Wondering how to invest in real estate? Many investors who want to tap into the real estate sector compare REITs to actual, tangible real estate. REITs—or real estate investment trusts—are corporations that act like mutual funds for real estate investing. You can invest in a REIT without having to own or manage any property yourself. Alternatively, you can go the direct real estate investing route and buy residential or commercial properties.

Key Takeaways

  • REITs allow individual investors to make money on real estate without having to own or manage physical properties.
  • Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making.
  • Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

Direct Real Estate

With a direct real estate investment, you buy a specific property or a stake in one, such as an apartment complex (residential) or a shopping center (commercial). Direct real estate investors make money through rental income, appreciation, and profits generated from any business activities that depend on the real estate.

Pros of Direct Real Estate Investing

One benefit of investing in physical properties is the potential to generate substantial cash flow—as well as the ability to take advantage of numerous tax breaks to offset that income. For example, you can deduct the ordinary and necessary costs to manage, conserve, and maintain the property. Another large tax break is for depreciation, in which you deduct the costs of buying and improving a property over its useful life (and lower your taxable income in the process).

Of course, there's also appreciation. While the real estate market fluctuates like the stock market does, property prices generally increase over time, so you may be able to sell later at a higher price.

Another perk: you have more control over decision making than you would with REITs. For example, you can select only properties that match your preferences for location, property type, and financing structure. You can also set rental prices, choose tenants, and decide how many properties to buy.

Cons of Direct Real Estate Investing

One of the main disadvantages of direct investing is that it requires a significant amount of time and energy (sweat equity) if you plan to be successful. You have to deal with tenant issues, maintenance emergencies, and your liability if there are any accidents on the property.

Financing can be another disadvantage. Many investors need to take on a mortgage or some other type of financing to pay for investments. If the market tanks or you have difficulty finding quality tenants, there's the chance you could default on the loan.

Another negative is that real estate is not a liquid asset. That means you probably won't be able to sell it quickly if you need cash in an emergency.

Pros

  • Positive cash flow and appreciation

  • Tax advantages

  • Control over decisions

Cons

  • Requires time and energy

  • Risk of financing default

  • Illiquid (not easy to buy and sell)

REIT

A REIT is a corporation that owns, operates, or finances income-producing real estate or real estate-related assets. Modeled after mutual funds, REITs pool the capital of numerous investors.

Today, there are more than 225 REITs in the U.S. that trade on major stock exchanges, and that are registered with the Securities and Exchange Commission (SEC). These REITs have a combined equity market capitalization of more than $1 trillion. World-wide, more than 35 countries currently offer REITs.

REITs can be appropriate for new investors with limited experience in real estate who want to diversify their portfolio without a ton of risk.

Pros of REITs

Perhaps the biggest advantage of REITs is that individual investors can access profits from real estate without the need to own, operate, or directly finance properties. They offer a low-cost way to invest in the real estate market. You can invest in a fund with as little as $500—a much lower entry point than direct real estate investing.

Another benefit is that REITs offer enticing total return potential. By law, REITs have to pay at least 90% of taxable income to shareholders, and it's not uncommon to have a 5% dividend yield—or more. REITs also have to potential for capital appreciation as the value of the underlying assets increases.

Another important perk is liquidity. Like stocks, you can buy and sell REIT shares on an exchange. In general, REITs trade under heavy volume, which means you can get into or out of a position when you want (or need) to.

Cons of REITs

Of course, there are some drawbacks to REITs. For starters, most REIT dividends aren't considered "qualified dividends," so they're taxed at a higher rate. This is something to pay extra attention to if you own REITs in a taxable brokerage account. Keep in mind that you can hold REITs in a tax-advantaged Roth IRA account.

Another con is that REITs can be very sensitive to interest rate fluctuations, and rising interest rates are bad for REIT prices. In general, REIT prices and Treasury yields have an inverse relationship: when one goes up, the other goes down, and vice versa.

One other drawback is that while REITs can help you diversify your overall investment portfolio, most individual REITs aren't diversified at all. That's because they focus on a specific property type—such as offices or shopping centers. If a REIT invests solely in hotels, for example, and the economy tanks or people stop traveling (think COVID-19), you can be exposed to property-specific risks.

Pros

  • Real estate profits without having to own, manage, or finance property

  • Higher than average dividends and potential for appreciation

  • Liquid (easy to buy and sell)

Cons

  • No tax advantages

  • Sensitive to interest rate fluctuations

  • Property-specific risks

The Bottom Line

Direct real estate investing may be a better choice if you want cash flow, tax breaks to offset that income, and great potential for appreciation. It's also good if you want more control over your investments and like a boots-on-the-ground approach.

REITs make sense for investors who don't want to operate and manage real estate, as well as for those who don't have the money or can't get the financing to buy real estate. REITs are also a good way for beginner real estate investors to gain some experience with the industry.