why REIT investing brings a lower annual return on investment:
- Companies focused on REIT investing still have other business expenses to take care of.
- REIT investing is usually centered on real estate assets that are of an institutional quality which tends to be in a lower yielding housing market.
- Because of the involvement of outside real estate investors, REIT investing companies want to avoid having to lower annual REIT dividends in the future. So, they keep REIT dividends at a relatively low – but reasonable – value, no matter the state of the housing market.
While it’s true that REIT investing is more predictable in annual return on investment, owning a rental property in the housing market will amount to more if a real estate investor takes the right steps to buy a good investment property.
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Buying Rental Property vs. REIT Investing: Building Equity
When considering equity for buying rental property vs. REIT investing, both will technically build some equity. However, with owning a rental property, real estate investors continuously build equity as tenants pay rent. This rental income goes to paying off the mortgage, increasing equity monthly. With REIT investing, it’s more of a waiting game: waiting for the value to increase over time. Owning a rental property also provides this aspect of appreciation, giving it an edge over REIT investing when it comes to building equity.
Buying Rental Property vs. REIT Investing: Tax Benefits
Owning a rental property, as well as REIT investing, has the benefit of tax deductions. However, owning a rental property will save you more on taxes. A large percentage of REIT dividends are taxed as ordinary income. Some REIT dividends are taken at a lower tax rate as capital gains or disregarded as return on capital. So even though at a high enough level REIT dividends can be exempt from taxable ordinary income, the amount of REIT dividends that ends up being taxed cuts into any savings.
Buying a rental property will open a real estate investor up to better tax advantages that he/she can’t get with REIT investing. Owning a rental property allows a real estate investor to claim tax deductibles for the expenses of rental property management and maintenance. Real estate investors can also claim depreciation on their taxes, something they cannot do with REIT dividends.
The final tax advantage of buying a rental property vs. REIT investing is the 1031 exchange. Real estate investors who own rental properties can defer capital gains when they sell a rental property and use the proceeds to buy more real estate assets in the housing market. REITs do not qualify for this tax deduction.
Buying Rental Property vs. REIT Investing: Passive Income
When real estate investors think of passive income, they think of REITs. However, passive income can be achieved when owning a rental property too. So, passive income is not necessarily an advantage for REITs over buying rental property.
Passive income can be created when owning a rental property if you hand over rental property management to a professional company rather than becoming a landlord. Some savvy real estate investors are even able to make passive income through rental properties by enlisting professional rental property management only at the beginning to find tenants and prep the rental properties. From there, becoming a landlord isn’t so hard if you enlist a good handyman to take care of daily maintenance. Becoming a landlord and dealing with rental property management becomes your choice, rather than having this choice taken away through REITs.
Related: What Are The Best Passive Income Investments In The Real Estate Market?
Buying Rental Property vs. REIT Investing: Being the Boss of Your Real Estate Investments
With REITs, real estate investors hand over all the control of the real estate investments to someone else. While this just depends on personal preference, buying rental property means choosing the real estate investments yourself. This direct investment means you have control over the location in the housing market of the rental property and every decision that needs to be made for it. Many favor becoming a landlord and taking on rental property management in order to have this control over their real estate assets. If you prefer managing the fate of your money, buying rental property is the way to go.
REIT investing is not a bad choice, but when real estate investors have to choose, buying rental property is ultimately the better option. An option that gives you total control, offers the best return on investment, saves you money on taxes, and allows you to make passive income seems like a no-brainer.
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Related: Is Investing in Rental Properties the Ultimate Way to Succeed in Real Estate Investing?