A REIT is a company that owns and in many cases operates income producing real estate. An investor can buy shares of these companies. In other words, a REIT is a pool of properties and/or mortgages bundled together. How does this stack up in the battle between REITs and private real estate investing?
The company offers shares of these combined assets in the form of a security or stock that an individual can buy into. There are all kinds of REITs that specialize in different types of real estate including office/commercial, apartment buildings/housing, hospitals, shopping centers, hotels, etc. REITs were invented as a real estate vehicle under a Public Law signed by President Eisenhower. REITs give all investors access to large scale real estate development investing.
IRS Rule on Income
One really neat feature of REITs is that IRS rules require the company to pay out 90% of their income back to share unit holders. This is typically in the form of a dividend. Dividend income is one of several strategies Money Vikings are harnessing to reach FI, so this makes REITs an ideal investment vehicle for those seeking income. Notch one in the advantages of REITs vs privae
REIT vs. Hands On Real Estate Ownership
We are going to run some numbers and look at the pros and cons of owning/investing in REIT’s vs actual hands on real estate investment ownership. The result may surprise you:
Real Estate Investment
Let’s say you invest in a $500,000 investment property (single family home) in a nice middle class neighborhood. You put $100,000 down and finance the remaining $400,000. In this scenario it is important to remember that your actual investment is $100,000.
On a $400,000 mortgage the total cost of principle, interest (4-5%), escrow for taxes, would be about $2,500/month
Add another $100/month for landscaping and another $100/month for deferred maintenance.
The house would cost about $2,700/month in expenses.
BOTTOMLINE: If you look at the rental market and let’s say the property would rent for about $3,100/month. So a person would be looking at a $400/month cash flow “profit”.
Now, keep in mind that this investment takes a lot of hands on care and feeding: There will be maintenance calls to respond to at off hours. Changes of occupancy to manage, advertising, screening tenants, contracts to negotiate and sign. Long term maintenance to manage. Minor and major repairs, etc.
But on the other hand, over many years you will be building equity in the property. So as the $400k note is drawn down and the price appreciates at 3-5% annually, the value of that investment can grow from the original $100k to $200k, $300k, etc.
Real Estate Investment Trusts (REIT)
Let’s analyze a $100,000 investment in a REIT. A very popular and strong REIT is the company Realty Income, ticker symbol “O” which we have written about before. With $100,000 you could by 1,538 shares of “O” at $65/share. The stock offers a 4% dividend yield. One really neat thing that I love about “O” is that they pay the dividend monthly, which makes it feel like a traditional real estate investment. Each share returns .255/share per month.
BOTTOMLINE: .255 x 1,538 shares = $392/month cash flow
All this with no calls in the middle of the night due to a leaky roof!
Here are the top 5 advantages of investing in real estate investment trusts (REITs):
High dividend yields
REITs are required to pay out at least 90% of their taxable income to shareholders in the form of dividends. This means that REITs typically offer higher dividend yields than other types of investments, such as stocks or bonds.
Diversification
REITs can provide diversification benefits to a portfolio. This is because REITs invest in different types of real estate, such as office buildings, apartments, hotels, and retail properties. This diversification can help to reduce the overall risk of a portfolio.
Liquidity
REITs are traded on major stock exchanges, which means that they are liquid investments. This means that investors can easily buy and sell REIT shares without having to worry about illiquidity.
Professional management
REITs are managed by professional real estate investment managers. This means that investors do not have to worry about the day-to-day management of their REIT investments. No calls about plumbing or electrical problems. Or even dealing with challenging tenants.
Of course, there are also some disadvantages to investing in REITs. These include the following:
- Volatility. REIT prices can be volatile, especially in the short term. This is because REITs are exposed to the same market forces as other assets, such as stocks and bonds.
- Risk of loss. Like any investment, there is always the risk of loss when investing in REITs. This is because the value of REIT shares can decline, and investors may not get back all of their money.
- Limited control. As an investor in a REIT, you do not have direct control over the management of the REIT’s assets. This means that you are relying on the REIT’s management team to make decisions that are in your best interests.
Here are advantages of private real estate investing not enjoyed by REIT investors:
- Passive income (kind of, not as passive as REITs). One of the biggest advantages of investing in real estate is the ability to generate passive income through rent collection. This means that you can earn money from your investment property without having to actively work for it.
- Tax advantages. There are a number of tax advantages that can be enjoyed by real estate investors. These include the ability to deduct mortgage interest, property taxes, and depreciation expenses from your taxable income.
- Appreciation. Over time, real estate tends to appreciate in value. This means that your investment property could increase in value over time, giving you the opportunity to sell it for a profit.
- Leverage. Real estate investors can use leverage to amplify their returns. This means that they can borrow money to buy an investment property, which can increase their potential profits.
- See related, Are You Prepared for Real Estate Investing?
