Should you invest in a REIT or directly in Real Estate? The answer is it depends. In this post, we make a comparison between investing in a REIT and directly in Real Estate assets.
- Advantages of Direct Real Estate over REIT
- Advantages of REITs over Direct Real Estate Investments
Direct real estate ownership is the most common type of investment in the world. In most cases, it is limited to owning own main home. But there are also many investors who buy real estate with the goal of renting it out and benefit from both the income generated and the appreciation of the asset.
Leaving aside the investment we make when we buy our main home, if we want to collect rental income and benefit from long-term price appreciation in the real estate market, we have two options available: we can buy real estate or invest in a REIT.
If we buy a piece of real estate, we will control it and can rent it out to someone who pays us rent. A REIT is a real estate investment trust. Effectively, a REIT is a vehicle that owns property with the goal of renting it out to collect income.
REITs are traded on stock exchanges and can be bought and sold very much like a stock. We can even invest in exchange-traded funds composed exclusively of REITs.
Therefore, for those investors asking themselves whether they should invest in a REIT or buy real estate, we will make an in-depth comparison between REIT and real estate.
We will do this analysis by looking at the advantages that each type of investment has relative to the other. Depending on your situation, capital, preferences, desired lifestyle, you will be able to decide which one suits you more, or if both are a good fit.
Advantages of Direct Real Estate over REIT
We kick off our comparison between real estate and REIT by discussing the advantages of the former:
1) Potential to Buy below Market Value
It is often said that when investing in the real estate market, money is made by buying at the right price. This is because it is very difficult to sell a property above its real market value. There are so may properties in the market that buyers can always find an alternative.
However, buying below the market value is a real possibility. This is mainly due to two reasons. First of all, if you know the area better than other buyers and the seller, you may be able to identify those properties whose prices are lower than their true market value.
There are many variables that can make you see things that other do not see. It can be about the property being in a highly sought-after area, the future development of some infrastructure, school proximity, etc. The important thing is that you have more and better information than other potential buyers and the seller, and you can use that to your advantage.
Second, it is possible to buy a property below market value if you find a motivated seller. There are sellers whose main motivation is to get rid of the property and get money as soon as possible. For them, price is secondary. If you can do a quick purchase, you can find properties at attractive prices.
The potential to buy below market value is inversely related to how efficient that real estate market is. If there are many buyers, many sellers, multiples agencies and all information is available online, the market will be quite efficient, and it will be more difficult to find bargains. The best example would be big cities.
On the contrary, a small real estate market, with a small number of potential buyers and where there is no easy access to information, will be more likely to offer us good buying opportunities.
If you invest in a REIT, the share price is determined by the marketplace on a real time basis. It is simply not possible for us to acquire shares below market value.
2) Potential to Add Value
Although REITs have professional managers dedicated to managing the real estate, the truth is that you will not be able to decide how things are run. On the other hands, if you buy a property directly, you will be able to take decisions that can increase the value of your real estate investment.
There are many options to add value, and deciding which one is best will depend on many variables such as the type of property, the area, the market, your strategy, etc. Some examples would be doing renovations, opening the kitchen to the dining room, or adding a second bathroom.
A bigger strategy to add value would be buying a large apartment and divide it into two smaller apartments. Adding value by implementing changes to the property is one of the best ways to make our real estate investments more profitable.
3) Direct Control
Direct control of a piece of real estate is not simply about being able to decide how to add value. You can do a lot more by controlling a house or an apartment.
For example, you can do a real estate investment that is both profitable and fits into your lifestyle. You could buy a beach house, rent it out as a vacation home from time to time and use it yourself the rest of the time.
As you can see, you decide how a property fits into both your investment portfolio, your lifestyle and your personal goals. Such control can only be exercised if you have bought the real estate yourself.
4) You decide how much Leverage to use
Leverage is the option to finance a portion of the purchase of a property with mortgage debt. That can increase the potential gains (and losses) significantly. In fact, real estate investment would be a lot less profitable without financing and leverage. And a lot more difficult to attain.
If you find a property with plenty of potential and you are able to finance its purchase with a mortgage, that can become a spectacular investment.
There is no doubt that adding leverage to an investment makes it riskier. However, mortgage debt is usually paid over many decades. And, in most cases, it is possible to fix the interest rate for the entire term of the loan.
Even though many REITs also use leverage to increase their returns, we as shareholders have no real control over how much debt is being taken. Therefore, by buying direct real estate we can decide how high we want our potential returns to be and what our risk appetite is.
5) Diversification with the Stock Market
Diversification well implemented is about owning assets with good potential returns that are not highly correlated. That increases the probability of us making money investing. That is why it is so attractive to combine stocks, real estate, gold, silver, commodities, etc.
Although REITs represent real estate investments, the truth is that their prices are highly correlated with movements in the stock market. Consequently, an investment portfolio containing mostly stocks and REITs would not be very diversified.
One of the main advantages of direct real estate investing is that real estate values are not as highly correlated with the stock market. So, while a correlation still exists, it is lower than it is for REITs.
Advantages of REITs over Direct Real Estate Investments
The second part of our comparison between REIT and direct real estate is about the advantages REITs can offer to investors:
A REIT is as liquid as any stock. Real estate investment trusts trade on exchanges. Whenever the exchange is open, we can buy and sell them easily and quickly from our brokerage account.
This means we can convert our REIT investments into cash in seconds. Or we can deploy our cash to invest in REITs with the same convenience. Additionally, we will be buying and selling at fair market values, without having to offer any price concession to raise cash quickly.
This contrasts with direct real estate, which is both slow and expensive to transact.
2) Easier Diversification
From a risk management perspective, there is more risk in owning just a few real estate assets than several REITs. This is because REITs invest in hundreds and even thousands of residential units at the same time.
Thanks to that, they collect rents from thousands of tenants, not being heavily exposed to delinquencies. The same applies to potential damages to our properties. Something can go bad with one property, but that will not impact the entire REIT.
Therefore, with a very modest investment, REITs make it possible for us to invest in the real estate market in a very diversified way.
If we own just a handful of houses and one of our tenants does not pay, this could have a severe impact on our finances.
3) Access to More Markets
Investing in REITs make it easier to access more remote markets, such as real estate assets in other states or even countries. All from the comfort of our home.
While it is possible to invest in real estate situated in other states and countries, that represents a heavier burden on us in terms of time, commitment and research. In contrast to that, if we reside in California but want to invest in Florida real estate, we can simply buy a REIT that holds residential real estate in Florida.
4) Access to Commercial Real Estate
Similarly, REITs also make it possible for us to invest in commercial real estate. While we have been speaking about housing so far, there are many different types of REITs that allow us to fully customize the way we invest in real estate.
If we want to invest in large office buildings, shopping malls, hospital buildings, warehouses or even data centers, the stock market and the REITs that trade on it will make that a possibility
Both REITs and direct real estate assets can be a great way to invest in property. There are many differences between them, and each has its own advantages.
The ideal investment will depend on your personal circumstances and preferences.
For those who seek the highest possible returns and are willing to take on the risk and the work involved, direct real estate investing is probably the way to go.
On the other hand, those investors who value convenience, liquidity and diversification would probably prefer to put their money into REITs.
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