REIT vs Rental Property Investing
Pros and Cons of REIT vs Rental Property Investing
Investing in real estate, and specifically income-producing rental properties, is a solid investment strategy.
Real estate investments have historically proven to be a powerful way to diversify a portfolio, boost returns, and safeguard against inflation.
Two investment avenues real estate investors may evaluate are real estate investment trusts (REITs) vs investing in a rental property.
As with any investment, it’s ideal to weigh the pros and cons of each to determine the best fit for an investor’s unique investment style, risk preferences, and desired returns.
Popularity of Real Estate Investing
Before making a case for reit vs rental property investing, it’s essential to first understand how real estate investing came about. Every economy throughout history has benefitted from land ownership. As economic models evolved, property ownership became accessible to a wider group of individuals. In the western world, real estate investment has become a powerful way to build personal wealth and safeguard against inflation or the volatility of the market. As an asset class, real estate has numerous tax advantages and is a tactic used by almost all high net worth individuals, as well as a growing group of moderately prosperous, ambitious individuals.
Real estate investing has gained significant traction and popularity in recent years due to several key factors. Some of the benefits of real estate investing include:
1. Tax Benefits–In many cases, real estate investors benefit from business deductions retailed to mortgage interest, operating expenses, depreciation, and property taxes
2. Increased Cash Flow–Choosing a property that generates a steady monthly cash flow lets you use the tenant’s monthly rent to pay your operating expenses and mortgage payment while still capitalizing on long-term appreciation to help boost total returns.
3. Appreciation–In addition to the value at purchase, real estate investments offer the opportunity to capitalize on market appreciation over time. If your property appreciates, you can sell that property for a profit, sell to make a 1031 exchange, or even cash-out refinance to purchase additional properties or shares in a reit.
4. Inflation Hedge–If you’re looking for a long-term investment, real estate investing offers a predictable hedge against inflation in the long run, as many real estate investments have historically increased in value over a 30-year terms.
5. To Build Equity–In many cases, a real estate investment will grow in value faster than you can save cash, offering the opportunity to build equity and use that equity to trade into other properties.
6. Diversify Portfolio–Adding real estate to your investments boosts your diversification, which can protect you in times of economic turmoil.
7. Lower Portfolio Risk–If your portfolio includes volatile investments, or if your stocks are decreasing in value, oftentimes your real estate investment will still be increasing in value, protecting you from other portfolio losses.
8. Builds a Hard Asset Portfolio–Unlike investing in the stock market, real estate investments create a hard asset investment for your portfolio–giving you more control over how you manage it or when you sell it.
9. Retirement Funding–Creating cash flow from real estate investments (i.e., rental properties or reit investing) is a great way to create income to support retirement.
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. REITs capitalize on special tax treatment that exempts them from federal income taxes on corporate income and gains that it distributes to its investors.
Unlike rental properties or any other real estate investment type, REITs offer investors greater portfolio diversification. By investing in a REIT vs a rental property, investors can actively invest in several properties compared to a single private real estate investment. REIT investments do not rely on one or two assets because they operate by pooling capital from multiple investors. This capital accumulation strategy provides desired portfolio diversification and strengthens the power of the investment as compared to a single, private rental property investment.
Pros of REIT Investing
- Hedge against inflation–unlike stocks, real estate investments are typically more insulated from market fluctuations. Additionally, unlike rental properties, REITs are more diversified throughout multiple properties and markets instead of just one, which further protects your investment against volatile market changes.
- Transparent corporate structures– Unlike individual rental properties that have little to no oversight and zero public reporting, REITs offer a level of financial oversight. REITs are required to monitor and report its performance to investors on a regular basis. In addition, if investing in a public REIT, the trust is by law required to report financial results to the SEC.
- Competitive Long-term performance – as with all real estate investments, REITs experience competitive long-term performance historically recording a better performance than bonds.
- Attractive passive income– The average REIT had a yield of over 3% in 2021, supporting that REITs provide solid passive income. This is largely because REITs are required to distribute 90% of their REIT taxable income to remain compliant with IRS regulations.
- Diversification of your portfolio– Without the potential market fluctuations of stocks and other private real estate investments, REITs are a great avenue for lowering risk and diversifying your overall portfolio.
- Potential for good returns – A typical REIT utilizes targeted strategies to increase property values, including adding amenities, additions, or buying low occupancy properties. Because of this, most REITs offer good return potential, as with most real estate investments in general.
- Liquidity (only for publicly traded REITs) – unlike typical real estate investments, including rental properties, public REITs offer liquidating options over time. Additionally, REITs are exempt from broker’s commissions that are present in the sale of a rental property investment.
- Access to commercial real estate investing – unlike residential rental property investing, REIT investments offer individual investors the opportunity to invest in commercial real estate, an opportunity often unattainable without a REIT.
- Tangible investment – REITs offer a tangible way to become an investor in commercial real estate, as they remove both acquisition barriers and the difficulties of owning an individual property, such as a rental property.
Cons of REIT Investing
- Dividends taxed as ordinary income – REIT dividends are taxed at the investor’s standard income tax rate. This is unlike other long-term investments, such as rental property investments, which are taxed at the lower capital gains tax rate.
- Sensitivity to interest rates – REITs profitability is subject to market conditions such as rising interest rates, which can negatively impact profit margins and lower dividend payouts.
- Risks associated with specific properties/tenants of properties – whether it’s a REIT or a rental property investment, all real estate investments have associated risks. Prospective investors should perform due diligence on the type of property, potential tenants, interest rates, tax laws, and location.
- Potential high fees – unlike a rental property investment which can be personally managed, REITs can be subject to management fees and high transaction costs, which can be a negative for prospective investors.
- Not a short-term (less than 3-5 years) strategy – REITs canhave little capital to grow investments because of the requirement to pay 90% of profits as dividend payouts to shareholders. Unlike individual rental property real estate investments, REITs can experience slow growth and should be regarded as long-term investments.
- No control over performance or returns – REIT investors have little control over the investments that make up the REIT and no decision-making power for the individual properties. Private real estate investments, on the other hand, such as rental property investments, allow investors to have control with the option to personally apply sweat equity and select properties with high income-earning potential.
Rental Property Investing
A rental property is an investment real estate property purchased with the purpose of generating income through rental income or appreciation. Investment properties are typically purchased by a single investor, pair, or group of investors. Although there are certain risk factors to consider when buying a rental property, people who own one or more rental properties have the opportunity to generate strong and predictable monthly income.
Pros of Rental Property Investing
- Tax benefits – One of the most significant benefits of a rental property investment is the opportunity for tax write-offs. Tax write-offs from rental properties can include property taxes, mortgage interest, property insurance, maintenance and repair costs, and property management fees.
- Increased Cash Flow – Rental property investments can offer reliable monthly cash flow through predetermined monthly rents and long-term lease agreements. Cash from real estate properties can often be higher and more predictable than REITs, where dividend payouts are spread out and unknown to investors until payout time.
- Low barrier to entry – Unlike investing in commercial real estate or other costly investments, there is a relatively low barrier to entry for residential rental property investing.
- Appreciation – The opportunity for appreciation is one primary reason people choose to invest in rental properties. While appreciation is never guaranteed, if investors invest wisely in popular areas with good schools, above-average household incomes, and desirable locations, rental properties can experience appreciation in addition to the monthly rent income.
- Inflation Hedge – Investing in a rental property, similar to a REIT investment, is a solid bet against inflation. Rental rates can rise with a rising consumer price index, leaving rental property investors with increased monthly cash flow.
- To Build Equity – Buying a rental property as an investment and paying its monthly mortgage builds equity. In contrast, with a REIT investment, you only make money when the REIT performs well, and dividend payouts are warranted. With a rental property investment, you can also generate forced equity appreciation through home improvements such as remodeling, updating, and landscaping.
- Diversify Portfolio/lower risk – rental property investments are a great way to diversify and lower your portfolio risk. Because they are individual investments, compared to REITs or stock investments, they are often less susceptible to system risk than public equities.
- Builds a hard asset portfolio – rental property investments and real estate investments are an excellent way to build your hard asset portfolio. Hard assets help build portfolio diversity, generate consistent returns, and minimize market volatility.
- Retirement Funding – Unlike REITs which have unpredictable dividend payouts, rental property investments can provide predictable monthly cash flow from tenant rents. As an individual investment, investors also have control over rent prices, and can personally accumulate cash over time to fund retirement or other accounts.
Cons of Rental Property Investing
- Less passive income – Owning a rental property investment is very hands-on. Because it is an individual investment, you are responsible for maintenance, property issues that arise, and finding new tenants to maintain cash flow. On the other hand, REITs require no personal management with dividend payouts made to investors.
- Appreciation not guaranteed – Appreciation can be both a positive and a negative for rental property investments. While appreciation can be a great perk, it is far from guaranteed. If an investment property is purchased in a bad location or at a high point in the market, the investor is less likely to experience significant appreciation.
- Potential for property vacancy – in down markets, there is the potential for property vacancy when owning a rental property investment. Property vacancies negatively affect monthly cash flow.
- Problematic tenants – While trying to avoid vacancy risk, investors can encounter another common issue: problem tenants. Bad tenants often don’t pay on time, damage the property, create noise complaints, or ignore tenant responsibilities. Problem tenants can cost money and lead to unplanned property vacancies.
- Liquidity – Rental property investments are not easy to liquidate. To liquidate, a property owner must prepare the property for listing, stage it, list it, and pay the broker’s commissions at the sale.
- Harder to scale – Because rental properties are individual investments, it can be challenging for individual investors to identify properties that will provide significant cash flow and are within local distance so they can be serviced and managed by the property owner. In contrast, REIT investments are very hands-off; investors are not involved in individual property identification and acquisition or property management and maintenance.
Reit vs Rental Property Statistics
Investors across the board seek investments that provide opportunities for predictable cash flow and appreciation growth. From high-net-worth individuals to a growing group of middle-class investors, real estate has historically an established avenue to diversify any investment portfolio.
REITs are characteristically a powerful, high-yield strategy for motivated investors. REITs provide high dividends plus the potential for moderate, long-term capital appreciation. They combine potential low barriers to entry with little hands-on management and maintenance compared to rental property investments.
In the US, REITs have historically outperformed private investments over time which is key when considering a REIT vs rental property investing. Additionally, REITs have the ability to better leverage their capital structures. With a larger pool of investment properties and investors, REITs can use individual property appreciation to grow the overall portfolio.
Since REITs were first created in 1960, they have grown in size, impact, and popularity. Today, REITs own over 500,000 properties in the U.S., and 145 million Americans live in households with REIT investments through their 401(k) and other investment funds. For investors looking to achieve a balanced portfolio, REITs can be integral to a well-rounded investment strategy.
Investing in a REIT
Real estate investments are a proven strategy to grow your net worth. Whether you invest in a rental property or a REIT, real estate offers an enviable combination of historically strong returns and passive income, while providing a potential hedge against inflation and the volatility of the market.
As an informed investor, always consider your options and the advantages of different types of real estate investments especially when it comes to REIT vs rental property investing. With a desire to invest in real estate, REITs are an unrivaled option that makes it possible for anyone to be a real estate investor, not just high-net-worth individuals.