Investors who are considering entering the real estate market have some interesting options. For example, investors can purchase shares in real estate investment trusts (REITs) or make direct investments. These are just two examples of ways to invest in real estate. Let’s explore the key differences between REITS and direct real estate investments, as well as some of the pros and cons of each option.
REITs give investors access to a diversified real estate portfolio. These come in a variety of structures. The typical REIT—a company that owns, operates, or finances real estate and other fixed income producing-assets—has publicly traded shares that can be purchased on a national exchange.
A REIT company may fund the underlying properties directly. These companies, known as equity REITs, are typically involved in the construction of office buildings or the management of apartments or hotels. Alternatively, mortgage REITs may purchase asset-backed securities or make direct real estate loans.
REITs must register with the SEC, and they’re subject to various regulations, most notably the requirement to pay 90% of the company’s taxable income in the form of shareholder dividends each year. There are also REITs that are not traded on an exchange, have potentially hefty fees, and more limited liquidity options.
The result is that a REIT provides access to a diversified pool of real estate investments that are almost impossible for the typical investor to create on their own.
The typical retail investor may not have enough liquid capital to take a diversified approach to the real estate market. They also may not have the expertise to assess the risks of a real estate investment. These investors may prefer a pooled approach to real estate. A REIT may be a great alternative. Investors not only get access to an income-producing product, but also to one that’s managed by professional real estate investors. Equity REITs, which are traded on national exchanges, have low capital requirements because investors are buying a share of the trust. Since it’s traded on the public equity market, an investor can buy and sell these assets with few liquidity constraints.
REIT investors are also taxed more favorably on income from the investment. Income is not typically taxed at a corporate level because the income from these pooled real estate assets is passed through to the investor. Unlike a large company where all income is taxed before distributing dividends, REIT investors receive profits as ordinary income.
Lastly, investors in real estate may not always be bullish on the space. Unwinding and subsequently shorting a real estate project without using an equity REIT would require considerable savvy and potentially even the use of expensive derivatives. In contrast, REITs allow speculators to go long or short, depending on their market view.
REITs are a massive pool of assets that make understanding the underlying risk quite difficult. An average investor may struggle to comprehend the portfolio beyond simple summary statistics.
REITs can also be more expensive than a direct lending approach. Fees charged for REIT managers’ salaries, for example, can eat into investors’ income. Savvy real estate investors with enough capital to diversify may be able to achieve higher returns by managing assets themselves.
Real estate investments can offer a diversified investment, typically uncorrelated to the stock market, for those seeking income and, in some cases, intermediate or long-term wealth generation. A real estate investor can invest in a wide variety of locations, property types, stages of development, and real estate classes to help diversify their portfolio.
Real estate investments are popular for several reasons. Investors enjoy the benefits of this typically uncorrelated, fixed-income asset to diversify portfolios of all sizes. The real estate market may provide direct access to new regions and allows investors to invest in local economies that may behave differently than macro trends.
This space is constantly innovating. Investors today have access to many unique structures. Bridge loans are one option for investors seeking a high-yielding, short-duration product. These loans help finance development companies with short-term capital constraints, which may include construction projects that need capital to be completed on time or a company looking to expand while assets are tied up in uncompleted projects.
Qualified Opportunity Zones (QOZ) are another new development in the real estate space. These projects are funded in areas of lower economic health. Part of the perks of investing in QOZ are deferred, reduced, or no taxes on capital gains, depending on where funds are generated. These perks mean investors who have previously earned in QOZ may reinvest since they pay no taxes on their earnings. These investments are designed to spur economic growth in low-income communities.
A direct investment in real estate does not come without risk. The liquidity risk of investing in the physical development or construction of a project is considerable, especially during economic downturns. The brokerage fees that come with selling a real estate project can eat into returns, compared to REITs.
Furthermore, the public availability of material information is not always present. It’s important to work with trusted parties and domain experts when dealing with real estate investments because dealers’ incentives are often misaligned.
For investors seeking a differentiated, income-driven investment product, the real estate asset class offers a wide variety of structures and options. Regardless of your portfolio size or liquidity constraints, real estate investing can be a great option for investors looking for typically uncorrelated, diversified fixed income. Asset-based lending provides the investor security, and experienced real estate managers help reduce risks when making a real estate investment. Through bridge loans and other short-term structures, a direct investor may be able to generate a balanced return with relatively short duration.
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