The Difference Between REITs and Direct Real Estate Investing

The difference between REITs and direct real estate investing are important to know in pursuit of profitability.

Real estate can be a smart addition to any investment portfolio. Real estate also provides great diversification, as it is a distinct asset class which does not have a strong correlation with other industries within the stock market.

The two ways to buy into real estate are to 1) invest in a real estate investment trust (REIT) or 2) make a direct investment into real estate. To dive deeper into the differences between these two potentially profit generating investments, read the following analysis.

The Difference Between REITs and Direct Real Estate Investing: What is a REIT?

A REIT is a company that owns, operates or finances income-producing real estate or real estate-related assets. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.

There are more than 225 REITs in the United States that trade on major stock exchanges, as well as are registered with the Securities and Exchange Commission (SEC). These REITs, which are primarily traded on the NYSE, have a combined equity market capitalization of more than $1 trillion.

Generally, REITs follow a simple business model. A REIT buys or develops properties and then leases them out to collect rent as its primary source of income. Investors can buy shares in a REIT company the same way they can any other public company. Investors further can buy publicly traded REIT shares on major stock exchanges such as the NYSE or NASDAQ.

In order to be classified as a REIT, a company must meet the following criteria:

• Pay at least 90% of taxable income as shareholder dividends each year.
• Invest at least 75% of total assets in real estate and cash.
• Derive at least 75% of its gross income from real estate-related sources, including rents from real property and interest on mortgages financing real property.
• Have a minimum of 100 shareholders after its first year as a REIT.
• Be an entity that would be taxable as a corporation, except for its unique REIT status.
• Be managed by a board of directors or trustees.
• Have shares that are fully transferable.
• Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
• Derive at least 95% of its gross income from such real estate sources and dividends or interest from any source.
• Have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.

Difference Between REITs and Direct Real Estate Investing: REIT Pros and Cons

Pros of Investing in REITs:

• Provide diversification within an investment portfolio.
• Have high dividend yields and potential for appreciation.
• Offer highly liquid investments, since it is easy for investors to buy and sell REITs.
• Give exposure to the real estate market without placing an extra responsibility on the investor, who does not need to own, manage, or finance the property personally.

Cons of Investing in REITs:

• Carry market risk and are sensitive to fluctuations in interest rates. In general, REIT prices and Treasury yields have an inverse relationship.
• There are property-specific risks associated with any real estate that a REIT may own because most individual REITs are not diversified. Instead, they focus on a specific property type.
• The tax rules associated with REIT dividends are not ideal for investors.

The Difference Between REITs and Direct Real Estate Investing: What is Direct Real Estate Investing?

With a direct real estate investment, an investor buys tangible real estate or a stake in one and operates it for his or her own financial benefit. For example, the investor may buy an apartment complex or shopping center and manage the property personally, taking on the responsibility of maintaining the property and overseeing the operations. Direct real estate investors make money through rental income, appreciation and profits generated from any business activities that depend on the real estate.

The Difference Between REITs and Direct Real Estate Investing: Pros and Cons of Direct Real Estate Investing

Pros of Direct Real Estate Investing:

• Appreciation of property values can allow for a direct investor to profit when he or she decides to sell properties.
• Tangible real estate has the potential to generate significant cash flow for the owner.
• Someone who decides to make a direct real estate investment has more control over decision making than a REIT investor does. Direct real estate investors can tailor their investments to exact preferences.
• There are numerous tax breaks to offset income. The investor can deduct the ordinary and necessary costs to manage, conserve and maintain property. Another large tax break is for depreciation, in which an investor can deduct the costs of buying and improving a property over its useful life and lower taxable income in the process.

Cons of Direct Real Estate Investing:

• The investor must take on the responsibility of managing the property. Therefore, the investor must dedicate time and energy (sweat equity) to the property to be successful. This could be in the form of dealing with tenant issues, maintenance emergencies and liability problems if there are any accidents on the property.
• Direct real estate investments are illiquid; it is not easy to buy and sell real estate quickly.
• Direct real estate investors are personally responsible for the financing of properties they own. If the market tanks or the investor has difficulty finding quality tenants, there’s the chance they could default on the loan.

The Difference Between REITs and Direct Real Estate Investing: Bottom Line

REITs are an easier way to gain exposure to real estate, as there is no personal responsibility to maintain, operate and finance any properties. REITs are also highly liquid, and they can provide high yields. REITs are a great way for new investors to gain experience with the real estate industry.

Direct real estate may be a good choice for investors who have the financial resources to make the investment in tangible real estate to take advantage of tax breaks, while earning significant cash flow. Direct real estate is also great for investors who want to have control over their investments. However, the illiquidity of direct real estate investment and the obligation to manage the properties are drawbacks that should be considered.

Adam Johnson is an editorial intern who writes for www.stockinvestor.com and www.dividendinvestor.com.