With the convenience and accessibility of the internet, public REITs are making a resurgence in the investment world. Hundreds of thousands of investors are looking at public REITs as a way to get into real estate investing without actually doing anything more than depositing funds into an online account. But are these REITs really a smart investment as far as returns and tax implications? Considering their popularity, it’s worth taking a closer look at public REITs vs. direct real estate investments.
What Are the Advantages of REITs?
Public REITs are essentially the same as buying stock, except that with a REIT, the investor is buying stock of a real estate company. Public REITs offer investors several advantages over other types of real estate investments. The popularity of REITs is driven by these benefits. The advantages of REITs include:
The Potential to Invest in Large Real Estate Projects
REITs allow smaller investors to get in on larger, previously out-of-reach investment opportunities. For example, someone with just $5,000 to invest would never be able to be included on a multi-million dollar residential development project. But by going through a REIT, these small investors are welcomed. A caveat is that the investor doesn’t get to pick and choose the particular projects their money goes toward. But if an investor wishes to be a part of something bigger, a public REIT offers a way to do that.
Professional, Experienced Management
REITs are mostly managed by professionals with a strong track record of success. As long as an investor goes through a vetted REIT management company, they can be reasonably assured that the investment is in good hands.
One of the most attractive features of REITs is their high liquidity. An investor can quickly and easily liquidate their investment at a moment’s notice, unlike almost every other kind of real estate investment.
REIT investments are often spread across several real estate projects, not just one. For this reason, REITs represent more manageable risks than some other investment types. Having the investment spread across a portfolio of properties means if one fails, there may still be others to pick up the slack.
For investors who don’t wish to be a landlord in any form, REITs offer a hands-free investment in real estate. An investor can technically own a property without having any of the responsibilities of being a landlord.
What Are the Disadvantages of REITs?
For all the benefits of REITs, there are significant disadvantages to this investment class that should be considered. These include:
Lack of Control
In a REIT, investors have zero control over the success or failure of the project. It’s akin to investing in the stock market…or rolling dice on a craps table. Being a silent partner is the one and only option.
REITs are publicly traded assets. As such, the share price is publicly driven by the whims of the market, which means that volatility is inherently built into REITs.
By law, REITs must redistribute 90% of taxable income to shareholders via dividend disbursements. Because of this, REITs can’t compound their profits, which limits their growth and investment strategies.
REIT dividends are taxed as ordinary income. This is unfavorable for investors as ordinary income is taxed at the regular tax rate.
REITs offer very little to be excited about, yield-wise. On average, an investor can expect an average yield of 5.6%, which is easily outdone by a variety of other real estate investment opportunities.
Comparison of REITs vs. Direct Real Estate Investment
There are so many advantages of direct real estate investing that thousands of books have been written on the subject. But if you’ve been interested in investing in REITs and want to compare that to direct investment in real estate, there are specific things you need to be aware of. The first huge advantage of direct investment in real estate is depreciation.
The Value of Depreciation in Direct Real Estate Investing
When an investor owns real estate directly, they can take advantage of depreciation. Depreciation is a tax deduction that entitles investors to a tax break for value depreciation of a physical asset such as real estate. It’s important to note that depreciation is not available for REIT investors. Because a REIT investor does not own a tangible asset, no depreciation is allowed on that investment. This makes a direct real estate investment highly more advantageous than a REIT investment. Here’s an example:
Let’s say a direct real estate investor buys a rental unit worth $75,000. An investor can depreciate the value of the building over 27.5 years, which is $2,200. The annual net income from renting out the property after expenses and before taxes would be around $3,000. Once we take off the depreciation, the taxable income for that year is only $800 ($3,000 – $2,200). On the other hand, a REIT investor would have to pay taxes on the total amount of their distribution.
Using Leverage With Direct Real Estate Investments
One of the advantages of direct real estate investment is leverage. With an average cash investment of $20k, an investor could purchase a $75k rental unit. This comprises $15k down and $3,000 in closing costs with a little cushion for incidentals. Assuming the unit rents for $750/month and after expenses like property management and the mortgage are paid, there’s $250 a month in positive cash flow. That comes out to $3,000 per year.
Now, if an investor took that same original $20k investment and bought a REIT instead, the investor would get an average of 5.6% return, which amounts to $1,120. After about 30% in taxes (remember, REIT Is taxed as ordinary income), that comes out to $785 per year. Not very impressive, is it?
Considering the direct real estate investment, the investor leveraged their $20k into a $75k property that they can then take depreciation, borrow against, sell or keep for positive, passive income indefinitely. On the other hand, after a year, the REIT investor has nothing more than their original $20k investment and a paltry extra $785.
It’s clear that direct real estate investments have distinct advantages over REITs; even more than are listed here. If you are an investor who’s been wanting to get into real estate without directly being involved, there’s another alternative than REITs. Turnkey rentals offer investors the chance to directly own real estate and to take advantage of all the perks that come along with that.
As the owner of a turnkey rental, your property management company would take care of the day-to-day tasks associated with being a landlord. You would get all the tax breaks—including depreciation—of real estate ownership, with none of the disadvantages associated with REITs.
This article has been contributed by Eric Martel.