This is the second article in our series about ways to invest in real estate.
In the overview article, we described nine different options for real estate investors. Direct investing in real estate—real property—is the gold standard. Adding real property to your investment portfolio provides a source of income and capital gains separate from more conventional assets like stocks, bonds, mutual funds, etc.
However, there are plenty of reasons why investors may choose not to buy real property. Is a REIT or REIT fund a good place to build savings and especially for your next property? We lay out the facts—you decide. We focus on publicly-traded REITs and REIT funds. Private or unlisted REITs deserve an entirely different discussion since they have additional, unique risks.
Differences Between Investing in Real Property and REITs
Both types of investments are most likely to be profitable when the real estate market is strong. They each provide rental income and possible capital gains from the sale of properties. But these two investment types have quite different profiles along several dimensions. To quantify these differences, compare the following two investments:
- Property: The example for the property alternative is a $300,000 single family house that you would like to rent out. It is in excellent shape and doesn’t require any extensive repairs. You wish to purchase the house with a Small Business Administration (SBA)guaranteed bank loan that requires 10% down ($30,000).
- REIT: The REIT option is actually a fund of REITs that trades on the New York Stock Exchange (NYSE). The fund invests in 12 different REITs and currently trades for $30/share. For this example, you are considering an investment of up to $30,000 in the REIT fund.
Let’s review the important factors in your decision about which alternative to pursue.
For this example, the investor should invest $30,000 in each investment. But to be clear, a major point of this article is that an investor might not have $30,000 lying around, ready for investment. The minimum investment for the REIT fund is one share, $30. Clearly, the REIT fund is far more flexible when it comes to the minimum investment.
Another point to consider is the timing of the investment. For the house purchase, you’ll invest all $30,000 at the closing. The real estate market goes through phases, just like all other asset markets. When you deposit your $30,000, you’ve committed to investing in real estate market phase as it exists on the closing date. Since no one knows the future, you have an investment timing risk.
Less so with the REIT fund. Through dollar cost averaging (DCA), you could buy the same amount of shares each month until you’ve reached your goal. You’ll be buying fewer shares when prices are high, and more shares when prices are low. For example, you might decide to invest $2,500 in each of the next 12 months. DCA helps you achieve a cost per share that is below price per share. It substantially reduces your investment timing risk.
Adding real estate to your investment portfolio helps diversify it by widening your asset allocations. Purchasing a $300,000 house can be a minor or major step toward diversification. For instance, if the property is the fifteenth in your portfolio, and it is geographically distant from your other properties, then your portfolio is well on its way to diversification. On the other hand, if the property is only your second and is in the same neighborhood as your first property, your diversification is more limited. In the worst case scenario, both rental properties could be vacant at the same time.
A REIT is already diversified in that it usually consists of hundreds of properties that are geographically spread out. A REIT fund is even better because it can be diversified across multiple sectors, such as multifamily homes, retail stores, offices, industrial properties and so forth. Buying into a REIT fund is an excellent way to diversify your portfolio.
If you are the hands-on type who and like to be in firm control of your investments, real estate property fits the bill. If you prefer, you can act as a landlord. Conversely, you can farm out some management chores like collecting rents to a property agent. You have the power to decide which property to buy, in which neighborhood, how much to improve it, and many other decisions. This requires you to have the time and expertise to pick good properties and care for them.
REITs and REIT funds provide you no control over their holdings. In fact, the only control you have is deciding when to buy and sell shares, and how many shares to own. It is a passive investment, meaning you don’t have to lift a finger to receive your monthly cash flow. Also, passive investments have some attractive features. For example, you can hold them in an IRA (USA) or RRSP (Canada) for tax benefits.
In our example, the house purchase uses 90% leverage, which is quite high. As long as it is occupied, you will be making cash on cash returns based on your $30,000 down payment. Amortization builds your equity slowly in the early years, so your leverage will remain high. Eventually, it will drop as you pay off the mortgage, but you could reestablish high leverage through a cash-out refinance.
But the SBA case is unusual. In many situations, you will have to put down as much as 40%, which reduces your leverage. Still, 60% leverage is not bad when measuring cash on cash return.
A REIT or REIT fund is leveraged to the extent that the issuer uses leverage in its financial operations—most do. You should be able to get the same range of leverage ratios with a REIT fund as you do with your own properties. If you are a qualified and experienced investor you can double that leverage by buying the fund shares on 50% margin.
The flip side of leverage is risk. Higher leverage means higher debt service. If something goes wrong and you can’t collect the rent on the properties you own, then you might face the real possibility of foreclosure.
REITs are professionally managed and take many precautions to manage risk. Still, could a REIT suffer from foreclosures? Yes, butat least with a REIT fund, you can have so many properties in the investment that the occasional foreclosure will be barely noticeable. However, if a whole sector (like retail) performs poorly, the REIT might have to cut its dividends and experience a drop in share price.
It’s hard to say which investment is more efficient. If you efficiently manage your own rental properties without the help or expense of a property manager, you can extract the maximum income from your properties. Of course, there are foreseeable expenses (e.g. roof or furnace replacement) and unforeseeable expenses (e.g. fire, flood) that that translate into out-of-pocket costs for you. But these expenses can often be managed through budget planning and the purchase of insurance.
REITs must distribute at least 90% of their income and gains each year. But keep in mind, these are profit-making organizations, and their cut diminishes your profits. Still, a good REIT is efficiently managed. With no other information, we’ll call it a draw for efficiency.
You can sell your public REIT fund shares in a split-second any time the market is open. If you deal with an open-ended REIT, you sell order will be executed overnight. Compare this to the hassles of selling a house. It might take weeks, months or even years to complete the sale. You won’t know what price a buyer will offer, whereas public REIT share pricing is transparent and timely. For liquidity, REITs win handily. Bear in mind though, that the pricing and liquidity for non-traded and private REITs can be as risky as for individual properties.
Owning your own rental properties gives you control and possibly high leverage. Owning REITs or REIT funds provides a low minimum investment, high liquidity, good diversification and a variable amount of leverage. One strategy to consider for aspiring investors is to invest in REITs to save for a downpayment on an investment property. You can immediately achieve your goal of investing in real estate until you have the funds to make the choice between real property or REITs. Now that you know the facts, you are better equipped to pursue the strategy that fits your needs best.