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The iron is hot when it comes to real estate investing. Over the past 5 years, both residential and commercial real estate have rewarded investors with annual returns greater than 7%. What’s more, current home ownershiprates are declining and residential and commercial vacancy rates are also declining, reflecting the fact that the total pool of renters is increasing.
Overall, these trends show us that investing in real estate, and more specifically, owning income-producing rental properties, continues to be a good investment strategy. Traditionally, people have achieved this by investing in real estate through direct investments. That is, financing a residential or commercial real estate property with a loan and acting as the landlord.
But with the recent popularization of real estate investment trusts (REITs), it’s now possible to invest in a large portfolio of real estate assets that gives you many of the same benefits as direct investing and more. In fact, while many are unfamiliar with REITs, investing in a REIT rather than buying a physical property might be a better investment for you. Let me explain.
Typically, when people want to invest in real estate they purchase a residential or commercial property with a loan. Some of these investors are short-term fix-and-flip investors while others are more permanent buy-and-hold investors. This means that overall, there are two ways to directly invest in real estate.
The first is through a short-term strategy where an investor uses a fix-and-flip loan to purchase, renovate, and then sell the property for a profit. In this scenario, the profit earned is the difference between the sale price and the purchase price plus holding costs, which include renovations. Fix-and-flip investors will typically try to sell a property within 6 - 12 months.
For fix-and-flip investors, a rule of thumb is that you need to make at least 30% above the purchase price in order to be profitable. This is due to the repair costs and other holding costs. This means that while fix-and-flippers make $58k, on average, it can be a risky investment. For example, as much as 40% of all short-term house flippers sell at either a breakeven or loss.
The second is through a long-term strategy where an investor uses a permanent loan to purchase a property before renting it out to long-term tenants. Profit is earned from the monthly rental income and asset price appreciation, minus any maintenance and upkeep. Buy-and-hold investors willy usually keep a property for more than 10 years.
For buy-and-hold investors, it’s common to see average annual returns between 7% - 10%, depending on the type of property and its area. However, some investors have been able to generate upwards of 20% annual returns in hot markets while others have seen losses due to low occupancy rates and rising costs of maintenance.
You can see that the benefits of these direct real estate investment strategies can be many. Short-term investors can take advantage of underpriced assets and make quick profits. Long-term investors can take advantage of passive rental income, tax deductions, depreciation write-offs, asset price appreciation, and more.
However, direct real estate investing, for all of its upside, has many downsides. These downsides include a lack of diversification, lower liquidity, and higher risk due to varying occupancy rates and maintenance costs.
For example, when people buy a property, they can typically only finance one at a time. This means that while you might be adding diversification to your overall portfolio, you have a lack of diversification within the real estate asset class. If you own a residential property and the residential market takes a dive, you become overexposed to losses.
Further, investments in physical properties are highly illiquid. This means that direct real estate investments naturally increase an investor’s liquidity risk. And the risk doesn’t stop there. Occupancy risk, property taxes, insurance, and maintenance costs can all cause an investor to cover more out-of-pocket costs than they anticipate.
What’s more, direct real estate investing is very time intensive and often requires a lot of work. For short-term investments, a fix-and-flipper is usually required manage the renovation timeline and sell the property within 12 months. For long-term investments, investors are required to find tenants, deal with maintenance and upkeep, and sometimes even renovate the property before renting it.
This is why real estate investment trusts (REITs) have become so popular lately. REITs offer many of the same benefits of direct real estate investment, such as rental profits, as well as solve many of the problems, such as a lack of liquidity and diversification. Until recently, however, REITs have gone by largely unnoticed by real estate investors.
But the cat’s out of the bag. REITs have a long history of outperforming direct real estate investing and the trend is expected to continue. For example, from 1977 to 2010, REITs have returned more than 12% annually. This is in comparison to the roughly 10% return of the S&P 500 and the 6% - 8% return of private real estate funds during the same period.
And over the past 5 years, REITs have an average annual return around 9% while the average annualized return of direct real estate investing is at-or-below 8%. These are impressive performance numbers that all investors should find interesting. But before you jump the gun, it’s important to understand what a REIT is as well as the different types available.
REITs are corporations that act like mutual funds for real estate investing. A REIT is an investment company designed so that 75% of the corporation’s assets are invested in real estate, cash, or treasuries. The major benefit of a REIT is that 90% of its annual profits are paid as dividends and not taxed at the corporate level.
REITs are typically either mortgage REITs or equity REITs. Mortgage REITs are companies that use short-term loans at low interest rates to purchase existing loans with a comparatively higher interest rate. The spread between the two interest rates represents the profits of a mortgage REIT. These REITs are typically leveraged as high as 5-to-1 and are therefore fairly volatile.
However, the more common equity REIT is much less volatile and is, in fact, quite possibly a better investment than direct real estate. Equity REITs are highly specialized REITs that invest in income-producing rental properties in specific sectors. For example, there are residential REITs, retail REITs, healthcare REITs, office REITs, and more.
These equity REITs earn profits from the monthly rental income and price appreciation of the properties that the company owns. For this reason, an equity REIT is very similar to direct real estate investing in that it acts much like a holding company that manages a portfolio of rental properties.
All REITs are either publicly-traded or privately-held. For those interested in starting their own REIT, the IRS has very clear guidelines regarding how to qualify. At the most basic level, you’ll have to form a corporation and then comply with such regulations that dictate your board structure, shareholder agreements, and how you invest your working capital.
The real opportunity, however, isn’t with privately-held REITs but is instead with publicly-traded REITs listed on open exchanges. These REITs trade just like stocks or ETFs, meaning that in addition to quarterly dividends equal to a proportional share of 90% of the profits, you’ll also own an appreciating asset that grows in value much like a stock.
You can find REITs for almost every sector and for both commercial and residential real estate. For as little as the price of a share, you can purchase a piece of a REIT that owns a portfolio of income-producing real estate assets. Quarterly dividends will come from the rent collected on these properties, and the value of your REIT shares can increase over time as profits grow.
Besides returns, the benefits of a publicly-traded equity REIT when compared to direct real estate investing are numerous. The first is greater diversification. With a REIT, you’re buying a piece of a large real estate portfolio that owns properties in a specific sector. Conversely, if you were to buy a property yourself, you’d typically only be able to finance a single property rather than many.
The second is more liquidity. Since these publicly-traded REITs can be bought and sold like a stock, an investor has much more liquidity when compared to investing in a physical property. The third - and maybe the most important - benefit of investing in a REIT is the fact that you don’t have to invest your time being a landlord. Instead, there is a professional management team that does it for the investors of a REIT.
What’s more, REITs have traditionally increased in value when interest rates rise. We are currently in a rising interest rate environment, meaning that we should expect the value of REITs to follow suit. Further, despite the zero-rate world we’ve been living in, many REITs have actually cut their debt rather than taking on more, meaning that they should be less volatile in the near-term.
Despite all of these benefits, there are of course downsides of REITs that we should mention. The first and possibly the biggest downside is a lack of control. When you purchase a property through a direct real estate investment, you’re the owner and you can do whatever you please with it. And then when it comes time to purchase a second investment property, you get to make the decision regarding what to buy.
With a REIT, however, you’re literally a passive investor. You don’t get to provide any input regarding which types of properties to buy and where. Instead, you have to pick a REIT in the right sector and choose one with a management team you trust.
Another downside with REITs is that they only have 10% of their annual profits to use for growth. While a 90% profit distribution in the form of dividends is great for the investor from a tax perspective, it doesn’t give a REIT much capital to fund itself and its future needs.
Instead, REITs will typically have to go out and get additional investments if they want to expand their portfolio. This means that the growth of a publicly-traded REIT is typically less than a normal stock.
What’s more, even though REITs provide greater diversification when compared to buying real estate, they’re still susceptible to macroeconomic movements. For example, retail REITs make up 24% of all publicly-traded REITs. These REITs can typically own anything from large shopping malls to freestanding retail shops. While this provides diversification within the retail sector, a retail REIT can still leave you exposed.
As of this year, there have been over 8,000 retail store closures across the nation. Further, experts believe that between 50 - 80 large malls might also close over the next two years. This may be a bad sign for retail REITS, showing that diversity within a real estate sector might not protect you from a declining asset.
Still, despite these downsides, the data is clear. REITs, and particularly equity REITs, have historically outperformed direct real estate investing and even the S&P 500. Further, we expect the real estate market to grow as more-and-more people look to rent.
Therefore, if you’re thinking about increasing your real estate exposure, it’s important to consider a REIT. While direct real estate investment is sometimes better, such as if you live in a local market that’s booming, the performance of REITs is typically the best.
If you’re want access to a diversified pool of liquid real estate assets that give you quarterly dividends as well as asset price appreciation, then a publicly-traded REIT is probably the right investment for you.
