Real estate can make for a strong addition to any investment portfolio, allowing you to grow your wealth while diversifying your assets. When it comes to adding real estate investments, however, there are two main approaches to consider: investing in individual properties or investing in REITs. Here’s a look at the pros and cons of both and how to decide which is right for you.
Deciding on whether or not to invest in passive income assets is best done in consultation with a financial advisor.
Investing in Real Estate
From a traditional perspective, investing in real estate means buying (and sometimes managing) individual properties. These properties could be residential or commercial in nature, and may include:
- Single-family homes
- Multi-family homes
- Condos
- Apartment complexes
- Commercial property
- Storage units
- Office buildings
- Warehouses
- Land for future development (lots)
As a real estate investor, you can either buy and hold property, or fix it up to sell for a profit. You can also purchase this property on your own or with partner investors.
Pros of Real Estate Investments
There are many reasons why investing in real estate could be a good move for your portfolio.
You can take advantage of tax benefits. Owning investment property opens the door to certain tax breaks. According to the IRS, you can deduct expenses such as mortgage interest, property taxes, the cost of repairs, depreciation and eligible operating costs. These deductions allow you to reduce your taxable earnings and even offset a portion of your rental income for as long as you own the property.
You have more control. When you are able to purchase, manage and sell an individual investment property, you hold the control over that investment. This may be the best choice for investors who prefer to play a managing role in their real estate investments, as you also get to choose how the property is managed, when it’s sold and even have a say in the tenants who utilize the space.
Direct investments allow for creative projects. Investing directly in real estate offers you freedom of personal creativity. When building or renovating a property, you’re able to choose everything from the building’s design to the paint on the walls and even the tenants who are chosen. It can make the process feel much more personal, and give you a sense of both emotional investment and pride. When investing in a REIT, you don’t retain any individual control of the property. For most people, the investment feels like any other mutual fund or stock purchase, versus feeling like property ownership.
Cons of Real Estate Investments
Of course, there are some important pitfalls to also keep in mind when it comes to investing in real estate directly.
All expenses fall on you. Whether the property needs a new A/C unit, sits vacant for a few months or it’s time to renovate, any costs associated with your property fall on you. This can be detrimental if you don’t have adequate savings at the ready.
You’re responsible for managing the property. If you own a property, you are ultimately responsible for its management. This means designing, finding tenants, managing repairs, marketing and more. While you can hire out for all of this, it still falls on your shoulders in the end.
It can be difficult and time-consuming to liquidate. If the time ever comes that you want (or need) to liquidate your real estate investments, selling a home can be much more difficult and take much longer than selling a REIT. You may need to pull from other sources or savings if you need access to funds quickly.
Investing in REITs
A REIT, or real estate investment trust, allows investors a way to add real estate to their portfolio without actually having to buy, manage or directly assume the risk of that property. The REIT itself is responsible for purchasing, managing and (eventually) selling any property it holds. Investors provide capital by buying shares and receive regular dividends in exchange. Investing in REITs may be less stressful and less time-consuming than owning and managing an investment property. However, REITs aren’t without their downsides.
Pros of REITs
Here are four of the main benefits of investing in REITs.
Dividends provide passive cash flow. At least 90% of a REIT’s taxable income must be distributed to investors in the form of dividends. For this reason, REITs are generally managed well (with low operating costs). Investors can usually count on them as a passive income stream, as well.
REITs are easier to buy. Purchasing shares of a REIT is very similar to purchasing shares of a mutual fund, exchange-traded fund (ETF) or individual stock. REIT shares can be purchased through most everyday brokerage accounts or, depending on the REIT, through a broker that participates in non-public offerings.
REITs are easier to sell. If you own an investment property and decide to sell or need to liquidate, the process isn’t always simple. Depending on the real estate market at the time, your property could sit for weeks or even months. Plus, there are agent commissions, closing costs, depreciation recapture and many other factors to consider. Selling a publicly traded REIT is pretty simple; you’ll simply need to request a trade through your brokerage account. As long as there are buyers available, your shares can sell quickly. (Privately traded REITs are more difficult to sell, however, so keep that in mind.)
Your initial investment amount is flexible. Buying real estate can easily be a five- or six-figure initial investment (or more!), plus the costs involved with any renovations, repairs, marketing or management. If you don’t have those kinds of funds at the ready, a REIT can be a much more affordable way to invest in real estate. Some publicly traded REITs have low investment minimums, in the thousands or even hundreds of dollars. Many of them, though, have no minimum investment requirement at all.
Cons of REITs
Real estate investment trusts may be a good choice for many investors, but there are still some considerations to keep in mind.
There are no tax breaks. If you own an investment property, you can take advantage of certain tax deductions (such as mortgage interest, property taxes or repairs), potentially lowering your taxable income. When investing in REITs, though, there are no such tax breaks available.
You won’t have any creative control. Some investors simply want to grow their savings and earn a return. Others, however, enjoy being part of the “process.” Buying shares of a REIT does not offer you any sort of creative control over the investment property the REIT holds. You won’t be able to offer input or make decisions about the property, tenants or the risks taken.
There’s no real sense of ownership. Owning and managing a rental property or commercial building offers investors a sense of ownership. They get to see their investment at work and watch the project grow – but REITs can’t provide that. If you’re the type of investor who is driven by, or appreciates, a personal investment experience, buying physical real estate may better suit you.
REIT vs. Real Estate: Which is the Better Choice?
So, which is better, investing in REITs or investing in real estate? Well, as with most aspects of personal finance, the answer really depends on you.
Real estate investments may be ideal for investors who want a more personalized experience. By purchasing, managing and selling property, investors can watch a project’s return in real life, from start to finish. They also have complete creative and management control, and are able to enjoy certain tax benefits along the way.
REITs may be a better choice for investors who prefer a simpler approach. With a REIT, investors can quickly and easily purchase shares with their choice of initial investment. Because the REIT manages the property, investors are not burdened with the everyday stress of vacancies, tenants, management or repairs. REITs also pay out dividends to investors, providing a reliable passive income stream.
The Bottom Line
REITs offer investors a hands-off option for investing in real estate and may be more affordable for beginners. Direct real estate investments may be more expensive upfront but give investors increased control and flexibility.Both real estate and REITs can help investors hedge inflation and market downturn risks. Both can also be a source of regular cash flow, though REITs are a much more passive investment than real estate. Whichever route you take, though, real estate can be a great way to grow your net worth, diversify your investments and hedge against inflation.
Tips for Investing
- Consider working with a financial advisor as you consider how best to invest in real estate. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you in minutes with several in your area. If you’re ready, get started now.
- Want to take a look at what your portfolio will look like in a decade? SmartAsset’s investment calculator can help you do just that. Enter how much you have invested, how much you’re contributing and what rate of return you expect. We’ll then show you your investment growth five, 10 or even 30 years into the future.
Photo credit: ©iStock.com/Prostock-Studio, ©iStock.com/Kwarkot, ©iStock.com/Bim