The real estate market currently offers an impressive variety of options for investors, which can sometimes make it difficult to decide which route or strategy to take. For example, investors might find themselves choosing between a direct investment in real estate and purchasing shares in a real estate investment trust (REIT).
To explore this further, let’s look at some of the key differences between direct real estate investments and REITs, as well as some of the pros and cons of both options.
Real estate investments provide an opportunity to diversify through assets that are typically uncorrelated to the stock market. Investors looking to generate additional income and, in some cases, intermediate or long-term wealth often find real estate investments an attractive option. Additionally, investors can choose from a wide variety of locations, property types, stages of development, and classes to diversify in a way that suits their individual ambitions and risk appetites.
As typically uncorrelated, fixed-income assets, real estate investments are great for diversifying any portfolio. Beyond diversification, direct investments provide the opportunity to identify new regions and local economies that could potentially behave differently—i.e., more favorably—than other assets in the broader real estate market.
The real estate investment space also features constant innovation, as investors today have more access to unique opportunities than ever before. For example, investors can make a direct investment in the form of a bridge loan, a high-yielding, short-duration product that assists financial development companies that may be suffering from capital constraints. This might include funding an ongoing construction project, or providing short-term liquidity to a company while their assets are tied up in the development phase. Or if investors are looking to defer, reduce, or eliminate capital gains taxes related to their investment, they can choose to fund projects in Qualified Opportunity Zones (QOZs), another new development put in place by the U.S. government to spur economic growth in low-income communities.
Direct investments in real estate can be incredibly high-risk, particularly for novice investors. The liquidity risk of investing in the physical development of a structure, for example, is quite significant, especially when the economy is trending downward. Additionally, when it comes time to sell a property, the associated brokerage fees can quickly eat into your overall returns.
Moreover, a lack of public availability when it comes to material information can be a huge challenge. Unfortunately, it is not uncommon for dealers’ and investors’ incentives to be fundamentally misaligned, leading to unanticipated tension and, in the worst cases, long and costly legal battles. This is why it’s always important to work with outside parties and domain experts with whom you are familiar and can trust throughout the lifecycle of the investment.
REITs allow investors to have access to a diversified real estate portfolio without needing to participate directly in the development of any project. While they come in a variety of structures, a typical REIT is a company that owns, operates, or finances real estate and other fixed-income-producing assets. Because traditional REITs are publicly traded, investors can easily purchase shares on a national exchange.
REITs are formed and operate around different strategies. An equity REIT, for example, is a company that focuses on funding the underlying properties directly, whether it’s the construction of office buildings or the management of hotels or apartment complexes. Mortgage REITs, by contrast, are typically formed around the purchasing of asset-backed securities or providing real estate loans.
REITs have to be registered with the SEC, and are therefore subject to various regulations, including the requirement to pay 90% of the company’s taxable income in the form of shareholder dividends each year. While non-publicly traded REITs exist, they tend to come with higher fees and more limited options for liquidity.
For investors with limited access to liquid capital or a lack of experience in the real estate market, the pooled approach of REITs can make them a viable alternative investment strategy. Investors will not only gain immediate access to an income-producing product, but also to one that is managed by a team of experienced professionals. Additionally, the publicly-traded nature and low capital requirements of equity REITs are often attractive to those who want to make a smaller investment, as well as reserve the right to buy and sell their shares with very few liquidity constraints.
There are also potential tax benefits to consider when investing in REITs. Because the decision to buy or sell shares is at the discretion of the investor, income typically isn’t taxed before the distribution of dividends as in a large company, but rather individual profits are taxed the same as ordinary income.
Lastly, investors may want the right to turn bearish on the real estate market if they believe it will underperform, and equity REITs provide the easiest way to short a real estate project without years of experience or the need to acquire expensive derivatives. With REITs, speculative investors can freely place long or short bets based on their own independent analysis of the market.
The underlying assets contained in REITs, as well as the associated risks, can sometimes be difficult for the average investor to comprehend, and some may not be comfortable moving forward based on simple summary statistics.
Although it is often less involved, investing in REITs could potentially be more expensive than taking a direct real estate investing approach, depending on the project(s) in question. Investors should expect REITs to come with certain fees, such as those charged to pay for the fund managers’ salaries.
For investors seeking a differentiated, income-driven investment product, the real estate asset class offers a wide variety of structures and options. As with any investment, deciding between REITs or a more direct approach is ultimately a matter of means and preference. Those with adequate real estate experience and a desire to get their hands dirty might want to dive into the direct investment of their choice. On the other hand, those looking to invest alongside established professionals, as well as avoid the complex responsibilities and tax requirements associated with development, may find REITs the more attractive choice.
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