Investors seeking exposure to real estate can look for investment properties to purchase and rent out, or they can buy shares of a real estate investment trust (REIT). Becoming a landlord offers greater leverage and a better chance of realizing big returns, but it comes with a long list of hassles, such as collecting rent and responding to maintenance issues. REITs provide a much simpler way to invest in real estate and earn consistent income through dividends, but they confer less control, and their upside tends to be lower than that of rental properties.
Becoming a landlord offers several advantages. Perhaps the biggest advantage is leverage. Investors with good credit can buy rental property with as little as 20% down, financing the rest. Therefore, the investor's cash outlay on a $100,000 property is only $20,000. If the value of the property increases by 20% in the first year, an amount not unheard of in a hot real estate market, then the investor enjoys a 100% return.
Although mortgage payments must be made on the financed amount, a smart real estate investor earns enough money in rental income to cover the mortgage, with money left over as profit. This allows the investor to earn money from both property appreciation and rent payments from tenants.
Being a landlord is a much more hands-on investment than owning shares of a REIT. Many people who have gotten into the business of purchasing rental properties have quickly learned that the time required to manage all of their properties becomes another full-time job. A person considering buying rental properties should brace themselves for a huge time commitment, or be prepared to pay a professional property manager to handle the minutiae involved, such as advertising vacancies, collecting rent and dealing with delinquent tenants.
Then there are the myriad expenses involved with owning property. Depending on how the lease agreement is written, a landlord could be financially responsible for everything from a leaky faucet to a broken refrigerator. This can eat into an investor's profit quickly. Moreover, dealing with frantic late-night phone calls every time a tenant's toilet does not flush properly can impede quality of life.
Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit. Building a diversified portfolio of one's own rental properties requires a hefty budget and a lot of time and expertise. Investing in the right REIT offers done-for-you diversification in one simple purchase. Furthermore, while rental properties are potentially lucrative investments, they can be highly illiquid, particularly when the real estate market turns soft. REIT shares, on the other hand, can be redeemed for cash in one five-minute phone call.
REITs lack the leverage advantage offered by financing rental properties. Because a REIT is required by law to distribute 90% of its profits to investors, that leaves only 10% to grow the company by investing in additional properties. Consequently, REIT share prices rarely grow as fast as, say, Silicon Valley tech companies, which rarely pay dividends and usually invest every penny of their profits into growth and innovation.
REIT investing offers less control than being a landlord. When an investor buys rental properties, the investor can see, touch and smell each property before he or she owns it. The investor can research the local rental market and examine data on how similar properties have fared recently. Buying REIT shares means ceding that control to someone else. This can be ideal for investors not wanting to make such decisions, but those who prefer a hands-on approach might be better off as landlords.