Investing In Real Estate Versus REITs

The U.S. real estate market is finally starting to fire on most, if not all, cylinders, with investors’ enthusiasm gathering steam seemingly each passing month.

According to a study from the Urban Land Institute and PwC,expectations on profitability from the U.S. real estate sector are on the upside going forward. “In 2010, only 18% of respondents felt the prospects for profitability were at a good or better level,” the ULI reports. “This has improved steadily each year, with 68% of respondents now feeling that profitability will be at least good in 2014.”

The study reports that myriad investment demographics are pouring into the market, including foreign investors, institutional investors and private equity funds, as well as leveraged debt from insurance companies, mezzanine lenders, and issuers of commercial mortgage-backed securities.

“The anticipated interest in secondary markets is indicative of how the U.S. real estate recovery is expanding beyond the traditional investment hubs,” says Patrick L. Phillips, chief executive officer at the ULI. “Access to greater amounts of both debt and equity financing, combined with a sustained improvement in the underlying economic fundamentals, means that the opportunities and returns offered in smaller markets are potentially very appealing.”

A burgeoning profit avenue for investors is the real estate investment trust market, a market that is truly growing by leaps and bounds. Ernst & Young reports the REIT (Real Estate Investment Trust) market has grown from $300 billion in 2003 to $1 trillion by 2013, with growth expected to accelerate going forward. (Check out our great video on REITs here.)

By definition, an REIT is a corporation, trust or association that owns and, in most cases, operates income-producing real estate and/or real estate-related assets. Modeled after mutual funds, REITs pool the capital of numerous investors. This allows individual investors to earn a share of the income produced through commercial real estate ownership, without having to go out and buy or finance property or assets.

REITs differ from traditional real estate investing, primarily due to the fund-heavy strategic asset flow from REITs, versus the traditional free, more direct access flow from real estate investing (like becoming a landlord or buying stocks from homebuilding companies.) But both investment offer distinct advantages, as follows:

Advantages of REITS:

Lower entry costs – REIT investors can invest in a fund for as little as $500 or $1,000. That can offset the costs of buying a property for six-figures, and having to pop down a hefty down payment.

Increased liquidity – REITS are very much like stocks where you can sell shares whenever you like, just like a stock. Compare that to a home purchase, where liquidity is a bigger challenge, and is often dependent on fickle market conditions.

No muss, no fuss – If you own a rental property, you are subjected to tenant complaints, late payments, broken appliances, and yard, driveway and home maintenance. Not so with REITS, which only require you track your investments on a reasonable and regular basis.

Investment flexibility – With REITs, you have the option to flex your financial muscles and invest in commercial properties, shopping malls, even a marina or a group of camping site vacation homes – all at a reasonable entry price. That’s much harder to do as a direct investor where up-front capital can often be a challenge.

Advantages of Direct Real Estate Investment

You call the shots – There is no fund manager to answer to when you’re a direct real estate investor. You decide on the rental price; you decide on the number of properties to buy; and you decide on who lives in and rents your property.

Less IRS debt – With direct real estate, you can save big on taxes, and keep Uncle Sam’s slick hands out of your pockets. From writing off depreciation to taking a mortgage tax deduction, there are no shortages of tax breaks linked to direct real estate investing.

Potentially fatter investment returns – Like any investment, the more money you invest, the more money you can earn. So by putting down $100,000 on a property, you’ll likely earn more than a REIT investor putting $1,000 into a real estate investment.

Experts Weigh In

That’s just for starters – some industry experts say the advantages of both investment classes cut much deeper than the descriptions above.

One big difference is that the market for REIT shares is much closer to the efficient market described by Nobel Prize winner Eugene Fama than the market for individual real estate parcels is, says David Reiss, a professor of law at Brooklyn Law School, and an expert on REITs.

“That means that the price of a REIT's shares is more likely to contain all available information about the REIT,” he says. “Because individual real estate parcels are sold in much smaller markets and because the cost of due diligence on a single property is not as cost-effective as it is on REIT shares, an investor has a better opportunity, at least in theory, to get a better return on his or her investment if he or she does the diligence him or herself.” 

Karnit Mosberg, a director with Friedland Realty Advisors and a real estate lawyer with experience representing REITs in acquisitions/dispositions, says REITs are a better deal for those who do not have the means to operate and manage real estate as well as for those who do not like the risk associated with owning real estate.

But, as always, there are caveats.

“The key distinctions are that a REIT must distribute most of its taxable income to shareholders whereas a real estate investor may have to wait to receive income from the asset depending on the operating/management costs associated with that parcel of real estate,” she says. “In addition, a new investor with limited real estate experience who wants to diversify their risk should enter the real estate market by purchasing stock in a REIT.”

The Bottom Line

With the U.S. real market on the upswing again, real estate investing grows more appealing. But which avenue you choose to enter that market be it a REIT or through direct investment, really depends on how much risk and responsibility you can handle.