REITs vs. Real Estate: Which Investment Is Better?

REITs vs. Real Estate: Which Investment Will Win the Battle for Your Wallet?

Diversification is a critical part of any investing strategy. When it comes to real estate vs REITs, many individuals are unsure of what path to go down.

There are significant similarities, advantages, and disadvantages to investing in REITs and real estate.

How Are They The Same?

Both Real Estate and REITs can provide a natural inflation hedge. As inflation increases, real estate and REIT owners tend to increase rent on leases as they come due.

For example, REIT dividend increases have outpaced inflation in 18 of the last 20 years compared to Consumer Price Index (CPI). Over the twenty years between 2000 and 2020, the annual growth for dividends was 9.4% vs. 2.1% for the Consumer Price Index, according to an analysis done by REIT.com.

How Are They Different?

Investing in REITs requires ALOT less capital compared to real estate. You can buy Vanguard’s VNQ REIT ETF shares for around $75 a share. If you only had $500, you could still invest in REITs.

Meanwhile, even if you only put 5% down on a rental property, you are still looking at $20,000 upfront, assuming the average duplex cost is around $400,000.

That said, the large difference in capital requirements is one of the largest differences between real estate and REITs.

Another significant difference between REITs and real estate is liquidity. You can easily buy and sell your REIT shares without limitations.

At the same time, it can be very difficult to sell your rental property quickly. Even if you sell your property quickly, funds can spend up to 45 days in escrow, and if all goes according to plan, it can take between 75 – 180 days to sell your property and get paid.

REITs are professionally managed, with a team of experts responsible for acquiring, financing, and managing the properties in the portfolio. Owning real estate requires hands-on management by you, the (owner). You are subsequently responsible for all decisions related to the property, including repairs, improvements, rent increases, and tenant disputes.

If you invest in real estate, you are in total control of all decisions, from capital improvements to what color you should paint the bathroom and how much to charge for rent.

Meanwhile, when you invest in a Real Estate Invest Trust (REIT), you do not have any say in the direction of the REIT’s strategy. All decisions are left to the company management.

Another key difference between REITs and Real Estate is diversification.+
When you invest in an individual REIT or REIT ETF, you can easily get diversification across multiple sectors of the real estate industry. Meanwhile, diversification across various real estate sectors for individual investors is difficult.

Another key difference between REITs and real estate is leverage. When you buy real estate, you can use borrowed money to amplify your returns. Meanwhile, you generally cannot use leverage if you are buying publicly-traded REITs.

Sure, you can use margin loans and introduce leverage when investing in REITs, but margin loans are much more expensive than a mortgage and introduce another level of risk. The average margin loans between 8 -12% at big-name brokers, with the best rates usually only for clients with $1,000,000 or more in assets, and it can’t be amortized over 30 years like a mortgage.

Meanwhile, the 30-year fixed mortgage is around 6.50% as of this writing, thus making it substantially cheaper to attain leverage through a mortgage.

Let’s take an example to illustrate the power of leverage using Cash on Cash Return which your pretax cash flow (after all operating expenses) is divided by your money invested.

If you put 25% down, your cash-on-cash return would only be 8%. Meanwhile, if you put 10% down, your cash-on-cash return would be 20%.

That is the power of leverage in real estate investing.

Because many REITs are publicly traded, they are subject to the gyrations of the overall stock market and subsequent volatility.

Meanwhile, real estate cannot be easily bought or sold, and property valuations will not gyrate to the same extent or frequency as publicly-traded REITs, making them less volatile.

An important note about volatility: There are a lot of people who argue lower volatility is a myth because of the way real estate is priced.

It’s partially true.

You only know the price of your real estate when it is marked to market (and even then, only for certain when it is eventually sold), but you know the price of your REIT every second that the stock market is open – this is also true.

If you had REIT-like price transparency on your real estate, many argue it would be as volatile as the stock market, if not more – maybe, maybe not.

The reality is you can’t get REIT-like transparency on your real estate, and until that happens, the argument for real estate being less volatile will continue to hold true, despite what any myth busters may say.

Real estate is less correlated to the overall stock market than publicly traded REITs.

A correlation of 1 means a stock or sector moves exactly with the overall stock market.

According to a Morningstar.com analysis, the FTSE NAREIT Equity REIT had a correlation of 0.59 with the CRSP 1-10 U.S.Estate Market Index, which represents nearly 100% of the investable U.S. Equities Market.

So if the total stock market moves down 10%, the equity REIT market is expected to drop 5.9%.

Some individuals may also say the correlation argument is also a myth.

Again, it’s only partially true.

Real estate prices are a lagging indicator, meaning their values tend to change after other economic indicators, like inflation and interest rates, are published.

If unfavorable economic data is released, REITs prices will react immediately. Meanwhile, real estate prices will not be because the trickle-down effect takes time to reflect in the real estate market.

Some say if you looked at REIT prices only once a year, lagged, using an average price, you could argue that they are not correlated to the stock market.

But the reality is REIT prices don’t lag, and they don’t use average prices, so it’s a weak argument.

Another significant difference between REITs and real estate is transaction costs. Buying and selling REITs through most online brokers like M1 Finance has no cost to purchase or sell REITs. Meanwhile, buying real estate comes with significant transaction costs.

To buy or sell a property often has closing costs of 3 -6% of the property purchase price. With the national average of a duplex being $388,000, you are facing roughly $11,500 – $23,000 in closing costs alone.

In numbers terms, the Vanguard VNQ REIT ETF trades at around $75 a share historically. Assuming the closing price is 6% of $388,000 =$23,000 in closing costs.

That means you could have bought approximately 300 shares of VNQ, with a dividend yield of around 4.2%.

That means you are giving up almost $1,000 yearly in income distributions due to closing costs.

PROs of Real Estate

Passive Income

REITs are truly passive income investments. One of the most significant advantages of REITs is their ability to generate passive income. Investing in REITs doesn’t require tenant management, maintenance, insurance, or unexpected expenses, making them a passive income strategy.

As of this writing, the average dividend yield for Equity REITs is 4.3%, according to the Motley Fool. Some REITs can pay significantly more, depending on their investment strategy.

If you invested $10,000 in REITs, you could expect to earn $430 in dividends. Meanwhile, the S&P 500 has a dividend yield of approximately 1.4%.

Tax Deductions

Generally speaking, real estate investors can deduct the normal maintenance expenses of their properties and other large deductions.

Significant tax deductions may include mortgage interest, property taxes, operating expenses, depreciation, and repairs.

Most individuals can deduct expenses for keeping their rental property in good operating condition. For example, certain materials, supplies, repairs, and general maintenance are usually deductible.

Tax deductions can help make a questionable investment property more appealing to real estate investors.

You Can Build Equity

Building equity in physical real estate is the difference between your property’s value and what you owe on your mortgage. Home equity is a way essentially a “forced savings” and a long-term wealth-building strategy.

While many people can argue that you can make more significant returns investing in the stock market, the “forced savings” of homeownership is still the largest financial asset for middle-income households, according to the Brookings Institute.

And while this article is more directed toward investment properties and not primary residences, the overarching concept still applies.

You Own A Physical Piece of Real Estate

For many individuals, there is a sense of pride when you own physical real estate.

Real Estate is tangible.

You can touch it. Walk through it. Paint it. You have creative control.

Owning physical real estate is a much different experience than seeing a bunch of numbers on a screen. It’s a feeling that cannot be replicated through REIT ownership.

Leverage

Unless you are a professional investor or money manager, there are not many outlets where individual investors can borrow large sums of money at a reasonable interest rate.

Let’s take an example to illustrate the power of leverage using Cash on Cash Return which your pretax cash flow (after all operating expenses) is divided by your money invested.

If you put 25% down, your cash-on-cash return would only be 8%. Meanwhile, if you put 10% down, your cash-on-cash return would be 20%.

That is the power of leverage in real estate investing.

Cons of Real Estate

Investing directly in real estate can cost you time and effort.

You must deal with tenant issues, maintenance, and liability if an accident occurs. Finances are another problem. Investors must borrow to purchase a property and are often beholden to the prevailing market interest rates.

Below are some of the main cons of direct real estate investing.

Property Maintenance

Owning physical real estate means there will be unavoidable maintenance costs. If you are unable or unwilling to manage the property yourself, you may need to hire a property management company. Property management companies charge 8% – 12%of your monthly rental income, which certainly isn’t chump change.

It’s important to note that a property management company doesn’t include the cost of repairs but more the management.

Closing Costs

Buying a rental property or any piece of real estate is expensive. According to Zillow.com, closing costs can average between 2% – 5% but vary from state to state.

For example, if you bought a $500,000 rental property, you can expect to pay between $10,000 and $25,000 in closing costs.

Standard closing costs can include the following:

• Application Fee
• Appraisal
• Lender’s Title Insurance
• Loan Origination Fee

Most individuals can lump closing costs into their mortgage payment, and it is usually the buyer of the real estate property who pays most of the expenses. Be sure to take into consideration closing costs before deciding if physical real estate is right for you.

Tenant & Liability Risk

When you own rental property, there is always a risk that something catastrophic happens, and you could be sued due to negligence or perhaps you have an ambulance-chasing tenant.

According to a recent article, rental property insurance is about 25% more expensive than traditional homeowners insurance, which costs approximately $1,445, so you can expect to pay about $1,800 for rental property insurance, which eats into your investment property cash flow.

Mortgage Interest

The interest rate you receive on your mortgage can impact your monthly payment and rental income if you plan on operating a rental property.

Most people can deduct mortgage interest on their taxes, but it is not a 1-for-1 deduction. And some people will note that home prices and mortgage rates have an inverse correlation, but that is an imperfect comparison because there are too many nuances.

As of this writing, the 30-year Fixed Mortgage Rate, which is the benchmark for borrowing, is over 5%. While historically, mortgage rates are still at a historic low, a 1% move in mortgage rates can drastically impact your monthly mortgage payment and cause wild swings in the housing market.

Property Taxes

High property taxes means the money being invested in your town, which makes it a more desirable place to live, which subsequently raises the value of your property.

The benefits of a desirable location aren’t always immediately seen, while you sure will notice the property tax bill coming in, so that is why I am listing this as a con.

You can use this property tax calculator to estimate the property taxes in your town.

Pros of REITs

Passive Income

REITs are truly passive income investments. One of the most significant advantages of investing in REITs is their ability to generate passive income. Investing in REITs doesn’t require tenant management, maintenance, insurance, or unexpected expenses, making them a passive income strategy.

As of this writing, the average dividend yield for Equity REITs is 4.3%, according to the Motley Fool. Some REITs can pay significantly more, depending on their investment strategy.

If you invested $10,000 in REITs, you could expect to earn $430 in dividends. Meanwhile, the S&P 500 has a dividend yield of approximately 1.4%.

Less Capital Required

Investing in REITs requires ALOT less capital. You can buy shares of Vanguard’s VNQ REIT ETF for around $75 a share. So even if you only had $500 or $5,000 you could still start investing in REITs.

Less Stress

A significant benefit of REITs is that there is less stress. REITs are truly a passive income investment.

REITs will never call you at 3 a.m. to fix a leaky faucet.

There is no risk of tenants no paying on time, a water pipe bursting, or neighbours complaining.

Liquidity

The most significant benefit of publicly traded real estate investment trusts is that you can easily buy and sell your shares with no limitations, which, unlike owning physical real estate, has no liquidity; you cannot easily or quickly buy or sell a property.

Liquidity should be strongly considered if you plan on holding your investment for less than 5 years.

Low Transaction Costs

Investing in publicly-traded Real Estate Investment Trusts is cheap. There are low to usually no brokerage costs through most big-name brokerages like TD Ameritrade or Fidelity. You can easily buy and sell REITs without large expenses.

Meanwhile, purchasing real estate often comes with closing costs of 3 – 6% of the property purchase price.

Cons of REITs

Real Estate Investment Trusts are an attractive way to gain exposure to the real estate market.

However, there are some issues to consider. There are no tax breaks like physical real estate. You also have no artistic control.

Stock Market Correlation & Volatility

Publicly traded REITs tend to correlate highly with the overall stock market. A correlation of 1 means a stock or sector moves exactly with the overall stock market.

According to a Morningstar.com analysis, the FTSE NAREIT Equity REIT had a correlation of 0.59 with the CRSP 1-10 U.S.Estate Market Index, which represents nearly 100% of the investable U.S. Equities Market.

So if the total stock market moves down 10%, the equity REIT market is expected to drop 5.9%.

And if you are a buy-and-hold investor or can not stomach periods of extreme volatility, you may want to think twice before investing in the real estate market through REITs.

Capital Gains Tax

If you sell your REITs for a profit, you are subject to either short- or long-term capital gains taxes.

Long Term Capital Gains are if an investment is held for a year or longer and the tax rate can range between 0% and 20%, depending on your income.

Short Term Capital Gains are if an investment is held less than a year. The rate is your ordinary income tax rate, ranging between 10% and 37%.

Now, capital gains taxes are generally unavoidable in any investment situation. You would also have to pay taxes if you sold your investment property unless you executed a 1031 Exchange, which allows you to defer capital gains by swapping one real estate investment property for another.

No Investor Control

When you invest in a Real Estate Invest Trust (REIT), you do not have control of the investment strategy. Sure, you can put your money towards a REIT that executes a particular strategy or invests in a certain property type, but you don’t have any say in how and when that strategy is executed.

Meanwhile, with direct real estate investing, you are in control of all facets of the property. You control all decisions, from property enhancements and how much to charge for rent to tenant screening.

Are REITs Better Than Real Estate?

Real estate investments in physical real estate or REITs can be advantageous for your investment portfolio, but you need to be sure which strategy works for you.

REITs are good for…

Investors who want a hands-off approach to real estate investing while generating passive income in the form of dividend income.

Physical Real Estate is a better option for…

Investors who prefer a more hands-on approach and have the time and energy to dedicate to managing a physical property, and lastly, want more control over investment decisions.