Investing in a REIT Versus Real Estate

Want to learn the differences between investing in a Real Estate Investment Trust (REIT) versus actual, tangible real estate? Both represent a wealth of opportunities but there are some major differences to keep in mind, which we explore below.

By Emily Southey | 10 minute read

Nov 23

Investing in a REIT Versus Real Estate

What Is a REIT?

REIT stands for Real Estate Investment Trust and they function similarly to mutual funds, except in this case, the fund is held by a corporation that owns, operates, or finances real estate or real estate-related assets. REITs may own anything from condo buildings and residential homes to office buildings, warehouses, or even hotels. They pool capital from multiple investors to create a single trust. Ultimately, when an investor purchases a REIT, they are essentially purchasing a share of the properties owned by the REIT. Investors can earn money from REITs in two main ways. The first is through dividend payments and the second is by selling their shares of a REIT after the property(ies) have increased in value. Today, there are thousands of REITs around the world. Generally speaking, REITs can be divided up into four categories:

 –

  • Mortgage REITs: Mortgage REITs are corporations that use short-term, low-interest loans to purchase existing loans. The loans they buy have higher interest rates. The difference between each interest rate is how they make money.
  • Equity REITs: Equity REITs invest in income-producing real estate, which makes them less volatile than mortgage REITs. Plus, an investor can choose which industry they want their equity REIT to invest in and how much risk they are willing to take on.
  • Publicly traded REITs: Publicly traded REITs don’t trade on the global stock market but tend to outperform other types of REITs, including equity REITs.
  • Private REITs: Private REITs are non-traded REITs, meaning they are privately run and not sold on the global stock market.

What Is Real Estate Investing?

While REITs are a form of real estate investing, real estate investing in the traditional sense is when a person invests in a physical, tangible piece of real estate. This direct form of investing in real estate involves purchasing a property or a stake in one and attempting to profit from the investment through rental income, appreciation, tax benefits, or cash flow from business activities. Real estate purchased for investment purposes could be anything from commercial to residential to industrial. For example, a real estate investment could mean buying a condo, apartment complex, warehouse, hotel, retail space, storage unit, office building, single-family home, or even land for future use. The property you choose can be purchased individually or with partner investors. It can be held for a long time or flipped and sold shortly after it was bought. Ultimately, the goal of direct real estate investing is to buy low and sell high. Some examples of common real estate investments include the following:

 –

  • Purchasing a property, renovating it, and selling it quickly at a higher price point (also known as house flipping);
  • Purchasing a property and renting it out to tenants, generating monthly income while it appreciates in value; and
  • Purchasing a property to live in and renting out parts of it, such as a spare room or basement suite.

Key Differences Between REITs and Real Estate

Now that you know what REITs and direct real estate investing are, we’re going to compare the two. Based on factors like profitability and affordability, here is a breakdown of the key differences between REITs and real estate.

 –

Profitability

Both REITs and real estate offer the potential for profit. When investing in a property, you have the opportunity to significantly increase your cash flow and earn a passive income by charging rent to tenants. You can also take advantage of several tax breaks, which further inflates your profit margin. On the other hand, REITs pay substantial dividends, which is also a passive form of income.

“REIT stands for Real Estate Investment Trust and they function similarly to mutual funds, except in this case, the fund is held by a corporation that owns, operates, or finances real estate or real estate-related assets. REITs may own anything from condo buildings and residential homes to office buildings, warehouses, or even hotels.”

Affordability

REITs require minimal capital, which makes them a much more affordable option than real estate. Like stocks, investors can choose from a wide range of REITs, many of which are affordable. Even more, some online trading platforms allow investors to purchase fractional shares of REITs rather than entire shares, which further increases their affordability. 

 –

In contrast, buying real estate is expensive, requires a considerable amount of capital, and comes with several hidden costs. For example, as an investor, you will have to budget for the down payment, as well as mortgage costs, maintenance costs, realtor commissions, capital gains taxes, and property management fees (if applicable). Further, there will invariably be times when you won’t be earning rental income from your investment property.

 –

Inflation

Since the price of real estate tends to go up with inflation, both REITs and direct real estate investments perform well against inflation. 

 –

Liquidity

REITs tend to be far more liquid than direct real estate investing. They can be bought or sold equally, similar to the process of buying and selling a mutual fund or exchange-traded fund (ETF). This allows investors to gain access to their money quickly and easily. Oppositely, real estate assets are usually considered long-term investments, making them much less liquid. Buying and selling a property involves longer transaction times (selling a home can take several months), higher costs, and long holding periods. 

 –

Volatility

The real estate market is relatively volatile, whether you invest in REITs or a physical asset. That said, REITs tend to fluctuate more than housing prices. 

Accessibility

Both real estate and REITs are accessible. However, REITs require minimal capital and minimal expertise, which makes them more accessible than real estate investing. When you invest in a REIT, you can let the fund manager take care of everything while you sit back and earn passive income. You also don’t have to deal with tenants or maintenance. Real estate, on the other hand, is accessible owing to the wide range of properties available (from house flipping to farmland to commercial properties). However, it requires far more research and an overall greater time commitment than investing in a REIT. 

 –

The Pros and Cons of Investing in REITs

There are both drawbacks and advantages to investing in REITs. We outline the pros and cons below. 

 –

The Pros

  • Cash flow through dividends: All REITs pay dividends that consist of rental income and capital gains, which translates to regular cash flow. 
  • Minimal capital required: Investors do not need to have much capital to invest in REITs. There are plenty of affordable options and you may even be able to buy fractional shares in a REIT, bringing costs down even more. 
  • Convenience: REITs are easy to buy and can often be bought and sold online through your financial institution, just like stocks, mutual funds, or EFTs. 
  • Easy diversification: Since little capital is required, diversifying investments is easy with REITs. For example, an investor can choose to buy shares in a REIT that owns international real estate, or one that focuses on a specific city, sector, or asset class (for example, warehouses or single-family homes). 
  • Less knowledge required: Another pro of purchasing a REIT is that little knowledge or expertise is required to do so. Since a company is deciding which property to invest in and managing the property on behalf of investors, you won’t need to dedicate time to extensively researching the market.
  • REITs can be liquid: One of the biggest drawbacks of investing in real estate is that it is illiquid, but REITs represent a liquid form of real estate investing. For example, selling your shares of a publicly traded REIT can be done in a matter of seconds with a few clicks of a button. This is the opposite of traditional real estate investing where gaining access to cash would mean a months-long process of selling your property. 

The Cons

  • Less opportunity for growth: Since REITs distribute the majority of their profits to investors, there isn’t much money leftover to reinvest in additional properties or grow a company. Therefore, REIT share prices may increase less than publicly traded company stocks that can reinvest their excess money rather than pay it out in dividends. 
  • Lack of control: With REITs, the investor has very little control over the asset, including how it is managed. It might not even be possible to visit the property owned by the REIT.
  • No major tax benefits: REITs don’t offer the same tax breaks as investment properties. Rather, dividends paid out by REITs are considered taxable income and taxed at your marginal tax rate. 
  • Stock market volatility: One final con of REITs is that they have a minor link to the stock market, which means they have the potential to be impacted by stock market volatility. If the stock market drops, so too might your investment, which isn’t usually the case with a direct real estate investment.

The Pros and Cons of Investing in Real Estate

Let’s move on to the pros and cons of investing in real estate, of which there are many. 

 –

The Pros

  • Income generation: One of the greatest benefits of investing in a piece of real estate is the potential for income generation. When you purchase an investment property, you can rent it out to tenants and generate income from the rent you collect. This income can then be used to cover associated costs of the property, such as mortgage payments, maintenance, property taxes, and more. 
  • Tax benefits: Owning an investment property offers many tax benefits. For example, investors can deduct both the ordinary and necessary costs to maintain and manage the property to reduce how much they pay in taxes. Further, when it comes time to sell the property, you will benefit from the preferential capital gains tax rate, in which only 50% of the profit realized is taxed at your marginal tax rate. 
  • Potential for appreciation: Another major pro of real estate investing is the potential for appreciation. The real estate market is less volatile than the stock market, which means property prices are very likely to gradually increase over time. This means that in most cases, if you hang onto it long enough, you will be able to sell your investment property at a higher price down the line.
  • Control: One final pro of direct real estate investing is that the investor is in control. They can decide which specific property they want to buy, how to manage it, what rental prices to set, which tenants to choose, and more. Plus, you get to choose the financing structure, which means you can also refinance your mortgage if interest rates drop or tap into lines of credit for other purposes. This level of control simply cannot be matched by REITs. 

The Cons

  • Time and energy: The first con of direct real estate investing is the time and energy it requires. When you buy a property, you become the landlord, which means dealing with maintenance issues, tenant emergencies, and more. If you don’t have the budget to hire a property management company, you will need to prepare for the time-consuming nature of owning an investment property.
  • Financing: Another con of real estate investing is that obtaining the necessary financing can be difficult. Many investors can only afford to purchase an investment property with a mortgage, but interest rates might be high and if the market drops or vacancy rates increase, you could end up defaulting on your loan.
  • Lack of liquidity: The illiquid nature of direct real estate investing is another con. Real estate is far from liquid, which means if you need cash in an emergency, you might be out of luck. Selling an investment property can take months and if you are forced to sell it at the wrong time, it could result in a loss. 
  • Extensive research: Buying real estate requires extensive planning and research. You need to time your purchase well, choose the right location, and have a firm grasp of landlord-tenant laws in your jurisdiction before jumping in.

Frequently Asked Questions

What factors contribute to REIT earnings?

The most common factors that affect REIT earnings are market, liquidity, and leverage risks. REITs, like stocks or mutual funds, are directly impacted by market trends. 

Why were REITs created?

REITs were created to provide investors of all income levels an opportunity to benefit from income-generating real estate.

Are REIT earnings and real estate earnings taxed the same way?

Not necessarily, though they can be. Dividend payouts from REITs held in non-registered accounts are taxed as ordinary income at an investor’s marginal tax rate. However, capital gains distributions, which occur when a REIT sells an asset and earns a profit, are treated like any other capital gain and subject to capital gains tax. Capital gains tax is also what investors of real estate assets must pay when they sell their properties for a higher price than they originally paid. However, like REIT dividends, any earnings direct investors make from rental income will be taxed at their marginal tax rates. 

Emily Southey

Wahi Writer