What should you invest in? REITs vs real estate?
Great question!
Most financial planners and advisors will buy you securities: stocks, bonds, mutual funds etc. If you say that you’re interested in investing in real estate, your advisor will probably suggest a REIT… Perhaps pitching it as a way to “gain exposure” to the real estate market.
After all, Forbes themselves have recently asserted that REITs are better than real estate investing.
What does this mean?
Well, let’s discuss REITs vs Real Estate Investing!
Discussion Points
What Is Real Estate Investing?
Real estate investing is the practice of building wealth and generating income through ownership of real estate – land, natural resources, and permanent structures like houses or commercial buildings.
Land and property ownership has been a major source of wealth for thousands of years.
Many modern real estate practices, including title, tenancy, and property taxes, date back to the Feudal era. Over time, “lords” simply became “landlords.”
Why Is Real Estate So Profitable?
Property is inherently valuable because the inventory is limited.
Barring a few volcanic islands, they simply “aren’t making any more land.”
Moreover, society has evolved to depend on the resources produced by land (agriculture, raw materials, etc.) and permanent structures built on that land (housing, industry, etc.).
Essentially, if you own property, you have wealth. Over time, property tends to appreciate in value. Useful real estate can also generate passive income in the form of rent revenue.
So How Do Investors Use Real Estate To Generate Wealth?
There are many specialized techniques to invest in property, but most of them break down to three main methods:
- Development – a Builder. Many individuals and companies create wealth by buying raw land and “developing it” – that is, building structures on it, like houses or commercial property. They might also buy “teardowns” – distressed or obsolete properties that they can replace with new structures to bring the land to its “highest, best use.”
- Arbitrage – a House-Flipper. Arbitrage is a fancy word for “buying low and selling high.” With real estate, this might involve buying a distressed property for a song, renovating it, and then immediately selling it for top dollar. In “hot” markets, you might not even need to fix the property up—demand is so high that the price increases quickly without any improvements.
People usually think of “house-flipping,” but large companies can flip apartment complexes and commercial property as well.
A real estate investor might even flip a contract without ever buying the property – securing the contract to buy at a low price, then finding an end-buyer willing to pay more for the property, and then pocketing the difference at closing. This is called wholesaling – acting as a middleman in a real estate transaction.
- Buy-And-Hold – a Landlord. This strategy involves buying property for the long term and renting it out to a tenant. This could be a residential tenant (house or apartment) or a commercial tenant (retail, office, industrial, agricultural, etc.). The tenant’s rent generates revenue, while the property appreciates in value over time.
All of these methods are equity investments – the investor takes title and owns the property. However, individuals can also be debt investors, lending money to equity investors to execute any one of the above strategies. The borrowers owe the money back with interest, while the property acts as collateral for the loan.
Pros Of Real Estate Investing?
- You Take Title. Most real estate investors own the property they invest in, taking title and enjoying all the appreciation that comes with it.
- Passive Income. Rental property can generate “mailbox money,” especially if you hand over the day-to-day operations of the property to a professional property manager.
- Easy Leverage. “Leverage” essentially means using other peoples’ money to get more exposure to equity. “Buying on margin” is an example from the world of stock investing.
You can easily leverage your equity with low-interest debt, also known as a mortgage. Lenders consider real estate a safe investment. When property is the collateral, they offer attractive loan terms compared to other asset classes.
Leverage can help you substantially accelerate your wealth-building process, but it increases the risk of the investment, — a big chunk of your cash flow goes to pay the mortgage. If you can’t make those payments, you may face foreclosure.
- Low Risk Over Long Periods of Time. Sometimes market forces push property value down (a “bad market”) but over the long-term, real estate is considered a safe investment, a good bet to be worth more next year than it was last year.
- Potential for High Returns. While they assume significant risk, real estate investors often balance the risk with the potential for big returns—sometimes doubling their money in as little as five years.
Cons Of Real Estate Investing?
- Hard to Find Good Property. Competition for promising property is fierce. Investors expend a great deal of time and money searching for property, building relationships with brokers and wholesalers so they get first crack at a great deal.
- Expenses. Real estate is expensive. Investors must account for property taxes, insurance, repairs, renovation costs, and many more. Consider BRRRR Investing to free up cash.
- High Risk Over Short Periods of Time. The abovementioned costs can quickly eat into your profits. Unlucky or unprepared real estate investors often lose money and could even face total loss if they can’t make their mortgage payments. Flippers attempting to time the market may lose big-time if they catch a “down market.”
- Tenants. Tenants aren’t ATM machines—they are people. The passive revenue of rental income comes with all the quirks and idiosyncrasies of the people paying the rent. If you get stuck with a bad tenant, your dreams of wealth could become a nightmare of lost revenue and eviction filings.
- Illiquid. Real estate is valuable, but compared to stocks or precious metals it can be hard to convert into cash in an emergency. To liquidate your investment, you will need to sell or refinance, which takes time. If you have to sell quickly, you will often sell at a loss.
- Distressed Property. Many real estate investors, especially beginners, start with older or distressed property. The price is right, but property is finicky. While it tends to appreciate over time, the buildings tend to deteriorate. Investors in older properties could find their equity and cash flow eaten up by a bad electrical system, plumbing system, foundation, roof, or any number of costly incidents.
Now that we’ve discussed some pros and cons, time to consider REITs vs Real Estate Investing!
What Is A REIT?
Before we consider REITs vs Real Estate Investing, what is a REIT?
REIT stands for Real Estate Investment Trust.
A REIT is a company that trades ownership shares on public exchanges, just like the shares of stock available on public stock markets like NYSE or NASDAQ.
What does the company do? Invest in real estate, using all the methods mentioned in the above section.
What’s the difference?
A REIT has more resources to deploy than most small real estate investors.
They typically have millions of dollars in funding available to deploy. They tend to buy “Class A” assets – new builds in great locations, also known as “Core Assets.” They may also pursue “Value-Added” assets – lightly distressed property that can be easily renovated into a higher valuation.
Either way, REITs use their deep pockets to pay top dollar with less leverage, usually resulting in more predictable cash flow and fewer expenses.
Think of buying a share of a REIT like buying a share of stock in a real estate investor’s company.
If the value of real estate goes up, the value of your REIT share goes up. If the real estate market takes a tumble, so does the value of your REIT share.
Pros Of Investing In REITs
- Easy to Buy. You don’t have to scour the globe or network with wholesalers for a REIT to buy—they are sitting right there on public exchanges for anyone to buy.
- Liquid. Because they are traded like stocks on open markets, REITs are easy to liquidate. Simply sell your shares on the exchange for whatever the open market is willing to pay for it.
- Safer Bet. REITs do gain and lose value based on the real estate market they invest in, but with Class A property and low leverage there is rarely the risk of total loss that you find with real estate investing. They are the Blue Chips of the real estate world.
- Outpaces Inflation. While they tend to lag behind the stock market as a whole, REITs tend to outpace inflation.
- Less Volatile Than Stocks. While REIT values can go up and down, they don’t tend to experience the wild swings you will see with individual stocks.
- Passive Income. As a REIT shareholder, you have no responsibility for the management of the underlying assets. Like stock ownership, it is a completely passive investment.
Cons Of Investing In REITs
- You Don’t Take Title. While your net worth may be “exposed” to the real estate market through your REIT shares, you don’t actually own the real estate. You don’t take title and have no ownership or disposal rights to the underlying property. On paper, you don’t own property—you just own another security.
- Lower Returns. Whereas real estate investors may try to double their money in five years or less, REIT owners will seldom see those kinds of returns. A REIT is less risk; as such, it offers lower potential reward—usually in the realm of 5-10% annually.
REITs vs. Syndication
“Syndication deals” have become popular in recent years.
Syndication deals are when private investors pool their money to buy an apartment complex, commercial building, core development property, or other asset that the investors can’t afford individually.
There is usually a “deal sponsor” running the show, and the cash contributors are “passive investors,” collecting a share of the cash flow and appreciation proportionally based on their contribution.
Are these ventures similar to REITs?
Yes and no. Both methods pool money to buy large real estate assets. However, a syndication is usually limited to one asset, while a REIT may acquire and dispose of a portfolio of assets.
REITs also register with the Securities Exchange Commission (SEC) to qualify to trade on public exchanges. This entails big registration fees, which REITs can afford to pay.
Smaller, one-property syndications can’t afford those filing fees, so the deal sponsor must follow strict rules to sell shares of a company while remaining legally exempt from SEC registration. This might involve only dealing with accredited investors, or sophisticated investors that the deal sponsor knows personally.
Ultimately, between REITs and individual real estate investors, syndications more closely follow the mould – distressed property, high leverage, etc.
The risk of total loss is real, but the investment group stands to realize outsized returns if the investment succeeds.
Concluding REITs Vs Real Estate Investing
When all you have is a hammer, everything starts to look like a nail.
Similarly, financial advisors deal in securities, and REITs are a form of real estate security that they can offer clients who want “exposure” to real estate.
But REITs don’t offer the big potential returns (or the headaches, or the risk of total loss) that come with real estate investing. For households with the right time horizon and risk tolerance, however, a REIT could be a wise inclusion in their investment portfolio.
What do you think about investing in REITs vs Real Estate?
Let me know in the comments!
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