REITs vs Rentals: What’s the Best Way to Invest in Real Estate?
There are several ways to invest in real estate. If you are interested in becoming a real estate investor, you may have looked into different ways real estate can create passive income. You may have considered purchasing a rental property, house hacking, or flipping houses.
But what if you wanted to invest in real estate without getting your hands dirty with repairs or engaging with tenants? You could invest in real estate, earn passive income, and build wealth by investing in real estate investment trusts (REITs).
Before you dive into real estate by buying a rental property or investing in REITs, read this article. It will outline the difference between rental properties and REITs and discuss the pros and cons of both. I am invested in both and can tell you first hand how my experience has been.
When you invest in the right rental property, you have the potential to earn a good return on your investment. For an investor who has the knowledge and time to find and manage rental properties, any of the benefits below is possible.
Benefits of a Rental Property
Rental property cash flow: Rental income is a major perk of investing in rental properties. It’s important to run the numbers. Before purchasing a rental property, write down your best estimates of the property’s monthly and yearly expenses. Then, make sure your estimated expenses do not exceed the rental income you will collect from the tenant. You have a positive cash flow if you have a positive number after subtracting your expenses from your rental income.
Asset appreciation: In addition to cash flow, rental properties can earn money through appreciation. As a rental property owner, you can directly benefit from the equity in the investment property. If the value of the property goes up, so does your potential profit when you sell the investment property.
Tax deductions: Real estate investors can deduct from their taxes a majority of the expenses incurred as a result of managing the property. For example, legal fees, insurance payments, property taxes and maintenance are all expenses you may incur as a real estate investor. All of these expenses are tax-deductible. With each deduction, you lower your taxable income.
Cons of Investing in Rental Properties
With ownership of rental property comes great responsibility. If you aren’t careful, a lucrative investment can suddenly become a money pit. Real estate investors can face rental vacancies, evictions and costly repairs. Before investing in real estate, consider these potential drawbacks.
Steep learning curve: If you lack experience with investing in real estate, it’s important to get educated before investing. You may need to learn about occupancy rates, renovation costs, and calculating return on your investment. There are also several different ways to invest in real estate; you may want to research which method is best for you.
Learning takes time, but there are several ways to cut your learning curve in half. You can read books about real estate investing, read blogs on websites like Bigger Pockets, or listen to podcasts. Another option is to invest in real estate with a partner who has more expertise than you or find a mentor to guide you through the process.
Time: Investing in real estate takes time. Although you can hire a team of experts and even a property manager to handle the day-to-day functions of the property, you still need to be involved in the major decisions and expenses of your investment.
Investing in rental properties is an active form of real estate investing. If you decide not to hire a property manager, you’ll have to look for a tenant, get leases signed, handle repairs, conduct evictions and more. Without a property manager, you get to keep more of the profit, but at the valuable cost of your time.
It’s important to stay on top of maintenance and repairs or the tenant could deduct money from the rent, file a complaint with the city, sue, or, worse, move out. All of these things could impact your rental property’s profitability.
Money: Real estate investing requires capital. To purchase a property, you need a down payment, a loan, or both. You need money to make money in this line of business. If you take out a loan to purchase a rental property, your interest rate now becomes another expense you have to take into consideration when running your numbers. Your rental income must cover your mortgage payment, repairs and maintenance, and any other fees associated with your rental property in order for the investment to yield cash flow.
If you don’t have enough money to purchase a rental property, you could look for other real estate investors willing to invest with you. However, this means you’ll have to give your partner a portion of the profits, which cuts into your cash flow.
A real estate investment trust (REIT) is a company that invests in commercial real estate. REITs give real estate investors the ability to invest in income-producing real estate without the need to buy the entire property. REITs are a passive way to invest in real estate.
Benefits of Investing in REITs
Regular cash flow: Rental properties provide monthly rental income. On the other hand, REITs provide monthly cash flow through dividend payments. Investors are paid dividends on a monthly or quarterly basis. Although dividend amounts can vary, by law, REITs are required to pay out at least 90% of their taxable income to investors as dividends.
Passive income: With REITs, you provide the capital and someone else does all the work. The managers of a REIT find the commercial real estate investments, hire property managers to handle the day-to-day responsibilities, and evaluate opportunities to make the best purchase. You simply sit back and enjoy the returns in the form of interest earned. If you purchase publicly-traded REITs, you will benefit from the dividends paid and any increased value of the REIT on the stock market.
No experience needed: Although you should do your own research and due diligence before making any investments, you do not need to know the ins and outs of investing in rental properties or real estate to invest in REITs. Remember, someone else is handling the daily duties and doing the due diligence on each commercial investment.
Low costs to enter: REITs have different minimum amounts required for investors. That amount may vary depending on if the REIT is publicly traded or a private REIT. However, since so many REITs exist, you can do your research to find ones you can afford. Some REITs require an investment of $1,000 or less. Here are some of the best REITs you can invest in now.
Diversification: It can take some investors years to build a diversified real estate portfolio with different types of rental properties in different markets. That level of investment requires capital, time and effort. Plus, you could have obstacles or challenges along the way.
With REITs, you get immediate diversification. Your investment is spread across several investment categories from the beginning. The diversification of REITs means you may not directly feel the impact of one tenant not paying rent or one property losing value. REIT diversification means you could have other properties in that same portfolio that are profitable and performing well.
Cons of Investing in REITs
Investment volatility: If you invest in publicly traded REITs that are traded on the stock market, your REIT may experience volatility. Your REIT could change in value due to the ups and downs of the stock market regardless of whether the value of the commercial properties in the REIT have changed.
However, non-traded (or private) REITs will not have the same volatility. Their value can fluctuate, but their value depends on the real estate the REIT owns. If the value of the real estate decreases, so could the value of the REIT.
No control: Some real estate investors appreciate not being involved in the daily decisions or work that come with active real estate investing. However, when you invest in a REIT you also cannot control what investments are purchased. You are not able to dictate those activities when you are simply investing in a REIT.
What’s Best for You?
I chose to invest in a REIT and rental properties. My investment in a REIT allowed me to dive into commercial real estate without the large costs normally associated with commercial properties.
However, I still appreciate a good rental property, too. I like the monthly cash flow and light property renovations but I am less interested in evictions, repairs and screening tenants. Because I understand my likes and dislikes, I have chosen to hire a property manager for my rental properties and invest in REITs for more passive income and diversification.
My investment strategy is working for me. Each investor has to come to their own conclusions about what they like and dislike. To get started, write a list of your investment goals. Second, write down the pros and cons of each option. Then, invest in a method that is best for your risk tolerance, finances and lifestyle.
Many real estate investors have been able to build enough passive income to sustain their lifestyle, achieve financial freedom, and, in some cases, retire early. Take your time, build your investment portfolio, and then allow your money to work for you.
If you have strong feelings about investing in rental properties versus investing in REITs, we want to hear from you. Please comment below about the form of investment that has worked best for you.