Buying Rental Property Vs. Investing In A REIT

By: Edwin Hui

Buying Rental Property Vs. Investing In A REIT

Tags: Buying Rental Property Vs. Investing In A REIT

 

 

 

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One of the most common questions I get from aspiring real estate investors is whether to buy property directly or purchase shares in a real estate investment trust, commonly referred to as a REIT.

For those who aren’t familiar with REITs, these vehicles allow individuals to buy shares in companies that own real estate as their primary business activity. While some REITs are private or non-traded, in this article we’ll focus on the publicly-traded REITs, which are the most visible and can be purchased by any investor with a brokerage account.

While both methods of investment allow investors to achieve real estate exposure, it’s a bit like comparing apples and oranges. One represents direct ownership, while the other is characterized by owning shares in a company whose sole purpose is to own and operate a portfolio of real estate assets. I own shares in several REITs as part of my personal equity portfolio, as well as some real estate directly. I view both of those investments differently and see the advantages and disadvantages of each.

To help you better understand the appeal of investing in brick and mortar real estate versus a publicly-traded REIT, here is a list of considerations. 

Owning Real Estate :

Hedge Against Stock Market Risk

Real estate is cyclical, as is the stock market. But the two do not generally move in lock-step — meaning they are not directly correlated. In order to have a diversified portfolio, by definition, it is important to hold investments that react differently at the same point in time. This is perhaps the most compelling reason to own real estate directly as opposed to owning REIT stock, especially during periods where equities may be fully-priced and potentially facing more near-term downside risk than upside potential.

Greater Ability To Use Leverage

Buying property directly often gives you the ability to use a higher level of debt financing than is typical in the REIT universe, as institutional investors frown on REITs that employ more than 40% leverage. By contrast, an individual investor buying an investment home can borrow up to 80% to 95% of its value depending on your personal financial status and the financial institute. So instead of putting $20,000 into a REIT, you could use it as a down payment and obtain $80,000 in financing for a $100,000 investment property and reap the gains of the entire asset appreciating in value over time. All things being equal, greater leverage can lead to higher returns on equity in upside scenarios.

Dividend Potential

Many equity REITs have annual dividends in the range of 2-3% or less while owning individual properties could generate annual distributions of 5-8%. This disparity results from the fact that REITs: 1) often focus on institutional quality assets and markets that have relatively low yields; 2) have corporate overhead costs to cover; and 3) want to avoid the risk of having to lower their dividends in the future — and thus only pay out a conservative level they believe to be sustainable. As a result, REIT dividends tend to be lower but also highly predictable.

Building Equity

While REIT investors can generate capital gains as the share price ideally increases over time, when you buy an investment property, you’re continuously building equity in a tangible asset. All the while, the tenant is paying your mortgage and your equity stake can increase as the value of the asset typically appreciates over the long term. Having more equity in your asset also gives you the ability to refinance over time and use the proceeds to buy additional assets and grow your portfolio.  

Control Over Your Investment Strategy

For many investors, having full control and owning the asset outright holds major appeal. You decide what markets and assets to invest in, how much debt to employ, whether to manage yourself or use a professional property manager, and you sign off on big decisions such as when to make capital improvements or sell properties. While direct investing can take a bit more effort, the payoff could be higher returns and some insulation from the volatility of the stock market.  



?REITS :

Liquidity

Immediate liquidity is perhaps the single greatest advantage of owning shares in a REIT. Like any other stock, it can be sold through your brokerage account at a market-clearing price at a relatively low cost. Depending on the type of assets, selling real estate that you own directly takes more time and can have much higher transaction costs if you sell through traditional brokerage channels.

Low Minimum Investment

While you can buy a REIT share for $10 or less, it, of course, takes more capital to own properties directly. For example, in order to qualify for attractive financing to purchase investment homes, you typically need to put down at least 20% of the value of the home. Additionally, if you are concerned about the potential for expenses to be higher than your revenues in a particular month due to non-recurring expenses or maintenance, it is a good practice to maintain a contingency “slush fund" of 1-2% of the total purchase price for general repairs and times when the property may be between tenants. If you are looking to get some exposure to the real estate industry and want to dip your toe in the water, REITs are a great way to get started.

Diversification

REITs offer geographic and asset-level diversification. Most specialize in a specific type of property, which means you can own shares in office buildings, single-family rental homes, apartments, hotels, self-storage units and more. As a direct investor, achieving that level of diversification is challenging without substantial capital upfront. Some investors mitigate this risk by purchasing multiple properties and/or buying in markets where they do not reside in order to ensure all of their eggs are not in one basket.  

Passive Ownership

REITs require no oversight on your part since management is outsourced to professionals and field experts. While some investors crave more control and direct exposure to hard assets — and the potentially outsized returns that can be generated with this strategy — others will find the passive nature of investing in REITs or other private real estate funds more attractive if they are looking for a completely hands-off solution.

 

Conclusion

Whether it’s direct investment, buying shares in a REIT, house hacking, house flipping or even working for sweat equity, there are many paths to becoming a real estate investor. All of them have pros and cons and varying degrees of risk and reward(you have to do your homework and treat it as a business). Rather than ask “which is best?” start by asking “which is best for me?” I find having a combination of direct investment and REIT ownership works well as a strategy to get balanced exposure across geographies and property types.

 

For reference, I own shares of XRE and VRE in the Canadian market. I also own a few International REITs