Understanding Direct vs. Indirect Real Estate Investments

Understanding the differences between direct and indirect real estate investments is key for anyone looking to diversify their portfolio. Direct real estate investment refers to the acquisition of physical property, giving investors control over the management and decisions related to the property. In contrast, indirect real estate investment typically means investing through real estate investment trusts (REITs) or real estate funds, offering a more hands-off approach with potential for diversification and liquidity.

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What Is Direct Real Estate Investing?

Investing directly in real estate means purchasing and managing physical properties like residential homes, commercial buildings or plots of land without intermediaries. This investing approach offers a number of financial incentives and benefits, including rental income, price appreciation and tax advantages. Here’s a closer look at four general types:

Residential Property Investment

Investing in residential properties is a common form of direct real estate investing. This includes purchasing single-family homes, duplexes or multi-family residences with the intention of renting them out or selling them for a profit. Investors benefit from rental income and potential appreciation in property value over time.

Commercial Real Estate Investment

Commercial real estate investment focuses on properties used for business purposes, such as office buildings, retail spaces and industrial complexes. Investors in commercial real estate can earn revenue through leasing these spaces to businesses, often resulting in higher returns compared to residential properties due to longer lease terms and higher rental rates.

Land Investment

Purchasing undeveloped land is another type of direct real estate investment. Investors buy land with the potential for future development or resale. This type of investment can be lucrative if the land appreciates in value or if it is sold to developers for commercial or residential projects.

Vacation Rentals and Short-Term Leases

Investing in vacation rentals or properties suitable for short-term leases has gained popularity with platforms like Airbnb and VRBO. This approach allows investors to capitalize on the demand for short-term accommodations, often leading to higher rental income compared to traditional long-term rentals.

What Is Indirect Real Estate Investing?

REITs are common forms of indirect real estate investing.

Indirect real estate investing allows individuals to invest in real estate without directly owning or managing properties. This approach is particularly attractive to those who seek the benefits of real estate investment, such as income and appreciation, but prefer to avoid the complexities and responsibilities of property management. Let’s take a closer look at four types of indirect investments:

Real Estate Investment Trusts (REITs)

One of the most common forms of indirect real estate investing is through real estate investment trusts (REITs). REITs are entities that own, operate or invest in a variety of income-producing properties. While some REITs focus on residential properties, other specialize in commercial real estate. Investors can buy shares of REITs on major stock exchanges, making it easy to diversify their real estate portfolio without significant capital.

Real Estate Mutual Funds

Real estate mutual funds are another popular option. While equity mutual funds take money from a pool of investors and purchase a diversified portfolio of stocks, real estate mutual funds do the same with real estate and related assets. Managed by professional fund managers, these funds invest in REITs, real estate stocks and other real estate-related securities, providing investors with broad exposure to the real estate market.

Real Estate Crowdfunding

Real estate crowdfunding platforms have emerged as a modern way to invest indirectly in real estate. These platforms allow investors to pool their money to fund specific real estate projects, such as commercial developments or residential properties. Crowdfunding can offer an opportunity to participate in real estate deals with relatively low minimum investments.

Real Estate Exchange-Traded Funds (ETFs)

Real estate ETFs offer another avenue for indirect real estate investment. These funds trade like stocks on major exchanges and track the performance of real estate indices or sectors. By investing in a real estate ETF, individuals can gain exposure to a range of real estate assets while still retaining the flexibility and liquidity they have when trading stocks.

Direct vs. Indirect Real Estate Investing

Direct real estate investors can benefit from rental income and potential appreciation in property value over time.

When choosing between direct and indirect avenues of real estate investing, you may consider how much control you want over your asset, how much capital you have to invest and the amount of risk you’re willing to assume. You may also want to assess the tax implications of both approaches, as well as your need for liquidity.

Direct Investment

Leverage: Most direct real estate investors make a down payment (like 20%) and borrow the bulk. This is a key strategy in real estate investing, which uses borrowed money to increase returns on investments.
Ideal for investors seeking control: If you want complete control over your investment and are willing to handle the responsibilities of property management, direct real estate investment may be suitable.
Higher capital and risk: Direct investments require more significant capital and come with higher risks, but they also offer the potential for substantial returns and tax benefits.
Tax implications: Direct real estate investors can benefit from a bevy of tax incentives including tax deductions on mortgage interest, property taxes and depreciation.
Liquidity and accessibility: Direct real estate investments are generally less liquid. Selling a property can be time-consuming and expensive due to transaction costs and market conditions. This illiquidity can be a drawback for investors needing quick access to cash.

Indirect Investment

Suitable for passive investors: If you prefer a hands-off approach and want to avoid the hassles of property management, indirect investment through REITs or mutual funds is an attractive option.
Lower capital and diversification: Indirect investments require less capital and offer diversification benefits, reducing the overall risk to your portfolio.
Tax implications: Indirect investments may not offer the same tax advantages as direct investments, as dividends from REITs are typically taxed as ordinary income. However, REITs can offer other tax breaks, such as avoiding double taxation and a 20% deduction to the shareholder of any dividends received (this is set to expire with the Tax Cuts and Jobs Act).
Liquidity and accessibility: REITs and real estate funds can be bought and sold like stocks, providing easier access to capital. This makes indirect real estate a more flexible option for those who may need to quickly adjust their investment portfolios.

	Direct Investments	Indirect Investments
Control	Full control and responsibility	Passive, managed by professionals
Risk and Capital Requirements	More capital required, higher risk	Less capital required, less diversification
Tax Implications	Many tax benefits	Fewer direct tax benefits
Liquidity and Accessibility	Less liquid, harder to sell	More liquid, easier to sell

Bottom Line

Investing in real estate, whether directly or indirectly, can be a rewarding way to build wealth and generate income. By understanding the nuances of each approach, you can make more informed decisions and create a balanced, diversified investment portfolio that stands the test of time.

Tips for Investing in Real Estate

When investing in real estate, make sure you’re taking advantage of the various tax benefits associated with owning property. For example, the IRS permits you to deduct a myriad of expenses related to real estate, including property management fees, building repair and upkeep, as well as mortgage interest and insurance. Depreciation is another unique tax benefit of owning real estate – one that you’ll want to take advantage of.
A financial advisor can help you plan and save for major financial purchases, including buying investment properties. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.